Advanced Search
MyIDEAS: Login

Monetary Policy Under Uncertainty, Regime Change and High Volatility

Contents:

Author Info

  • Emiliano Basco

    ()
    (Central Bank of Argentina)

  • Tomás Castagnino

    (Central Bank of Argentina)

  • Sebastián Katz

    ()
    (Central Bank of Argentina)

  • Sebastián Vargas

    (Central Bank of Argentina)

Abstract

Economic policy usually faces a number of risks and uncertainties, as a byproduct of the changing nature of signals, the economic structure, the interaction of aggregate variables, the mutations in the behavior of economic agents and their reaction to policy decisions. It is generally acknowledged that uncertainty poses a challenge to monetary policy making. In the recent years, a growing body of literature addresses the effect of a variety of sources of uncertainty in the design of monetary policy. However, this literature has mainly focused in developed economies albeit that the uncertainty phenomena is generally more severe in emerging countries. We overview recent progress in economic literature that emphasizes the influences of uncertainty over the design of monetary policy. This literature has its main focus on developed economies but, a fortiori, those considerations seem particularly appropriate for economies that are characterized by the presence of deep uncertainty about the “correct” model that governs economic interactions, the value of structural parameters, the main transmission mechanisms of monetary policy and the nature of the significant and recurrent shocks which affect them. Economies like Argentina, have shown a clear propensity to the gestation of macroeconomic instability and a high frequency of regime changes. In the paper we show that in this environment, the uncertainty that surrounds the decision making process can undermine the efficacy, margins, and hence, the credibility of monetary policy. Experience shows that under such environment, uncertainty is particularly deep-rooted. On the one hand, the magnitude and persistence of the shocks which these economies typically face and the absence of appropriate mechanisms to restore macroeconomic equilibrium have made the job of the policymaker particularly tough. On the other hand, the source of these shocks and uncertainty for economic agents can often be attributed to the own policy decisions. Thus, the instability and inconsistency of policies, together with the difficulties to meet intertemporal budget constraints have been a source of uncertainty in their own right. We discuss the macroeconomic functioning of these economies and intend to define the relation between aggregate volatility, macroeconomic disequilibrium, regime changes and uncertainty. With this in mind, we illustrate the empirical relevance of many of these arguments for the Argentine experience. The analysis focuses on the distinction between conventional aggregate instability episodes, and two types of crisis that, from our point of view, have mainly characterized our economies in the near past. Moreover, we emphasize the differential characteristics and consequences of episodes of deep nominal uncertainty and the shortening of planning horizons, on the one hand, and plan inconsistency and generalized breaks of contracts, on the other. Agents that face this adverse context are naturally involved in adaptive behavior, and have frequently exacerbated aggregate disequilibrium forces. This is partly because recurrent past policy failures have yielded very low credibility on current and future policies, implying well-grounded inquiries about the possibility of policy regime change. Hence, agents display a high demand for a visible anchor for expectations to reduce the uncertainty surrounding the conjectures about macroeconomic sustainability. In such conditions, usual monetary policy tradeoffs become much stronger, as deep uncertainty seems to call for predetermined rules to coordinate expectations, while on the other side, the engagement in unconditional monetary arrangements can complicate the absorption of shocks. Thus, it appears to be a reasonable strategy for monetary policy in emerging economies to preserve flexibility, while at the same time, meeting the objective of a stable nominal environment, helping to reduce volatility and crisis probability. The uncertainty and low credibility of policies have shown a tendency to mutually reinforce by mechanisms of negative interaction: the uncertainty of the environment has made the job of the policymakers tougher, but at the same time, uncertainty has been increased endogenously by the own policy decisions and actions. In this paper we emphasize that in the literature about uncertainty for developed economies, this feedback mechanism has usually been neglected or held under the ceteris paribus clause. Finally, we analyze the most relevant sources of dominance -fiscal, external and financial- that have characterized the formulation of monetary policy in our countries. Dominances are relevant because if agents perceive that the actions of the monetary authority are dominated its ability to achieve monetary policy goals could be severely undermined. In other words, the resurgence of solvency problems in the financial front, in the fiscal front, or a low demand for domestic assets under the perception of lack of external sustainability can create renewed pressures in the management of monetary policy. We conclude that although monetary policy should take into account potential sources of dominance, this should not generate doubts about the compromise of the authorities in providing a nominal anchor for expectations and contracts. If this is not the case, perverse interactions that magnify factors of potential dominance and intensify the already eroded state of credibility on monetary policy can emerge. In the presence of dominances, the best way to widen the action margins and increase the efficiency and power of monetary actions is to attack the origin of dominances and to design monetary schemes that specifically take into account its consistency with the rest of the macroeconomic policy. In a context of uncertainty, regime changes and in those situations where agents and authorities are involved in a learning process about the environment, it seems reasonable to keep policy options open avoiding irreversible courses of action. However, this attitude should not be interpreted as a synonym of full discretion. It is essential then, to have a clear and transparent communication strategy, associated to a monetary scheme whose institutionality gives high priority to the objective of price stability. If this is not the case, to resort to the notion of uncertainty would be a perfect excuse to reintroduce the absence of course in the conduction of policy, going against the possibility of recovering lost credibility.

Download Info

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
File URL: http://www.bcra.gov.ar/pdfs/investigaciones/WP%202007%2025.pdf
File Function: Spanish version (versión en Español)
Download Restriction: no

Bibliographic Info

Paper provided by Central Bank of Argentina, Economic Research Department in its series BCRA Working Paper Series with number 200725.

as in new window
Length: 72 pages
Date of creation: Nov 2007
Date of revision:
Handle: RePEc:bcr:wpaper:200725

Contact details of provider:
Postal: Reconquista 266 - C1003ABF - Buenos Aires
Phone: (54-11) 4348-3582
Fax: (54-11) 4000-1257
Email:
Web page: http://www.bcra.gov.ar
More information through EDIRC

Related research

Keywords: Argentina; credibility; crisis; macroeconomic volatility; monetary policy; regimen change; uncertainty;

Find related papers by JEL classification:

References

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
as in new window
  1. Calvo, Guillermo A, 1988. "Servicing the Public Debt: The Role of Expectations," American Economic Review, American Economic Association, vol. 78(4), pages 647-61, September.
  2. Svensson, Lars E O, 1999. "How Should Monetary Policy Be Conducted In An Era Of Price Stability?," CEPR Discussion Papers 2342, C.E.P.R. Discussion Papers.
  3. Williams, John C. & Levin, Andrew T. & Wieland, Volker, 2001. "The performance of forecast-based monetary policy rules under model uncertainty," Working Paper Series 0068, European Central Bank.
  4. James H. Stock & Mark W. Watson, 2003. "Has the Business Cycle Changed and Why?," NBER Chapters, in: NBER Macroeconomics Annual 2002, Volume 17, pages 159-230 National Bureau of Economic Research, Inc.
  5. Paul Jenkins & David Longworth, 2002. "Monetary Policy and Uncertainty," Bank of Canada Review, Bank of Canada, vol. 2002(Summer), pages 3-10.
  6. Woodford, Michael, 1997. "Doing Without Money: Controlling Inflation in a Post-Monetary World," Seminar Papers 632, Stockholm University, Institute for International Economic Studies.
  7. Frenkel, Roberto & Ros, Jaime, 2006. "Unemployment and the real exchange rate in Latin America," World Development, Elsevier, vol. 34(4), pages 631-646, April.
  8. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute, The.
  9. Walsh, Carl E., 2004. "Implications of a Changing Economic Structure for the Strategy of Monetary Policy," Santa Cruz Department of Economics, Working Paper Series qt84g1q1g6, Department of Economics, UC Santa Cruz.
  10. Cottani, Joaquin A & Cavallo, Domingo F & Khan, M Shahbaz, 1990. "Real Exchange Rate Behavior and Economic Performance in LDCs," Economic Development and Cultural Change, University of Chicago Press, vol. 39(1), pages 61-76, October.
  11. Ilan Goldfajn & Poonam Gupta, 1999. "Does monetary policy stabilize the exchange rate following a currency crisis?," Textos para discussão 396, Department of Economics PUC-Rio (Brazil).
  12. Philippe Aghion & George-Marios Angeletos & Abhijit Banerjee & Kalina Manova, 2005. "Volatility and Growth: Credit Constraints and Productivity-Enhancing Investment," NBER Working Papers 11349, National Bureau of Economic Research, Inc.
  13. Weintraub, E Roy, 1977. "The Microfoundations of Macroeconomics: A Critical Survey," Journal of Economic Literature, American Economic Association, vol. 15(1), pages 1-23, March.
  14. Martin Feldstein, 2003. "Monetary policy in an uncertain environment," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 373-382.
  15. Frederic S. Mishkin, 2000. "Inflation Targeting in Emerging-Market Countries," American Economic Review, American Economic Association, vol. 90(2), pages 105-109, May.
  16. Ricardo Hausmann & Ugo Panizza & Ernesto H. Stein, 2000. "Why Do Countries Float the Way They Float?," Research Department Publications 4205, Inter-American Development Bank, Research Department.
  17. Eswar S. Prasad & Raghuram G. Rajan & Arvind Subramanian, 2007. "Foreign Capital and Economic Growth," NBER Working Papers 13619, National Bureau of Economic Research, Inc.
  18. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  19. Woodford, Michael, 1995. "Price-level determinacy without control of a monetary aggregate," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 1-46, December.
  20. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  21. P. Krugman & L. Taylor, 1976. "Contractionary Effects of Devaluations," Working papers 191, Massachusetts Institute of Technology (MIT), Department of Economics.
  22. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November.
  23. Adrián Armas & Francisco Grippa, 2008. "Metas de inflación en una economía dolarizada: La experiencia del Perú," Revista de Análisis del BCB, Banco Central de Bolivia, vol. 10(1), pages 7-44, December.
  24. Susanto Basu & Alan M. Taylor, 1999. "Business Cycles in International Historical Perspective," Journal of Economic Perspectives, American Economic Association, vol. 13(2), pages 45-68, Spring.
  25. Axel Leijonhufvud, 1998. "Microfoundations: Adaptative or Optimizing?," Department of Economics Working Papers 9802, Department of Economics, University of Trento, Italia.
  26. Mirman, Leonard J, 1971. "Uncertainty and Optimal Consumption Decisions," Econometrica, Econometric Society, vol. 39(1), pages 179-85, January.
  27. Frederic S. Mishkin & Klaus Schmidt-Hebbel, 2001. "One decade of inflation targeting in the world : What do we know and what do we need to know?," Working Papers Central Bank of Chile 101, Central Bank of Chile.
  28. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  29. Malcolm D. Knight & Chair, 2003. "Implications of a changing economic structure for the strategy of monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 361-371.
  30. Alan S. Blinder & Ricardo Reis, 2005. "Understanding the Greenspan standard," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 11-96.
  31. Carlos Díaz Alvarado & Alejandro Izquierdo & Ugo Panizza, 2004. "Fiscal Sustainability in Emerging Market Countries with an Application to Ecuador," Research Department Publications 4371, Inter-American Development Bank, Research Department.
  32. Hansen, Lars Peter & Sargent, Thomas J., 2003. "Robust control of forward-looking models," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 581-604, April.
  33. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  34. Carlos F. Diaz Alejandro, 1963. "A Note on the Impact of Devaluation and the Redistributive Effect," Journal of Political Economy, University of Chicago Press, vol. 71, pages 577.
  35. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  36. Imbs, Jean, 2002. "Why the Link Between Volatility and Growth is Both Positive and Negative," CEPR Discussion Papers 3561, C.E.P.R. Discussion Papers.
  37. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, January.
  38. Olivier Blanchard, 2004. "Fiscal Dominance and Inflation Targeting: Lessons from Brazil," NBER Working Papers 10389, National Bureau of Economic Research, Inc.
Full references (including those not matched with items on IDEAS)

Citations

Lists

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

Statistics

Access and download statistics

Corrections

When requesting a correction, please mention this item's handle: RePEc:bcr:wpaper:200725. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Federico Grillo).

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.