Economic Models - Convex Optimization
Economic Models - Convex Optimization Economic Models - Convex Optimization
Inflation Control in Central and Eastern European Countries 177 Hungarian experience: when the two objectives were in conflict, as in June 2003, one had to be abandoned, and a devaluation took place. Since the accession to the EU also required the complete adoption of the acquis communautaire, thereby including the elimination of capital controls, the apparent paradox of several CEECs switching to a free float and inflation targeting, for the period preceding the adoption of the euro, is then a strategy that may protect their currencies from unrealistic parities and speculative attacks. On the other hand, a direct inflation targeting can only be successful if the monetary authority has earned itself a solid reputation, and this primarily requires the independence from any political interference. Since the CEECs only acquired a formal central bank independence in the last few years, as a part of the process of adoption of the acquis communautaire, their credibility may still be weak. Central bank independence is even more a concern, when the definition is extended beyond the mere legal requirement: in most of the cases for example, the credibility was seriously weakened because the fiscal authority had the opportunity to partially finance its expenditures through the central bank; political pressures, as experienced in the Czech Republic and in Poland, may undermine the credibility of the central bank even when they are resisted, because they may erode the consensus in the country. Several indices of central bank independence, were proposed in the literature: according to Maliszewski (2000), and to the extensive survey in Dvorsky (2000), the CEECs were lagging behind with respect to their Western counterparts, Poland and the Czech Republic faring better than Slovenia. Indeed, it is exactly because the credibility of the monetary authorities is lower in the CEECs that Amato and Gerlach (2002) proposed to supplement the inflation targeting with a mild monetary commitment, this would increase the information in the market. It is then important to ascertain if the exchange rate commitment is a risk worth taking, not only for the countries on the way to EMU that are still more than two years away from the formal discussion of their convergence according to the Maastricht criteria, but also for other emerging economies in the world. 2.3. A Summary of the Results of Previous Analyses Several empirical analyses on inflation control in CEECs appeared in the recent years. Iacone and Orsi (2004) surveyed many applied works: these varied for the country that was analyzed, for the period considered and for the methodology adopted, making comparison rather difficult.
178 Fabrizio Iacone and Renzo Orsi Interpretation of the results was often dubious because either the variables of interest were replaced by first or second differences, or the intermediate steps linking the monetary instrument to the target were omitted, thus obscuring any potential evidence about the channel through which inflation may be controlled. Reliability was also hampered by the fact that in many cases no stability analysis was provided, despite the potentially disruptive effects of the transition on the estimates, nor any attempt was made to model the slow formation of a market economy despite this being the main feature of the period. It seems nevertheless fair to conclude that the exchange rate is very important for the stabilization of inflation, an appreciation of the real exchange rate reducing the growth rate of prices. The empirical evidence supporting the existence of a standard interest rate channel was much more controversial, the results depending largely on the econometric approach and model adopted by the researcher and on the sampling period considered. 2.4. A Structural Model for Monetary Policy It is possible that the weak support provided by these analyses is at least partially due to the methodology adopted: VAR models have the advantage of requiring a minimal structural specification, but, in return, they need the estimation of many parameters. Considering the short length of the sampling size and the potential extreme instability of the parameters due to the transition, large standard errors and non-significant estimates seem to be unavoidable consequences. A structural model can provide a more parsimonious approach: we followed Rude-bush and Svensson (1999) and considered the model ⎧ ⎨ π t = α 0 + α π1 π t−1 + α π2 π t−2 + α π3 π t−3 + α π4 π t−4 + α y y t−1 + ε π,t PC ⎩ y t = β 0 + β y y t−1 − β AD where y t is a measure of the economic activity, π t is the annualized inflation within the quarter, it is a short-term interest rate, ¯π = 4 1 ∑ 3j=0 π t−j is the average inflation rate in the last four quarters (i.e., the inflation over the last year), and ī = 4 1 ∑ 3j=0 i t−j is the average interest rate over the same period. The equations are referred to as Phillips Curve (PC) and aggregate demand (AD), respectively because the first one can be given a structural interpretation as a PC while the second one may describe the transmission of monetary policy on the economic activity quite like in an AD function.
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178 Fabrizio Iacone and Renzo Orsi<br />
Interpretation of the results was often dubious because either the variables<br />
of interest were replaced by first or second differences, or the intermediate<br />
steps linking the monetary instrument to the target were omitted,<br />
thus obscuring any potential evidence about the channel through which<br />
inflation may be controlled. Reliability was also hampered by the fact that<br />
in many cases no stability analysis was provided, despite the potentially<br />
disruptive effects of the transition on the estimates, nor any attempt was<br />
made to model the slow formation of a market economy despite this being<br />
the main feature of the period.<br />
It seems nevertheless fair to conclude that the exchange rate is very<br />
important for the stabilization of inflation, an appreciation of the real<br />
exchange rate reducing the growth rate of prices. The empirical evidence<br />
supporting the existence of a standard interest rate channel was much more<br />
controversial, the results depending largely on the econometric approach<br />
and model adopted by the researcher and on the sampling period considered.<br />
2.4. A Structural Model for Monetary Policy<br />
It is possible that the weak support provided by these analyses is at least<br />
partially due to the methodology adopted: VAR models have the advantage<br />
of requiring a minimal structural specification, but, in return, they need<br />
the estimation of many parameters. Considering the short length of the<br />
sampling size and the potential extreme instability of the parameters due to<br />
the transition, large standard errors and non-significant estimates seem to<br />
be unavoidable consequences.<br />
A structural model can provide a more parsimonious approach: we<br />
followed Rude-bush and Svensson (1999) and considered the model<br />
⎧<br />
⎨ π t = α 0 + α π1 π t−1 + α π2 π t−2 + α π3 π t−3<br />
+ α π4 π t−4 + α y y t−1 + ε π,t PC<br />
⎩<br />
y t = β 0 + β y y t−1 − β<br />
AD<br />
where y t is a measure of the economic activity, π t is the annualized inflation<br />
within the quarter, it is a short-term interest rate, ¯π =<br />
4 1 ∑ 3j=0<br />
π t−j is the<br />
average inflation rate in the last four quarters (i.e., the inflation over the<br />
last year), and ī =<br />
4 1 ∑ 3j=0<br />
i t−j is the average interest rate over the same<br />
period.<br />
The equations are referred to as Phillips Curve (PC) and aggregate<br />
demand (AD), respectively because the first one can be given a structural<br />
interpretation as a PC while the second one may describe the transmission<br />
of monetary policy on the economic activity quite like in an AD function.