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Previous lecture. Both prices and wages sticky Changed loss function depends on losses associated wiht wage deviations Stabilizing wage and inflation is important but there is a trade off. Optimal policy. Flexible wages => stabilize price level

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  1. Previouslecture • Bothprices and wagessticky • Changed loss functiondepends on lossesassociatedwihtwage deviations • Stabilizingwage and inflation is importantbutthere is a trade off

  2. Optimal policy • Flexible wages => stabilizepricelevel • Flexible prices => stabilizewagelevel • Wages & pricessticky => efficiency no longerpossible => policy tradeoff • Structural parameters in weights for wage and price inflation determine optimal policy

  3. Problem • Toocomplicated • Structural parameters difficult to identify • Output gap unobservable • Modelunknown

  4. Special case

  5. Optimal policy as before • Stabilize the compositepricelevel with the derivedweights • => output is stabilized as before • But: Wage inflation should be included in the target variable

  6. Simulations with simple rules

  7. Results • Wage inflation important • Strictprice inflation targeting suboptimal • Strictbetterthan flexible

  8. Further extensions • Open economy • Prices on tradables • Price discrimination or not, pricing to market or law of oneprice • Localcurrency or producercurrencypricing • Small/largeeconomy • Policy target variable • Phillips curve, Dynamic IS Curve, Policy rule

  9. Inflation targeting in practice • Inflation measure, different aspects • Theory: depends on pricestickyness • Practice • CPI • GDP deflator • otherindexes • asset prices • wages

  10. CPI • Narrowmeasure • Bothdomestic and import prices • Nondurables, durables, services • durables prices, housingprices, interest rates • Publishedmonthly • Well-known • Done for otherpurposes (compensation, cost of living)

  11. Conclusion • Wages are mostimportant under reasonableparameterizationaccordingtoMankiw & Reis • Compare with Erceg, Henderson & Levin (2000) • Wagesshould be included in target

  12. Transmission mechanism • Policy rate • Short & long market rates • Credibility & expectations • Interest rates and demand • Consumption • Investments • Asset prices • Exchange rates and trade • Public sector & fiscal policy • Effects with considerabledelay • 2 yearforesight

  13. Decisionsbased on forecasts • Models • NK model, general equilibrium • Riksbank as example • RAMSES, NK interpretation • Supported by othermodels, time-seriesmodels (VARs), ”without interpretations”, sectoral experts • Forecasthorizon • RAMSES longhorizon • Supportingmodelsshorterhorizon • Modeluncertainty • Whatmodel? • Rationalexpectations and changingmodels • Different opinions

  14. Major alternatives • 2nd generation neokeynesianmodels with rationalexpectations, forward-lookingbehavior, not fullymicrofoundedbigsize • NK models, fullymicrofounded small size • time-seriesmodels, no theory • alternative theories

  15. RAMSES – DSGE model • NK model • Bayesianeconometrics • Small model – 12 data variables • Open economy • Stickyprices, wages, import prices, different markups • Hoursworked, no unemployment • Simple fiscal policy, no policy rule • Estimated Taylor rule

  16. Extensions in RAMSES • Habit formation, backward-lookingconsumption • Phillips curvebackward and forward looking • Adjustmentcosts in investments (capital stock adjustment) • CPI-X (”core”) inflation • Taylor rule for policy • Ongoing research

  17. Target variables: Inflation • Inflation measure • CPI or CPI-X or? • Wages? • Producerprices? • CPI deficiencies • Toonarrowmeasure • Qualitychanges, 2% is stablepricelevel? • Interest rates, capitalgains, durables

  18. Target variables: Output gap • Measure of potential or trend • Mechanic or based on theory • Different mechanicalmeasures • Hodrick-Prescott (HP gap) • Theoreticalmeasuresmodeldependent • Flex-price gap • No consensus

  19. Alternative theories • Hysteresismodels • Temporaryshocks -> Permanent effects • Insider-outsider • Near-rationalexpectations • Akerlof’s Phillips curve • Mankiw/Reisinattentive agents • Friedman’srule - zerointerest rate • Inflation tax

  20. Policy environment • Legislation (commitment) • Central bank independence • Credibility • Transparency • Commitment • Evaluation • by central bank • independent • loss function? • Accountability • responsible to the parliament • officialtarget, measurable

  21. Legislation • Example: Sweden • Central bank law • Price stability • Independent central bank • Target 2% determined by the central bank • Flexible inflation targetingdetermined by the central bank

  22. Different in othercountries • UK • ultimate target and specifictarget by parliament • USA • only ultimate targets in Federal ReserveAct • ECB • ultimate target and specifictarget set by governingcouncil of ECB

  23. Problems with accountability • Specifictargets not determined by principal but by agent • Targets difficult to measure

  24. Independence The independence of the Executive Board is also emphasized in the SverigesRiksbank Act, which states that the members of the Executive Board may neither seek nor take instructions when fulfilling their monetary policy duties.

  25. Legislation

  26. alsosaid

  27. Law & CB July 2008

  28. Flexibility • The two-year horizon can be interpreted as a restriction as to how much consideration can normally be given to real economic developments, a restriction which – like the specified inflation target – the Riksbank has imposed on itself to make the target of maintaining price stability credible

  29. and…

  30. 1993 & 2008 Price stability is a prerequisite for sustainedeconomicgrowth as well as full employment and it prevents an arbitraryredistribution of income and wealth. Also, monetary policy does not have the task of, and cannot be used for, achieving lasting higheremployment or growth. Whatmonetary policy canachieve, however, is to ensure an inflation rate which over a number of years is well in line with the inflation target and to contribute to dampening the fluctuations in the real economy. In this way, monetary policy cancreategoodconditions for an efficientlyfunctioningeconomy and a favourable, stablemacroeconomicdevelopment.

  31. Evaluation • Inflation close to target? • What inflation measure • Confusion in Sweden • Loss function? • Whatmeasures? • What loss function? • Accountability • Who evaluates and how?

  32. Evaluation: Forecasts • Are forecastsgood or bad? • Short-runmodels • Provide better starting points for structuralmodel • VAR models • Structuralmodels • NK models still in developingphase • Modeluncertainty • Howstructural? Identificationissues • Forecastexperience

  33. Forecast performance

  34. Policy evaluation • Target not so explicit • How to interpret ”flexible targeting” • Practice vs theory • Theory: efficientallocation • Practice: low inflation • Inflation target: CPI butincludingwage inflation advantageous: shouldoneignorewage inflation in evaluation?

  35. Inflation targeting era • Inflation low • Inflation less volatile • Output growth high • Output volatilitylower • Does this depend on inflation targeting? • Comparecountries • Denmark vs Sweden • Experts on Sweden, Giavazzi & Mishkin

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