Policymakers’ Revealed Preferences and the Output–Inflation Variability Trade–off: Implications for the European System of Central Banks

Abstract

This paper explores two aspects of the conduct of monetary policy under a monetary union. First, even if the preferences of policymakers over in£ation and output variability are identical across member countries, di¡erences in economic structure will mean di¡erent desired policy responses to even a common shock. Second, policymakers may be forced to make important concessions in their preferences over in£ation and output variability. To examine these issues, in this paper we estimate the objective functions that the European national central banks were implicitly maximizing over the 15 or so years prior to monetary union, as well as the slopes of the in£ation^output variability trade-o¡ in each country.While the slopes of the trade-o¡s vary dramatically across countries, the objective functions are quite similar, with most countries having weights in excess of three-quarters on in£ation variability and less than one-quarter on output variability. Our ¢ndings suggest that the concessions (in terms of preferences over output and in£ation variability) that current in£ation-targeting countries such as the UK and Sweden would have to make on accession to the European Monetary Union (EMU) are likely to be minimal. On the other hand, the di¡erences in economic structure across the Eurosystem countries might make it di¤cult to formulate a common policy even in the face of common goals, suggesting that there may still be signi¢cant costs to joining for countries currently outside the EMU.

Inflation Targeting and Monetary Policy Activism

“…For Germany, the activism indicator remained at a relatively high level even in the 1970s. This finding is consistent with Cecchetti et al (2002) and Assenmacher-Wesche (2006), who find a higher preference of the Bundesbank for inflation stabilization.…”

Squeezing the Interest Rate Smoothing Weight with a Hybrid Expectations Model

“…15 Notice that our calibration strategy relies on the assumption of optimal behavior undertaken by the Fed in the period analyzed. As pointed out by Cecchetti, McConnell, and Perez-Quiros (2002), this is equivalent to assume that Greenspan has operated along the efficiency-frontier that defines the trade-off between inflation and output gap, otherwise labelled as 'Taylor Curve' (Taylor, 1979). Moreover, our search for the optimal weight µ assumes that the parameters of our economy remains unvaried after a modification of the monetary policy conduct.…”

Central Bank preferences and monetary rules under the inflation targeting regime in Brasil

“…Results suggest that central banks developed stronger aversion to inflation variability in the course of the 1990s. Cecchetti et al (2001) estimate the preferences of central banks of countries in the European Monetary System and demonstrate that the objective functions of these monetary authorities are surprisingly alike. By utilizing a calibration strategy, Collins and Siklos (2004) show that the central banks of Australia, Canada, U.S. and New Zealand can be described as having an optimal inflation target, placing considerable weight on short-term interest rate smoothing and attaching sheer weight on output variability.…”

“…The results obtained by these studies suggest that the Fed has placed considerable weight on interest rate smoothing and given lesser or unsubstantial importance to the output gap during the Volcker-Greenspan period. Cecchetti and Ehrmann (1999), Cecchetti et al (2001) and Collins and Siklos (2004) extend the analysis of monetary authority's preferences to other countries besides the U.S. Cecchetti and Ehrmann (1999) use VAR models to capture the economic dynamics of 23 countries (including both developed and developing economies) and to identify the preferences of central banks by way of estimates of inflation-output variability. Results suggest that central banks developed stronger aversion to inflation variability in the course of the 1990s.…”