Monetary Theory and Policy

Monetary Theory and Policy

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Monetary Theory and Policy

Second Edition

Carl E. Walsh

The MIT Press

Cambridge, Massachusetts

London, England

6 2003 Massachusetts Institute of Technology

All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical

means (including photocopying, recording, or information storage and retrieval) without permission in

writing from the publisher.

This book was set in Times New Roman on 3B2 by Asco Typesetters, Hong Kong and was printed and

bound in the United States of America.

Library of Congress Cataloging-in-Publication Data

Walsh, Carl E.

Monetary theory and policy / Carl E. Walsh. — 2nd ed.

p. cm.

Includes bibliographical references and index.

ISBN 0-262-23231-6

1. Monetary policy. 2. Money. I. Title.

HG230.3.W35 2003

332.40

6—dc21 2002044919

To Judy

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Contents

Preface xvii

Introduction 1

1 Empirical Evidence on Money, Prices, and Output 9

1.1 Introduction 9

1.2 Some Basic Correlations 9

1.2.1 Long-Run Relationships 9

1.2.2 Short-Run Relationships 12

1.3 Estimating the E¤ect of Money on Output 15

1.3.1 The Evidence of Friedman and Schwartz 15

1.3.2 Granger Causality 20

1.3.3 Policy Uses 21

1.3.4 The VAR Approach 24

1.3.5 Structural Econometric Models 35

1.3.6 Alternative Approaches 37

1.4 Summary 40

2 Money-in-the-Utility Function 43

2.1 Introduction 43

2.2 The Basic MIU Model 45

2.2.1 Steady-State Equilibrium 51

2.2.2 The Interest Elasticity of Money Demand 56

2.2.3 Limitations 59

2.3 The Welfare Cost of Inflation 59

2.4 Extensions 64

2.4.1 Interest on Money 64

2.4.2 Nonsuperneutrality 65

2.5 Dynamics in an MIU Model 67

2.5.1 The Steady State 70

2.5.2 The Linear Approximation 72

2.5.3 Calibration 74

2.5.4 Simulation Results 76

2.6 Summary 80

2.7 Appendix: Solving for the Dynamics in the MIU Model 80

2.7.1 The Decision Problem 80

2.7.2 Functional Forms 83

2.7.3 The Steady State 84

2.7.4 The Linear Approximation 85

2.7.5 Solving Linear Rational Expectations Models with Forward￾Looking Variables 88

2.8 Problems 90

3 Money and Transactions 95

3.1 Introduction 95

3.2 Shopping Time Models 96

3.3 CIA Models 100

3.3.1 The Certainty Case 101

3.3.2 A Stochastic CIA Model 111

3.4 Other Approaches 118

3.4.1 Real Resource Costs 118

3.4.2 Search 120

3.5 Summary 126

3.6 Appendix: The CIA Approximation 127

3.6.1 The Basic Decision Problem 127

3.6.2 The Steady State 129

3.6.3 The Linear Approximation 130

3.7 Problems 131

4 Money and Public Finance 135

4.1 Introduction 135

4.2 Budget Accounting 136

4.2.1 Intertemporal Budget Balance 141

4.3 Money and Fiscal Policy Frameworks 144

4.3.1 Fiscal Dominance, Deficits, and Inflation 145

4.3.2 The Fiscal Theory of the Price Level 164

4.4 Optimal Taxation and Seigniorage 172

4.4.1 A Partial Equilibrium Model 173

4.4.2 Optimal Seigniorage and Temporary Shocks 177

4.4.3 Friedman’s Rule Revisited 178

4.5 Nonindexed Tax Systems 192

4.6 Summary 194

4.7 Problems 195

viii Contents

5 Money, Output, and Inflation in the Short Run 199

5.1 Introduction 199

5.2 Flexible Prices 200

5.2.1 Imperfect Information 200

5.2.2 Limited Participation and Liquidity E¤ects 208

5.3 Nominal Rigidities 211

5.3.1 Wage Rigidity in an MIU Model 211

5.3.2 Imperfect Competition and Price Stickiness 216

5.3.3 Inflation Persistence 223

5.4 A New Keynesian Model for Monetary Analysis 230

5.4.1 The Basic Model 232

5.4.2 Evaluating the New Keynesian Inflation Adjustment Equation 240

5.4.3 General Equilibrium 244

5.5 Sticky Wages and Prices 254

5.6 Summary 255

5.7 Appendix 256

5.7.1 An Imperfect-Information Model 256

5.7.2 A Sticky-Wage MIU Model 261

5.7.3 The New Keynesian Phillips Curve 263

5.8 Problems 266

6 Money and the Open Economy 269

6.1 Introduction 269

6.2 The Obstfeld-Rogo¤ Two-Country Model 270

6.2.1 The Linear Approximation 274

6.2.2 Equilibrium with Flexible Prices 275

6.2.3 Sticky Prices 282

6.3 Policy Coordination 287

6.3.1 The Basic Model 288

6.3.2 Equilibrium with Coordination 292

6.3.3 Equilibrium Without Coordination 293

6.4 The Small Open Economy 297

6.4.1 Flexible Exchange Rates 299

6.4.2 Fixed Exchange Rates 303

6.5 Open-Economy Models with Optimizing Agents and Nominal

Rigidities 305

Contents ix

6.5.1 A Basic Open-Economy Model 305

6.5.2 The Flexible-Price Equilibrium 309

6.5.3 Deviations from the Flexible-Price Equilibrium 310

6.5.4 Extensions 312

6.6 Summary 314

6.7 Appendix 315

6.7.1 The Obstfeld-Rogo¤ Model 315

6.7.2 The Small Open-Economy Model 318

6.8 Problems 319

7 The Credit Channel of Monetary Policy 323

7.1 Introduction 323

7.2 Imperfect Information in Credit Markets 326

7.2.1 Adverse Selection 327

7.2.2 Moral Hazard 331

7.2.3 Monitoring Costs 332

7.2.4 Agency Costs 337

7.3 Macroeconomic Implications 340

7.3.1 A Simple Model with Bank Loans 340

7.3.2 General Equilibrium Models 345

7.3.3 Agency Costs and General Equilibrium 351

7.3.4 Agency Costs and Sticky Prices 354

7.4 Does Credit Matter? 356

7.4.1 The Bank Lending Channel 357

7.4.2 The Broad Credit Channel 360

7.5 Summary 361

8 Discretionary Policy and Time Inconsistency 363

8.1 Introduction 363

8.2 Inflation Under Discretionary Policy 365

8.2.1 Policy Objectives 365

8.2.2 The Economy 368

8.2.3 Equilibrium Inflation 370

8.3 Solutions to the Inflation Bias 378

8.3.1 Reputation 379

8.3.2 Preferences 393

x Contents

8.3.3 Contracts 397

8.3.4 Institutions 403

8.3.5 Targeting Rules 405

8.4 Is the Inflation Bias Important? 412

8.5 Do Central Banking Institutions Matter? 419

8.6 Summary 425

8.7 Problems 425

9 Monetary-Policy Operating Procedures 429

9.1 Introduction 429

9.2 From Instruments to Goals 430

9.3 The Instrument Choice Problem 431

9.3.1 Poole’s Analysis 432

9.3.2 Policy Rules and Information 436

9.3.3 Intermediate Targets 439

9.3.4 Real E¤ects of Operating Procedures 447

9.4 Operating Procedures and Policy Measures 448

9.4.1 Money Multipliers 449

9.4.2 The Reserve Market 451

9.4.3 Reserve Market Responses 458

9.4.4 A Brief History of Fed Operating Procedures 462

9.4.5 Other Countries 469

9.5 Problems 471

10 Interest Rates and Monetary Policy 473

10.1 Introduction 473

10.2 Interest-Rate Rules and the Price Level 474

10.2.1 Price-Level Determinacy 474

10.2.2 Interest-Rate Policies in General Equilibrium 480

10.2.3 Liquidity Traps 484

10.3 The Term Structure of Interest Rates 488

10.3.1 The Expectations Theory of the Term Structure 489

10.3.2 Policy and the Term Structure 491

10.3.3 Expected Inflation and the Term Structure 496

10.4 Simple Models for Policy Analysis 499

10.4.1 A Closed-Economy Model 500

Contents xi

10.4.2 Optimal Policy 508

10.4.3 An Open-Economy Model 512

10.5 Summary 514

10.6 Problems 515

11 Policy Analysis in New Keynesian Models 517

11.1 The Basic New Keynesian Model 517

11.2 Policy Objectives 518

11.3 Optimal Commitment and Discretion 523

11.3.1 Commitment 524

11.3.2 Discretion 526

11.3.3 Discretion Versus Commitment 527

11.3.4 Commitment to a Rule 529

11.3.5 Policy Trade-o¤s Under Discretion 531

11.3.6 Model Uncertainty 533

11.3.7 Endogenous Persistence 536

11.4 Extensions to the Open Economy 539

11.5 Targeting Regimes and Instrument Rules 540

11.5.1 Inflation Targeting 541

11.5.2 Other Targeting Regimes 545

11.5.3 Instrument Rules 546

11.6 Appendix 550

11.6.1 Approximating Utility 550

11.6.2 Solving for Optimal Policy 555

11.7 Problems 556

References 559

Name Index 593

Subject Index 601

xii Contents

Figures

1.1: Dynamic Correlations, GDPt and Mtþj: 1967:1–2000:4 12

1.2: Dynamic Correlations, Output, Prices, and Interest Rates: 1967:1–

2000:4 14

1.3: Detrended Money and Real GDP 16

1.4: Interest Rates and Detrended Real GDP 18

1.5: Output and Price Response to a Funds-Rate Shock (1965–2001) 31

1.6: Output and Price Response to a Funds-Rate Shock (1965–1979) 32

2.1: Steady-State Real Balances (Separable Utility) 56

2.2: The Welfare Costs of Inflation 61

2.3: Output and Labor Responses to a Money Growth Shock 78

2.4: Nominal Interest Rate and Inflation Response to a Money Growth

Shock 79

3.1: Output and Labor Response to a Money Growth Shock 118

3.2: Nominal Interest Rate and Inflation Response to a Money Growth

Shock 119

4.1: Seigniorage as a Function of Inflation 158

4.2: Money Growth and Seigniorage Revenue 160

4.3: Equilibrium with a Fixed Nominal Money Supply 167

4.4: U.S. Deficits and Seigniorage 1909–1986 (as a percentage of GDP) 177

5.1: The E¤ects of a Money Shock with Staggered Price Adjustment 222

5.2: Change in Inflation Versus Unemployment (1960–1998) 241

5.3: Output, Inflation, and Real Interest Rate Responses to a Policy

Shock in the New Keynesian Model 248

6.1: Nominal Exchange Rate Response to a Monetary Shock 301

7.1: Expected Loan Profit with Adverse Selection 330

8.1: Equilibrium Inflation Under Discretion (Linear Objective Function) 372

8.2: Equilibrium Inflation Under Discretion (Quadratic Loss Function) 374

8.3: Temptation and Enforcement 381

8.4: The Optimal Degree of Conservatism 395

8.5: Average Inflation Versus Central Bank Independence 420

9.1: The Reserves Market 459

9.2: The Reserves Market Response to a Reserve Demand Increase 460

9.3: Federal Funds Rate, 1965–2001 465

10.1: The Dynamics of a Liquidity Trap 486

10.2: Short- and Long-Term Interest Rates: 1967–2001 497

10.3: Response to a Policy Shock (Baseline Parameters) 505

10.4: Output Response to a Demand Shock Under Alternative Policy

Rules 506

10.5: Inflation Response to a Demand Shock Under Alternative Policy

Rules 507

10.6: Inflation Coe‰cient in the Interest Rate Rule 511

10.7: Response to a Home Policy Shock 513

10.8: Response to a Foreign Policy Shock 514

11.1: Output Gap Response to a Cost Shock: Timeless Precommitment

and Pure Discretion 528

11.2: Response of Inflation to a Cost Shock: Timeless Precommitment

and Pure Discretion 529

11.3: Equilibrium Output Gap and Inflation Under Discretion 532

11.4: The E‰ciency Frontier Under Discretion and the Social Marginal

Rate of Substitution Between s2

p and s2

x 533

11.5: Responses to a Cost Shock with Endogenous Persistence ðf ¼ 0:5Þ 539

xiv Figures