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A Time-Varying Parameter Model of A Monetary Policy Rule for Switzerland. The Case of the Lucas and Friedman Hypothesis

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Author Info
Marwan Elkhoury () (IUHEI, The Graduate Institute of International Studies, Geneva)

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Abstract

This paper is an empirical research of a monetary policy rule for a small open economy model, taking Switzerland as a case-study. A time-varying parameter model of a monetary policy reaction function is proposed to integrate various trade-offs to be made about various macroeconomic variables -- inflation, the output gap and the real exchange rate gap. The Kalman filter estimations of the time-varying parameters shows how rational economic agents combine past and new information to make new expectations about the state variables. The uncertainty created by the time-varying parameter model, and estimated by the conditional forecast error and conditional variance, is decomposed into two components, the uncertainty related to the time-varying parameters and the uncertainty related to the purely monetary shock. Most of the monetary shock uncertainty comes from the time-varying parameters and not from the pure monetary shock. The Lucas and Friedman hypotheses about the impact of uncertainty on output are revisited, using a conditional variance to test them. Both hypothesis are confirmed, using the one-step ahead conditional variance of the monetary shock. An inverse relation between the magnitude of the response on output to the nominal shock and the variance of this shock is found, as Lucas had predicted. Moreover, there is a direct negative impact of uncertainty which reduces output in the long-term.

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Paper provided by Economics Section, The Graduate Institute of International Studies in its series HEI Working Papers with number 01-2006.

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Length: 47
Date of creation: Dec 2005
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Handle: RePEc:gii:giihei:heiwp01-2006

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Keywords: time-varying parameter model; Taylor rule; Kalman Filter.;

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  1. Barro, Robert J. & Gordon, David B., 1983. "Rules, discretion and reputation in a model of monetary policy," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 101-121. [Downloadable!] (restricted)
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  2. Nicolas A. Cuche, 2000. "Monetary policy with forward-looking rules: The Swiss case," Working Papers 00.10, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
  3. Andrews, Donald W K & Ploberger, Werner, 1994. "Optimal Tests When a Nuisance Parameter Is Present Only under the Alternative," Econometrica, Econometric Society, vol. 62(6), pages 1383-1414, November. [Downloadable!] (restricted)
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  4. Nelson, C.R. & Kim, C-J., 1988. "The Time-Varying-Parameter Model As An Alternative To Arch For Modeling Changing Conditional Variance: The Case Of The Lucas Hypothesis," Discussion Papers in Economics at the University of Washington 88-10, Department of Economics at the University of Washington.
  5. Krugman, Paul R, 1991. "Target Zones and Exchange Rate Dynamics," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 669-82, August. [Downloadable!] (restricted)
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  6. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  7. Friedman, Milton, 1977. "Nobel Lecture: Inflation and Unemployment," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 451-72, June. [Downloadable!] (restricted)
  8. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March. [Downloadable!] (restricted)
  9. Michael J. Dueker & Andreas M. Fischer, 1998. "A guide to nominal feedback rules and their use for monetary policy," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 55-63. [Downloadable!]
  10. Charles R. Nelson & Chang-Jin Kim, 1988. "The Time-Varying-Parameter Model as an Alternative to ARCH for Modeling Changing Conditional Variance: The Case of Lucas Hypothesis," NBER Technical Working Papers 0070, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  11. Bera, Anil K & Lee, Sangkyu, 1993. "Information Matrix Test, Parameter Heterogeneity and ARCH: A Synthesis," Review of Economic Studies, Blackwell Publishing, vol. 60(1), pages 229-40, January. [Downloadable!] (restricted)
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  12. Andreas M. Fischer, 2002. "Fluctuations in the Swiss Franc: What has Changed Since the Euro's Introduction?," Working Papers 02.03, Swiss National Bank, Study Center Gerzensee. [Downloadable!]
  13. Nelson, C.R. & Kim, C-J., 1988. "The Time-Varying-Parameter Model As An Alternative To Arch For Modeling Changing Conditional Variance: The Case Of The Lucas Hypothesis," Working Papers 88-10, University of Washington, Department of Economics.
  14. Blanchard, Olivier Jean & Kahn, Charles M, 1980. "The Solution of Linear Difference Models under Rational Expectations," Econometrica, Econometric Society, vol. 48(5), pages 1305-11, July. [Downloadable!] (restricted)
  15. 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. [Downloadable!] (restricted)
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