Monetary policy in the euro area - Simulations with the NIME model [ Working Paper 11-02 - 01/11/2002]

In this paper, we investigate with a macroeconometric world model how mone-tary policy rules affect economic activity in the euro area. In the economic literature, there is a general consensus that a credible monetary policy rule is to be preferred to discretionary interventions by central banks because monetary surprises can increase expected inflation and worsen economic performance (Kydland and Prescott (1977)). Several monetary policy rules have been proposed, for example, money targeting (Friedman (1956)), inflation targeting (Bernanke et al. (1999)), nominal income targeting (Hall and Mankiw (1994), Frankel and Chinn (1995)), and an interest rate rule that targets inflation and output relative to a reference value (Taylor (1993)). Although the theoretical merits of these rules have been thoroughly discussed in the literature, the empirical investigation of the implications of these rules has only recently commenced (Bryant et al. (1993)).

This paper provides some additional empirical evidence on the effects of monetary policy rules in the euro area. More particularly, we investigate with the NIME model the responses of the main macroeconomic variables to diverse shocks under money targeting and a Taylor rule. Under money targeting, the monetary authorities target the money supply in every period. Under a Taylor rule, the monetary authorities set the short-term interest rate by weighing inflation and output relative to a reference value. The shocks we investigate are a temporary increase in real demand, a permanent increase in the velocity of money, and a permanent drop in labour productivity. The temporary real demand shock allows us to analyse to what extent money targeting, when compared with a Taylor rule, tempers inflationary pressures that arise in the real sector. The productivity shock and the money velocity shock allow us to examine to what extent money targeting may compromise price stability when money growth targets are not immediately revised in the face of these shocks.

In the second section of this paper, we briefly describe the NIME model. The NIME model is a macroeconometric world model that covers the euro area, the other countries of the European Union, the United States, Japan, and the rest of the world. In this model, money is neutral in the long run. However, in the short run, money is not neutral because of imperfect competition and imperfect information.

In the third section, we briefly highlight some differences and similarities between money targeting and a Taylor rule. Under money targeting the short-term interest rate is determined by the conditions in the money market, while under a Taylor rule, the short-term interest rate is determined by the conditions in the goods market. Both rules require a specific information-set. Under money targeting, the monetary authorities require knowledge about potential output (growth), the velocity of money, and the contemporaneous money supply. Under a Taylor rule, the monetary authorities need knowledge about potential output (growth), the output gap, and the equilibrium interest rate.

From the fourth section until the seventh section, we present simulation results for the euro area. These simulation results give a detailed description of the effects of shocks under money targeting and a Taylor rule. The case of a temporary demand shock is straightforward to implement. However, in the case of a permanent shock one also has to make assumptions on how the monetary authorities revise their reference values and their targets. Here, we distinguish two sub-variants. In a first sub-variant, the monetary authorities revise immediately the reference value for output or the money target. In the other sub-variant, the monetary authorities do not change the reference value or the money target. In these sections, we also compare the simulation results for the euro area with the simulation results for similar policy rules and shocks in the United States (U.S.).

In the last section, we draw some conclusions. First, in the case of a temporary demand shock, we find that money targeting causes the smallest deviation from trend for private supply in the first year. This is because the induced changes in the interest rate are larger under money targeting than under a Taylor rule in the first year. However, as time progresses and the conditions in the money market and the goods market evolve differently, we find that after the first year money targeting loses its potency to provide more output stability than a Taylor rule. Therefore, we also investigate the implications of a two-pillar strategy that sets the short-term interest rate by weighing the conditions in the money market against the conditions in the goods market. We find that such a policy rule provides more output stability than money targeting or a Taylor rule. However, it should also be noted that this higher output stability is gained at the expense of lower stability of the financial variables. Second, in the case of a permanent shock to the velocity of money, we find that important short run deviations from trend may occur if the monetary authorities do not immediately adjust the money supply. Third, in the case of a permanent drop in labour productivity, we find that money targeting tempers the initial decline in output, especially if money targets are not revised. However, it should also be stressed that such loose monetary policy only delays adjustment towards the new steady state, and that it compromises price stability in the long run if money targets are not revised in due course.