DOBRI AN ON RECENT TRENDS IN MONETARY POLICIES THE MONETARY TRANSMISSION MECHANISM AND OPEN MARKET OPERATIONS DORIN DOBRI AN Spiru Haret University ABSTRACT. Bar-Ilan and Seidmann analyze the co-determination of monetary policy and the labor contracts chosen by members of the public, who can either fix or index their nominal wages. Mateut et al. investigate the role of trade credit in the transmission of monetary policy: most models of the transmission mechanism allow firms to access only financial markets or bank lending according to some net worth criterion. Gerlach-Kristen shows that it is preferable for monetary policy to be conducted by a committee instead of a single policy maker if there is uncertainty about potential output. Chowdhury et al. apply a structural approach to examine the relevance of the cost channel for inflation dynamics in G7 countries: since firms’ costs of working capital increase with interest rates, they augment a (hybrid) New Keynesian Phillips curve by including the short-run nominal interest rate. Chowdhury et al. find significant and varying direct interest rate effects for the majority of countries, including member countries of the EMU; the estimated interest rate coefficients can substantially affect inflation responses to monetary policy shocks, and can even lead to inverse inflation responses, when the cost channel is (relative to the demand channel) sufficiently strong.1 Bar-Ilan and Seidmann analyze the co-determination of monetary policy and the labor contracts chosen by members of the public, who can either fix or index their nominal wages. As Bar-Ilan and Seidmann put it, fixed nominal wages allow the central bank to offset productivity shocks, while the public fix nominal wages in response to the central bank offsetting shocks: so there is an equilibrium in which, realistically, nominal wages are fixed and shocks offset. Bar-Ilan and Seidmann say that there may be equilibria in which agents index their nominal wages, and the central bank optimally 158 responds by stabilizing price (the central bank does not deviate for fear that agents would change their labor contracts such that the central bank's least favored equilibrium will subsequently be played).2 Mateut et al. investigate the role of trade credit in the transmission of monetary policy: most models of the transmission mechanism allow firms to access only financial markets or bank lending according to some net worth criterion. Mateut et al. consider external finance from trade credit as an additional source of funding for firms that cannot obtain credit from banks, and predict that when monetary policy tightens there will be a reduction in bank lending relative to trade credit.3 Ciccarelli and Rebucci study empirically the transmission mechanism of European monetary policy by means of time-varying, heterogeneous coefficient models estimated in a numerical Bayesian fashion. Based on pre-European Monetary Union evidence from Germany, France, Italy, and Spain, Ciccarelli and Rebucci find that (i) the long-run cumulative impact on output of a common, homoskedastic monetary policy shock has decreased in all countries after 1991; these declines are statistically significant and accompanied by some changes in the conduct of monetary policy over the same period.4 According to Bratolini and Prati, volatility patterns in overnight interest rates display differences across industrial countries that existing models (designed to replicate the features of individual countries’ markets) cannot account for. Bratolini and Prati present an equilibrium model of the overnight interbank market that matches cross-country differences in patterns in interest volatility by incorporating differences in how central banks manage liquidity in response to shocks; their model is consistent with central banks’ practice of rationing access to marginal facilities when the objective of stabilizing short-term interest rates conflicts with another high-frequency objective, such as an exchange rate target.5 Gerlach-Kristen shows that it is preferable for monetary policy to be conducted by a committee instead of a single policy maker if there is uncertainty about potential output, and examines three decision procedures (an optimal procedure, averaging and voting), finding that the latter is the appropriate way to reach 159 decisions if policy makers are not equally skilled. Gerlach-Kristen demonstrates that efficient decision procedures reduce the persistence of shocks.6 Leith and Malley derive a general equilibrium model based on optimising behaviour, which also implies a data consistent framework for monetary policy analysis. Their model accounts for nominal inertia in both price and wage setting as well for habits in consumption. Using US and European data from 1970 to 1998 Leith and Malley’s parameter estimates reveal that (i) price contracts last for 8 months and 13 months in the US and Euro-area, respectively; (ii) wage contracts have a length of 7 months and 1.75 years in the US and Europe, respectively; (iii) the extent of backward-looking behaviour in price setting is statistically significant in both economies with 41% of price contracts in the US and 28% in the Euro-area set according to a simple rule-of-thumb; (iv) backward-looking wage setting is only present in Europe with 17% of contracts set in a backward-looking manner; and (v) similar habits effects are present in both European and US consumption. Leith and Malley simulate the effects of monetary policy by considering the impact of a 1 point increase in nominal interest rates for one quarter. Their parameter estimates imply that there is a relatively muted inflationary response to interest rate increases in Europe (price inflation falls by -0.08% in Europe and 0.11% in the US) and there is a correspondingly large output response (-0.2% in the US and -0.6% in Europe).7 Dedola and Lippi study the monetary transmission mechanism using disaggregated industry data from five industrialized countries, and document the cross-industry heterogeneity of monetary policy effects, relating it to industry characteristics suggested by monetary transmission theories. Dedola and Lippi find that sizable and significant cross-industry differences in the effects of monetary policy (such differences swamp the hardly detectable cross-country variability). Sectoral output responses to monetary policy shocks are systematically related to the industry output durability, financing requirements, borrowing capacity and firm size.8 Holden argues that a strict monetary regime may reduce equilibrium unemployment by disciplining wage setters, as wage setters abstain from raising wages to avoid a monetary contrac160 tion, and that precisely because a strict monetary regime may discipline the unco-ordinated wage setting, thus lowering unemployment in the unco-ordinated outcome, it also reduces wage setters’ incentives to co-ordinate. Holden shows that an accommodating monetary regime may reduce equilibrium unemployment, via the strengthening of the wage setters’ incentives to coordinate.9 Strobel uses a two-country model where policymakers minimize Barro–Gordon-type loss functions over inflation, and inflation preferences follow geometric Brownian motions, to characterize and solve the optimal stopping problem describing a given country's decision of whether or not to pursue monetary integration with the other one, and derive the conditions under which monetary integration can, or will never, be an equilibrium outcome in our economy. Strobel carries out comparative statics analysis on the bounds characterizing these conditions and on the range of relative inflation preference parameters that support monetary integration in equilibrium.10 Coenen et al. perform a quantitative assessment of the role of money as an indicator variable for monetary policy in the euro area, and document the magnitude of revisions to euro area-wide data on output, prices, and money, and find that monetary aggregates have a potentially significant role in providing information about current real output. Coenen et al. proceed to analyze the information content of money in a forward-looking model in which monetary policy is optimally determined subject to incomplete information about the true state of the economy. Coenen et al. show that monetary aggregates may have substantial information content in an environment with high variability of output measurement errors, low variability of money demand shocks, and a strong contemporaneous linkage between money demand and real output. Coenen et al. conclude that money has fairly limited information content as an indicator of contemporaneous aggregate demand in the euro area.11 Schabert examines the effects of monetary policy shocks by exploiting the information contained in open market operations. A sticky price model is developed where money is the counterpart of securities deposited at the central bank. The model's solution reveals that a rise in central bank holdings of open market securities can be inter161 preted as a monetary expansion. Schabert provides estimates of vector autoregressions for US data, showing that reactions to an unanticipated rise in open market securities are consistent with common priors about a monetary expansion, i.e., a decline in the federal funds rate, a rise in output, and inertia in price responses.12 REFERENCES 1. Chowdhurya, I. et al., “Inflation Dynamics and the Cost Channel of Monetary Transmission”, in European Economic Review, 50 (4), 2006, pp. 995 1016. 2. Bar-Ilana, A. • Seidmann, D.J., “Endogenous Contract Structure and Monetary Policy”, in European Economic Review, 50 (4), 2006, pp. 1043 1060. 3. Mateut, S. et al., “Trade Credit, Bank Lending and Monetary Policy Transmission”, in European Economic Review, 50 (3), 2006, pp. 603 629. 4. Ciccarelli, M. • Rebucci, A., “Has the Transmission Mechanism of European Monetary Policy Changed in the Run-Up to EMU”, in European Economic Review, 50 (3), 2006, pp. 737 776. 5. Bartolini, L. • Prati, A., “Cross-Country Differences in Monetary Policy Execution and Money Market Rates’ Volatility”, in European Economic Review, 50 (3), 2006, pp. 349 376. 6. Gerlach-Kristen, P., “Monetary Policy Committees and Interest Rate Setting”, in European Economic Review, 50 (2), 2006, pp. 487 507. 7. Leith, C. • Malley, J., “Estimated General Equilibrium Models for the Evaluation of Monetary Policy in the US and Europe”, in European Economic Review, 49 (8), 2005, pp. 2137 2159. 8. Dedola, L. • Lippi, F., “The Monetary Transmission Mechanism: Evidence from the Industries of Five OECD Countries”, in European Economic Review, 49 (6), 2005, pp. 1543 1569. 9. Holden, S., “Monetary Regimes and the Co-Ordination of Wage Setting”, in European Economic Review, 49 (6), 2005, pp. 833 843. 10. Strobel, F., “Monetary Integration and Inflation Preferences: A Real Options Analysis”, in European Economic Review, 49 (4), 2005, pp. 845 860. 11. Coenen, G. et al., “Data Uncertainty and the Role of Money as an Information Variable for Monetary Policy”, in European Economic Review, 49 (4), 2005, pp. 975 1006. 12. Schabert, A., “Identifying Monetary Policy Shocks with Changes in Open Market Operations”, in European Economic Review, 49 (3), 2005, pp. 561 577. 162