Testing for neglected monetary effects on inflation

The ICM equation for aggregate consumer price inflation in Table 8.12 contains three key sources of inflation impulses to a small open economy: imported inflation including currency depreciation (a pass-through effect), domestic cost pressure (unit labour costs), and excess demand in the product market. Monetary shocks or financial market shocks may of course generate inflation
impulses in situations where they affect one or more of the variables associ­ated with these inflation channels. In this section, we will investigate another possibility, namely that shocks in monetary or financial variables have direct effects on inflation which have been neglected in the ICM...

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Summary and conclusions

The dominance of EqCMs over systems consisting of relationships between differenced variables (dVARs) relies on the assumption that the EqCM model coincides with the underlying data generating mechanism. However, that assumption is too strong to form the basis of practical forecasting. First, para­meter non-constancies, somewhere in the system, are almost certain to arise in the forecast period. The example in Section 11.2.1 demonstrated how allowance for non-constancies in the intercept of the cointegrating relations, or in the adjustment coefficients, make it impossible to assert the dominance of the EqCM over a dVAR...

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Money and inflation

The role of money in the inflation process is an old issue in macro­economics, yet money plays no essential part in the models appearing up to and including Chapter 7 of the book. In this chapter, we explore the relevance of monetary aggregates as explanatory variables for infla­tion. First, we derive money demand functions for the Euro area and, for Norway, and investigate whether these functions can be interpreted as inverted inflation equations. Second, we make a survey of inflation models that have been used in the recent past to analyse Euro area data. Moreover, we evaluate the models’ statistical properties and make fore­cast comparisons. Finally, we make a similar evaluation and comparison of Norwegian inflation models...

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Interest rates for government bonds RBOt and bank loans RLt

Finally, the model consists of two interest rate equations. Before the deregula­tion, so st = 0, changes in the bond rate RBOt are an autoregressive process, corrected for politically induced changes modelled by a composite dummy.

ARBOt = 0.12ARBOt_ i + 0.30sARSt + 0.95 sARWt (0.04) (0.03) (0.07)

— 0.02s • ecmRBo t-1 + 0.011RBOdumt (9.12)

(0.01) (0.001)

T = 1972(4)-2001(1) = 114

<r = 0.18%

Far(i-S)(5, 104) = 0.83[0.53]

Xnormality (2) = 0.46[0.80]

Fhetx2 (10,98) = 1. 61[0.11]

(Reference: see Table 9.2. The numbers in [..] are p-values.) where

RBOdumt = [*74q2 + 0.9*77q4 — 0.6*78q1 + 0.6*79q4 + *80q1 + *81q1 + *82q1 + 0.5*86q1 — 1.2*89q1]t.

After the deregulation, the bond rate reacts to the changes in the money – market rate sARSt as well as the foreign rate sARWt, with the long-ru...

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The New Keynesian Phillips Curve Model

Recall the definition in Chapter 7: the NPCM states that inflation is explained by expected inflation one period ahead E(Apt+i | It), and excess demand or marginal costs xt (e. g. the output gap, the unemployment rate, or the wage share in logs):

Apt = bpi E(Apt+i | It) + bp2’xt. (8.12)

The ‘hybrid’ NPCM, which heuristically assumes the existence of both forward – and backward-looking agents and obtains if a subset of firms has a backward-looking rule to set prices, nests (8.12) as a special case. This amounts to the specification

Apt = bp1E(Apt+i | It) + bpiApt-i + bp^xt. (8.13)

Our analysis in Chapter 7 leads to a rejection of the NPCM as an empir­ical model of inflation for the Euro area and we conclude that the profession should not accept the NPCM too readily...

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Relative loss calculations

So far we have summarised the counterfactual results through the effects on the mean and variability of a number of key variables. In the following we will investigate how the interest rate rules in Table 10.1 perform when we select different weights X, ф in the monetary authorities’ loss function. We write the loss function as a linear combination of the unconditional variances of output growth A4yt and underlying inflation, A4put, with a possible extension in terms of the variance of interest rate changes ARSt.

£(X, ф) = V[A4put] + XV[Д4yt] + фУ[ARSt]. (10.2)

In Table 10.3 we report the square root of the loss according to equation (10.2) for different values of central bank preference parameters (i. e. the weights X and ф)...

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