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University of Arkansas, Fayetteville ScholarWorks@UARK Theses and Dissertations 8-2016 Essays on Monetary Policy Rules and Inflation Dynamics Saad Ahmad University of Arkansas, Fayetteville Follow this and additional works at: http://scholarworks.uark.edu/etd Part of the Macroeconomics Commons Recommended Citation Ahmad, Saad, "Essays on Monetary Policy Rules and Inflation Dynamics" (2016). Theses and Dissertations. 1635. http://scholarworks.uark.edu/etd/1635 This Dissertation is brought to you for free and open access by ScholarWorks@UARK. It has been accepted for inclusion in Theses and Dissertations by an authorized administrator of ScholarWorks@UARK. For more information, please contact scholar@uark.edu, ccmiddle@uark.edu. Abstract There has been a growing trend to utilize nonlinear models to analyze key issues in monetary policy and international macroeconomics. Using traditional linear models to understand nonlinear relationships can often lead to inaccurate inference and erroneous policy recommendations. The three essays in this dissertation explore nonlinearity in the Federal Reserve’s policy response as well as between a country’s inflation dynamics and integration in the global economy. My aim in accounting for potential nonlinearity is to get a better understanding of the policy makers’ opportunistic approach to monetary policy and evaluate the inflation globalization hypothesis, which basically predicts that global factors will eventually replace the domestic determinants of inflation. In the first essay I develop a broad nonlinear Taylor rule framework, in conjunction with realtime data, to examine the Fed’s policy response during the Great Moderation. My flexible framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis. The second essay uses a threshold methodology to investigate the importance of nonlinear effects in the analysis of the inflation globalization hypothesis. Finally the third essay investigates the relationship between inflation and globalization, under an open-economy Phillips Curve framework, for a panel of OECD countries with a dynamic panel GMM methodology. Contrary to most of the previous literature, which ignores such nonlinearities, my new approach provides some interesting empirical evidence supportive of the effect globalization has on a country’s inflation dynamics. Acknowledgements I am deeply grateful to my dissertation committee chair, Andrea Civelli, for his continued guidance and support during my graduate studies. I owe profound thanks to my committee members, Jingping Gu and Tim Yeager, who helped improve my work and increased my research capabilities. Lastly, this dissertation and my academic studies would not be possible without the constant support and belief of my parents, Ahmad and Nausheen. 1 Introduction There has been a growing trend to utilize nonlinear models to analyze key issues in monetary policy and international macroeconomics. Using traditional linear models to understand nonlinear relationships can often lead to inaccurate inference and erroneous policy recommendations. The three essays in this dissertation explore nonlinearity in the Federal Reserve’s policy response as well as between a country’s inflation dynamics and integration in the global economy. My aim in accounting for potential nonlinearity is to get a better understanding of the policy makers’ opportunistic approach to monetary policy and evaluate the inflation globalization hypothesis, which basically predicts that global factors will eventually replace the domestic determinants of inflation. The validity of the inflation globalization hypothesis could eventually lead to prominent changes in the conduct of monetary policy, so it is imperative to identify the exact role global forces play in the inflation process. In the first essay, A multiple threshold analysis of the Fed’s balancing act during the Great Moderation, I develop a broad nonlinear Taylor rule framework, in conjunction with realtime data, to examine the Fed’s policy response during the Great Moderation. My analysis finds that standard two-regime smooth transition models are unable to fully capture the Fed’s nonlinear response. I therefore utilize the Multiple Regime Smooth Transition model (MRSTAR) to get a better understanding of the Fed’s asymmetric preferences and opportunistic conduct of monetary policy. With the MRSTAR model I am able to use both inflation and the output gap as concurrent threshold variables in the Fed’s policy response function and am able to determine that policy makers prioritize loss of output over inflationary concerns. My flexible nonlinear framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis. 1 The second essay, Globalization and inflation: A threshold investigation, uses a threshold methodology to investigate the importance of nonlinear effects in the analysis of the inflation globalization hypothesis. Accounting for potential nonlinearities in the Phillips Curve, I show that trade openness is not rejected as a threshold variable for the effects of domestic and foreign slack on inflation in many advanced economies, and also find a switch of the output gap slopes from one regime to the other that is consistent with the key predictions of the inflation globalization hypothesis. For some countries the threshold Phillips Curve model also leads to improvements in out-of-sample forecasts over the linear Phillips models, especially at longer horizons. Contrary to most of the previous literature, which ignores such nonlinearities, my new approach provides some interesting empirical evidence supportive of the effect globalization has on a country’s inflation dynamics. Finally the third essay, A dynamic panel threshold analysis of the inflation globalization hypothesis, investigates the relationship between inflation and globalization, under an openeconomy Phillips Curve framework, for a panel of OECD countries with a dynamic panel GMM methodology. Previous studies on the inflation globalization hypothesis have examined this question primarily at the individual-country level. However, a panel approach seems quite appropriate as globalization measures, such as trade openness, often exhibit considerable cross-sectional variation. Using this framework, I find strong evidence in favor of including global factors, as captured by the foreign output gap, in a country’s inflation process. I further augment the dynamic panel model with a threshold component and show that trade openness acts as a threshold variable for the effects of domestic and foreign slack on inflation. Importantly, the switch in the output gap slopes from one regime to the other is consistent with the key predictions of the inflation globalization hypothesis, so that in more open economies the foreign output gap replaces the domestic output gap as the key determinant in the country’s domestic inflation process. 2 2 Chapter 1 A multiple threshold analysis of the Fed’s balancing act during the Great Moderation Abstract Empirical evidence has generally shown that the Fed follows close to a Taylor rule in setting policy rates. This paper continues this line of inquiry by developing a broad nonlinear Taylor rule framework, in conjunction with real-time data, to examine the Fed’s policy response during the Great Moderation. Our analysis finds that standard two-regime smooth transition models are unable to fully capture the Fed’s nonlinear response. Thus we utilize the multiple-regime smooth transition model (MRSTAR) to get a better understanding of the Fed’s asymmetric preferences and opportunistic conduct of monetary policy. With the MRSTAR model we can use both inflation and the output gap as concurrent threshold variables in the Fed’s policy response function and are able to determine that policy makers prioritize loss of output over inflationary concerns. Our flexible nonlinear framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis. 3 2.1 Introduction For over 20 years the Taylor rule (Taylor, 1993) has been used to both shape and evaluate the central bank’s policy actions. An important feature of the rule was that it allowed the nominal policy rate to respond to both inflation and the output gap, reflecting the twin concerns of monetary authorities. While Taylor intended his rule to be normative, the fact that it was also a good match with the Fed’s interest-rate setting behavior increased its appeal as a tool to conduct historical policy analysis (Asso and Leeson, 2012). Figure 1 plots the recommended rates from the Taylor rule alongside the historical Fed Funds rate and we continue to see the Fed generally being close to the Taylor rule when setting the policy rates. In the course of time, a few modifications have been further made to the original Taylor rule to better fit the Fed’s policy response. First there is strong indication that policy makers are forward-looking so that expectations of inflation and the output gap play a greater role than current or lagged values in setting interest rates (Clarida et al., 2000). An interest-rate smoothing term was also added because in practice the Fed prefers to change its policy rate gradually to account for the uncertainty in its economic models (Blinder and Reis, 2005). Moreover, a focus was put on looking at the real-time data that is actually available to the policy makers at the time of their decision (Orphanides, 2001). Finally, the possibility of the Fed’s policy rule being nonlinear has also been examined (Kim et al., 2005 and Hayat and Mishra, 2010). We continue this line of inquiry by developing a broad nonlinear Taylor rule framework to examine the Fed’s policy response during the Great Moderation, an era in which the U.S. economy experienced low output volatility and relatively mild inflation (Ahmed et al., 2004). Purported changes in the Fed’s conduct of monetary policy and the role they played in the 4