Money in Monetary Policy Design: A Formal Characterization of Ecb-Style Cross-Checking

Abstract

The European Central Bank (ECB) has assigned a special role to money in its two‐pillar strategy and has received much criticism for this decision. The case against including money in the central bank's interest rate rule is based on a standard model of the monetary transmission process that underlies many contributions to research on monetary policy in the last two decades. In this paper, we develop a justification for including money in the interest rate rule by allowing for imperfect knowledge regarding unobservables such as potential output and equilibrium interest rates. We formulate a novel characterization of ECB‐style monetary cross‐checking and show that it can generate substantial stabilization benefits in the event of persistent policy misperceptions regarding potential output. (JEL: E32, E41, E43, E52, E58)

Central Bank Misperceptions and the Role of Money in Interest Rate Rules

“…The cross-check is triggered in a nonlinear-fashion whenever a statistical test on the basis of the monetary model signals a trend shift. An earlier note, Beck and Wieland (2007), presented an interest rate rule that incorporates such a shift 5 and simulated a counterfactual example in the traditional Keynesian-style model with backward-looking dynamics of Svensson (1997), Orphanides and Wieland (2000) and Orphanides (2003). The present paper shows how to derive an interest rate rule with cross-checking from an optimization problem and proceeds to implement cross-checking in the benchmark New-Keynesian model.…”

Money In Modern Macro Models: A Review of the Arguments

“…A number of NK models, summarised by the term information channel literature, (see Beck & Wieland, 2007Coenen et al, 2005) arguing via money's informational content regarding (potential) output or the natural rate of interest, while other models focus on the information money provides for asset price developments.…”

“…32 The main reasons for the welfare gain are that money growth contains information on current output growth and that data on the euro area money stock are subject to only negligible measurement errors. 33 Beck & Wieland (2007, too, allow for 32 In their approach, performance of different interest rate rules is measured by a commonly used central bank loss function which aims at minimising the variances of inflation around its target, of the output gap and interest rate changes, respectively (e.g. Rudebusch & Svensson, 1999;Ehrmann & Smets, 2003;Coenen et al, 2005).…”

Money in Monetary Policy Design: Monetary Cross-Checking in the New-Keynesian Model

“…This particular series of output gap misperceptions measured in percentage point terms was also previously used in Beck and Wieland (2007a) in the context of a model with 7 Specifically, with velocity defined as v t ≡ −m t + p t + y t and money demand determined by equation (5) the long-run trend in velocity corresponds to Δv = (1 − γ y )Δy. Changes in the trend in velocity may arise from changes in potential output growth y, changes in the income elasticity of money demand, γ y , and possibly from other sources such as financial innovations (see Orphanides and Porter (2001) and Masuch et al (2001) (2004)).…”