IDEAS home Printed from https://ideas.repec.org/p/emx/ceedoc/2012-10.html
   My bibliography  Save this paper

Do real balance effects invalidate the Taylor principle in closed and open economies?

Author

Listed:
  • Stephen McKnight

    () (El Colegio de México)

  • Alexander Mihailov

    () (University of Reading)

Abstract

This paper examines the implications for equilibrium determinacy of forward-looking monetary policy rules in a Neo-Wicksellian model that incorporates real balance effects. We show that in closed economies the presence of small, empirically plausible real balance effects significantly restricts the ability of the Taylor principle to prevent indeterminacy of the rational expectations equilibrium. This problem is further exac- erbated in open economies, particulary if the monetary policy rule reacts to consumer- price, rather than domestic-price, inflation. These findings still hold even when output and the real exchange rate are introduced into the policy rule, thereby suggesting that the widespread neglect of real balance effects in the literature is ill-advised.

Suggested Citation

  • Stephen McKnight & Alexander Mihailov, 2012. "Do real balance effects invalidate the Taylor principle in closed and open economies?," Serie documentos de trabajo del Centro de Estudios Económicos 2012-10, El Colegio de México, Centro de Estudios Económicos.
  • Handle: RePEc:emx:ceedoc:2012-10
    as

    Download full text from publisher

    File URL: http://cee.colmex.mx/documentos/documentos-de-trabajo/2012/dt201210.pdf
    Download Restriction: no

    Other versions of this item:

    References listed on IDEAS

    as
    1. Stephen McKnight & Alexander Mihailov, 2007. "Re-examining the Importance of Trade Openness for Aggregate Instability," Economics & Management Discussion Papers em-dp2007-52, Henley Business School, Reading University.
    2. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2004. "Indeterminacy with inflation-forecast-based rules in a two-bloc model," International Finance Discussion Papers 797, Board of Governors of the Federal Reserve System (U.S.).
    3. Javier Andrés & J. David López-Salido & Javier Vallés, 2006. "Money in an Estimated Business Cycle Model of the Euro Area," Economic Journal, Royal Economic Society, vol. 116(511), pages 457-477, April.
    4. Anton Muscatelli & Patrizio Tirelli & Carmine Trecroci, 2002. "Monetary and Fiscal Policy Interactions over the Cycle: Some Empirical Evidence," CESifo Working Paper Series 817, CESifo Group Munich.
    5. Carlstrom, Charles T. & Fuerst, Timothy S., 2001. "Timing and real indeterminacy in monetary models," Journal of Monetary Economics, Elsevier, pages 285-298.
    6. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
    7. Joshua Aizenman & Jaewoo Lee, 2007. "International Reserves: Precautionary Versus Mercantilist Views, Theory and Evidence," Open Economies Review, Springer, pages 191-214.
    8. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages 208-231, June.
    9. Stephanie Schmitt-Grohe & Jess Benhabib & Martin Uribe, 2001. "Monetary Policy and Multiple Equilibria," American Economic Review, American Economic Association, pages 167-186.
    10. Nicoletta Batini & Andrew Haldane, 1999. "Forward-Looking Rules for Monetary Policy," NBER Chapters,in: Monetary Policy Rules, pages 157-202 National Bureau of Economic Research, Inc.
    11. Stephen McKnight, 2011. "Should Central Banks Target Consumer or Producer Prices?," International Finance, Wiley Blackwell, pages 445-479.
    12. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Serie documentos de trabajo del Centro de Estudios Económicos 2011-02, El Colegio de México, Centro de Estudios Económicos.
    13. Jess Benhabib & Stefano Eusepi, 2005. "The design of monetary and fiscal policy: a global perspective," Proceedings, Federal Reserve Bank of San Francisco.
    14. Schabert, Andreas & Stoltenberg, Christian, 2005. "Money demand and macroeconomic stability revisited," Working Paper Series 458, European Central Bank.
    15. Brams, S.J. & Kaplan, T.R., 2002. "Dividing the Indivisible: Procedures for Allocating Cabinet Ministries to Political Parties in a Parliamentary System," Working Papers 02-06, C.V. Starr Center for Applied Economics, New York University.
    16. Andrés, Javier & David López-Salido, J. & Nelson, Edward, 2009. "Money and the natural rate of interest: Structural estimates for the United States and the euro area," Journal of Economic Dynamics and Control, Elsevier, vol. 33(3), pages 758-776, March.
    17. Alessandro Piergallini, 2006. "Real Balance Effects and Monetary Policy," Economic Inquiry, Western Economic Association International, vol. 44(3), pages 497-511, July.
    18. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
    19. Kurozumi, Takushi, 2006. "Determinacy and expectational stability of equilibrium in a monetary sticky-price model with Taylor rule," Journal of Monetary Economics, Elsevier, pages 827-846.
    20. Bergin, Paul R., 2006. "How well can the New Open Economy Macroeconomics explain the exchange rate and current account?," Journal of International Money and Finance, Elsevier, vol. 25(5), pages 675-701, August.
    21. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 279, European Central Bank.
    22. Lubik, Thomas A. & Schorfheide, Frank, 2007. "Do central banks respond to exchange rate movements? A structural investigation," Journal of Monetary Economics, Elsevier, pages 1069-1087.
    23. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
    24. Ludger Linnemann & Andreas Schabert, 2006. "Monetary Policy and the Taylor Principle in Open Economies," International Finance, Wiley Blackwell, vol. 9(3), pages 343-367, December.
    25. Carlstrom, Charles T. & Fuerst, Timothy S., 2001. "Timing and real indeterminacy in monetary models," Journal of Monetary Economics, Elsevier, pages 285-298.
    26. Luis-Gonzalo Llosa & Vicente Tuesta, 2008. "Determinacy and Learnability of Monetary Policy Rules in Small Open Economies," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1033-1063, August.
    27. Mihailov, Alexander, 2005. "Operational Independence, Inflation Targeting and UK Monetary Policy," Economics Discussion Papers 9982, University of Essex, Department of Economics.
    28. James Bullard & Eric Schaling, 2009. "Monetary Policy, Determinacy, and Learnability in a Two-Block World Economy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(8), pages 1585-1612, December.
    29. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 971-993, October.
    30. Takushi Kurozumi, 2006. "Determinacy and Expectational Stability of Equilibrium in a Monetary Sticky-Price Model with Taylor Rule," Bank of Japan Working Paper Series 06-E-2, Bank of Japan.
    31. Bergin, Paul R. & Shin, Hyung-Cheol & Tchakarov, Ivan, 2007. "Does exchange rate variability matter for welfare? A quantitative investigation of stabilization policies," European Economic Review, Elsevier, pages 1041-1058.
    32. Lubik, Thomas A. & Schorfheide, Frank, 2007. "Do central banks respond to exchange rate movements? A structural investigation," Journal of Monetary Economics, Elsevier, pages 1069-1087.
    33. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
    34. Jordi Galí & J. David López-Salido & Javier Vallés, 2007. "Understanding the Effects of Government Spending on Consumption," Journal of the European Economic Association, MIT Press, pages 227-270.
    35. Tamim Bayoumi & Douglas Laxton & Paolo Pesenti, 2004. "Benefits and spillovers of greater competition in Europe: a macroeconomic assessment," International Finance Discussion Papers 803, Board of Governors of the Federal Reserve System (U.S.).
    36. T. de Scitovszky, 1941. "Capital Accumulation, Employment and Price Rigidity," Review of Economic Studies, Oxford University Press, vol. 8(2), pages 69-88.
    37. De Fiore, Fiorella & Liu, Zheng, 2005. "Does trade openness matter for aggregate instability?," Journal of Economic Dynamics and Control, Elsevier, vol. 29(7), pages 1165-1192, July.
    38. Jess Benhabib & Stephanie Schmitt-Grohé & Martín Uribe, 2002. "Chaotic Interest-Rate Rules," American Economic Review, American Economic Association, pages 72-78.
    39. Jess Benhabib & Stephanie Schmitt-Grohé & Martín Uribe, 2002. "Chaotic Interest-Rate Rules," American Economic Review, American Economic Association, pages 72-78.
    40. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, pages 473-506.
    41. Werner, Thomas & Lombardo, Giovanni & Kremer, Jana, 2003. "Money in a New-Keynesian model estimated with German data," Discussion Paper Series 1: Economic Studies 2003,15, Deutsche Bundesbank, Research Centre.
    42. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2004. "Indeterminacy with Inflation-Forecast-Based Rules in a Two-Bloc Model," School of Economics Discussion Papers 0204, School of Economics, University of Surrey.
    43. Alexander Mihailov, 2006. "Operational independence, inflation targeting, and UK monetary policy," Journal of Post Keynesian Economics, Taylor & Francis Journals, vol. 28(3), pages 395-421.
    44. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, pages 263-267.
    45. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, pages 383-398.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Stephen McKnight & Alexander Mihailov & Antonio Pompa Rangel, 2016. "What Do Latin American Inflation Targeters Care About? A Comparative Bayesian Estimation of Central Bank Preferences," Economics & Management Discussion Papers em-dp2016-12, Henley Business School, Reading University.
    2. Stephen McKnight, 2016. "Investment and forward-looking monetary policy: A Wicksellian solution to the problem of indeterminacy," Serie documentos de trabajo del Centro de Estudios Económicos 2016-02, El Colegio de México, Centro de Estudios Económicos.
    3. Stephen McKnight & Alexander Mihailov & Kerry Patterson & Fabio Rumler, 2014. "The Predictive Performance of Fundamental Inflation Concepts: An Application to the Euro Area and the United States," Economics & Management Discussion Papers em-dp2014-03, Henley Business School, Reading University.
    4. Stephen McKnight & Alexander Mihailov & Antonio Pompa Rangel, 2016. "What Do Latin American Inflation Targeters Care About? A Comparative Bayesian Estimation of Central Bank Preferences," Economics & Management Discussion Papers em-dp2016-12, Henley Business School, Reading University.

    More about this item

    Keywords

    equilibrium determinacy; real balance effects; trade openness; forward- looking inflation targeting; taylor principle;

    JEL classification:

    • E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:emx:ceedoc:2012-10. 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: (Rocío Contreras Romo). General contact details of provider: http://edirc.repec.org/data/cecolmx.html .

    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 CitEc recognized a reference but did not link an item in RePEc 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 RePEc Author Service 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.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.