Money Stock Control and Inflation Targeting in Germany: A State Space Modelling Approach to the Bundesbank’s Operating Procedures and Intermediate Strategy

175 Pages·2001·3.491 MB·English

by  Dr. Claus Brand (auth.)

Money Stock Control
and Inflation Targeting in Gennany
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Claus Brand
Money Stock Control
and Inflation Targeting
in Germany
AState Space Modelling Approach
to the Bundesbank's Operating Procedures
and Intermediate Strategy
With 24 Figures and 26 Tables
Springer-Verlag Berlin Heidelberg GmbH
Series Editors
Wemer A. Müller
Martina Bihn
Author
Dr. Claus Brand
European Central Bank
Kaiserstraße 29
60311 Frankfurt a.M.
Gennany
E-mail: [email protected]
This book was submitted as a doctoral dissertation
to the Universität GH Essen, Gennany, in 1999
ISSN 1431-1933
ISBN 978-3-7908-1393-7
Cataloging-in-Publication Data applied for
Die Deutsche Bibliothek - CIP-Einheil~aufnahme
Brand, Claus: Money stock control and inflation targeting in Gennany: astate
space modelling approach to the Bundesbank's operating procedures and intenne
diate strategy; with 26 tables 1 Claus Brand. - Heidelberg; New York: Physica
Verl.,2001
(Conlributions to economics)
Zugl.: Essen. Univ., Diss.
ISBN 978-3-7908-1393-7 ISBN 978-3-642-57601-0 (eBook)
DOI 10.1007/978-3-642-57601-0
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Contents
1. Introduction.... ............. .... ... . . . . . . . . . . . . . . . . . . . . . . 1
1.1 Intermediate strategies for monetary policy . . . . . . . . . . . . .1 . . .
1.2 The role of the Bundesbank. . . . . . . . . . . . . . . . . . . . . . .3 . . . . . . .
1.3 The methodological framework. . . . . . . . . . . . . . . . . . . . 4. . . . . . .
2. Measuring monetary policy: Operating procedures and in-
termediate strategies ....... ...... ... .................... . 7
2.1 The conduct of monetary policy in Germany . .. . . . . . . . . . . . . 7
2.1.1 The practice of monetary targeting. . . . . . . . . . . . . . . . . 7
2.1.2 The development of instruments for monetary control . 19
2.2 Operating procedures and money supply ................ .. 30
2.3 A note on the identifiability of money demand ... ... ....... 32
2.3.1 The identification problem. . . . . . . . . . . . . . . . ... . 3.2 . . . .
2.3.2 Money demand and monetary policy rules. . . . . . . . . .. 33
2.3.3 Tracing the supply side using bank reserves? . . . . . .. .. 34
2.4 A note on the identifiability of autonomous monetary policy
actions. . . . ... .. .. .. .. .. .. .. .. .. . .. .. . ... ... .. ... . ... .. 35
2.4.1 Common identification problems in VARs ... .. ... ... 35
2.4.2 Identifying monetary policy regimes .... .......... .. 37
2.4.3 Narrative approaches . . . . . .. .. . . . . . . . . . . . . . . . . . . 39 ..
2.4.4 Unresolved issues. . . . . . . . . . . . . . . . . . . . . .. .. . .3 9 . . . . . .
2.5 Evidence from recent empirical analyses of German monetary
policy.. .... ...... .. ... .... . ...... .... . ... .. .. .. .. .. . . . 40
2.5.1 Was there no role for monetary aggregates in Germany? 40
2.5.2 Did the Bundesbank pursue a Lombard rate regime? .. 41
3. Theoretical framework. . . . . . . . . . . . . . . . . . . . . . . ... . 4. 5 . . . . . . . .
3.1 Basic considerations . . . . . . . . . . . . . . . . . . . . . . . .. .. . .4 .5 . . . . . .
3.2 Interest rate operating procedure (from 1985 on) .......... . 47
3.3 An alternative approach: reserves targeting. . . . . . . . . . ... . . 4.9
3.4 Discount window borrowing procedure (1975-1984) . . . . . . . .51.
3.5 Concluding remarks .... ... .. ... ..... .. ..... ... ......... 52
VI Contents
4. Analysis of time series using linear state space models ... , 53
4.1 Basic concepts ......... , . . . . ... .. . . .. . . . .. . . . . . . . . . .. . 53.
4.1.1 Common approaches to multivariate time series analysis 53
4.1.2 The system theoretic approach. . . . . . . . . . . . . ... . 5. 4. . .
4.1.3 Filtering and smoothing. . .. . . . . . . . . ... .. .. .. . . ... . 55
4.2 The linear state space model. . . . . . . . . . . . . . . . . . .. . . .5 .5 . . . . .
4.3 Specific properties of the linear model. . . . . . . . . . . . . ... . .5 8. . .
4.3.1 Innovation state space representation.. . . . . . . . .. .. . 5. 8
4.3.2 Linear state space models and time series models . . . .. 59
4.3.3 Minimality..................... ......... ...... .. 64
4.4 Signal extraction using the Kalman filter. . . . . . . . . . . .. .. . .6 7 .
4.4.1 Filtered forecasts. . . . . . . . . . . . . . . . . . . . . . .. . 6.7 . . . . . . .
4.4.2 Smoothed forecasts . . . . . . . . . . . . . . . . . . . ... . . 70. . . . . . .
4.4.3 The use of the Kalman filter in econometrics. . . . . .. . . 70
4.5 Structural analysis. . . . . . . . . . . . . . . . . . . . . . . . .. . . .7 1. . . . . . . . .
4.5.1 Impulse-responses to orthogonal innovations.. .. .. . . . 71
4.5.2 Impulse-responses to non-orthogonal innovations us-
ing a Wold-ordering scheme ........ . . . . . . . . . ... . 7.2 .
4.5.3 Impulse-responses to non-orthogonal innovations: Be-
yond the Wold-ordering scheme . . . . . . . . . . . . .. . . .7 4. . .
4.5.4 The forecast error variance decomposition .. . . . . . .. . . 76
4.5.5 Distribution of impulse-response functions. . . . . . .. .. . 77
4.6 Model selection and estimation. . . . . . . . . . . . . . . . . ... . .7 9. . . . .
4.6.1 The model building algorithm ............... " . . ... 79
4.6.2 Salient features of the algorithm as compared with VARs 83
4.6.3 Model specification tests ............... ........... 85
4.7 Modelling nonstationary time series and common stochastic
trends.. .......... ................................... .. 88
4.7.1 Detrending and common trend representation in
econometrics. . . . . . . . . . . . . . . . . . . . . . . . ... .8 .8 . . . . . . . .
4.7.2 Modelling trend and cycle . . . . . . . . . . . . . . . . .. .. . 90 . . . .
4.7.3 A useful generalisation for cointegrated time series ... , 95
4.7.4 Properties of the decomposition into permanent and
transitory components . . . . . . . . . . . . . . . . . . . .. .9 .6 . . . . .
5. Empirical implementation and results ..................... 101
5.1 Is a multiplier approach adequate to model German money
supply? ............................................... 101
5.1.1 Data ............................................ 101
5.1.2 Results .......................................... 102
5.2 Monetary targeting and the business cycle . . . . . . . . . . ... . 11. 7. .
5.2.1 Data ............................................ 117
5.2.2 Results.. ...... ........ ........................ .. 118
5.3 A quantity theory based approach to inflation targeting ..... 126
5.3.1 Money stock control and inflation targeting .......... 126
Contents VII
5.3.2 The po approach .................... ............. 128
5.3.3 Data and results ................................. 129
6. Conclusions ............................................... 141
6.1 Methodological remarks .... : ............................ 141
6.2 Money stock control and the day-to-day conduct of monetary
policy .................................... ............. 142
6.3 Money stock control and inflation targeting in Germany ..... 143
6.4 Prospects for the ECB's monetary policy strategy .......... 144
List of figures ................................................. 147
List of tables ................................................. 149
Bibliography .................................................. 151
A. GAUSS-prograDlS ........................................ 157
A.1 Estimation of balanced state space model ..... ............. 157
A.2 Obtaining in-sample forecasts using the Kalman filter ....... 166
A.3 Calculation of impulse-responses ......................... 168
A.4 Calculation of forecast-error variance decompositions ..... .. 169
A.5 Decomposition of Error Variance-Covariance-Matrix Ll ...... 170
A.6 Aoki C-Test for model specification . . . . . . . . . . . . . . ... .1 7. 1. . . .
List of figures
2.1 Inflation and the development of the German overnight money
market rate (monthly: 1974.01 - 1997.04; dotted line: overnight
rate; solid line: annual change in consumer price index.) . . . . .. .. . 13
2.2 Development of M3 (monthly: 1974.01 - 1997.04). .............. 14
2.3 Development of West German GDP - (quarterly, in prices of 1991,
1974.01 - 1990.04). ..... ......... ............... ............ 15
2.4 Development of GDP for unified Germany - (quarterly, in prices
of 1991, 1991.01-1998.01). .. . . . . . . . . . . . . . . . . . . . . .. .. . 1. 6. . . . . . .
2.5 Development of the German Lombard, discount and overnight
money market rate. . . . . . . . . . . . . . . . . . . . . . . . . . .. .. . .2 .1 . . . . . . . .
2.6 Development of Lombard and discount loans and credit via REPOs 24
4.1 Graphical representation of model (4.3)-( 4.4} .................. 58
4.2 Graphical representation of system (4.10), (4.11) in innovation form. 59
4.3 The Kalman filter ... . . . . . . . . . . . . . . . . . . . . . . . . . . ... 6.9 . . . . . . . . .
5.1 Impulse-responses from money market model: 1991.01-1997.04 ... 107
5.2 Forecast error variance decomposition from money market model:
1991.01-1997.04 .................................... ........ 108
5.3 Impulse-responses from money market model: 1985.02-1990.05 ... 111
5.4 Forecast error variance decomposition from money market model:
1985.01-1990.05 ............................................ 112
5.5 Impulse-responses from money market model: 1975.01-1985.01 ... 115
5.6 Forecast error variance decomposition from money market model:
1975.01-1985.01 .. .. ......... .. ..... .. ....... ... .. ..... ..... 116
5.7 Impulse-responses from general model: 1990.05-1997.04 ..... .. .. 120
5.8 Impulse-responses from general model: 1990.05-1997.04 ......... 121
5.9 Impulse-responses from general model: 1975.01-1985.01 ......... 124
5.10 Impulse-responses from general model: 1975.01-1985.01 ......... 125
5.11 Capacity utilisation: 1975.1-1997.1V ........................... 131
5.12 Velocity of German M3: 1975.1-1997.1V ..... ....... ............ 132
5.13 GDP deflator and P*: 1975.1-1997.1V ......................... 133
5.14 Impulse-responses for price gap and overnight rate from state
space representation: 1975.1-1997.1V ....... .. ................. 138
5.15 Impulse-responses for price gap and overnight rate from VAR rep-
resentation: 1975.1-1997.1V .. ................................ . 139
List of tables
2.1 Monetary targets of the Deutsche Bundesbank. . .. . . . . . . . . . 1.1 . . .
3.1 Interaction among the variables under an interest rate rule .... .. 49
3.2 Interaction among the variables under a reserves targeting procedure 51
3.3 Interaction among the variables under the discount borrowing rule 52
5.1 Singular values of trend part for small model (1991.01-1997.04) .. 103
5.2 Ratios of singular values of trend part for small model (1991.01-
1997.04) ....... ... .. ... .. ... .................... ........... 104
5.3 Residual diagnostics: Trend part of model for subperiod 1991.01-
1997.04 ........ ............ ....... ........................ 104
5.4 Singular values of cyclical part for small model (1991.01-1997.04). 104
5.5 Ratios of singular values of cyclical part for small model (1991.01-
1997.04) .... .... ..... ........................ .......... .... 105
5.6 Residual diagnostics: Joint model for subperiod 1991.01-1997.04 .. 105
5.7 Model parameter estimates (1991.01-1997.04) .............. .... 106
5.8 Model parameter estimates (1985.02-1990.05) ............ .... .. 109
5.9 Residual diagnostics for subperiod 1985.02-1990.05 ..... ........ 110
5.10 Model parameter estimates (1975.01-1985.01) .................. 113
5.11 Residual diagnostics for subperiod 1975.01-1985.01 ............ . 114
5.12 Model parameter estimates (1990.06-1997.04) .................. 119
5.13 Residual diagnostics for subperiod 1990.06-1997.04 .. ... ........ 119
5.14 Forecast error decomposition: 1990.06-1997.04 .. .... ........... 122
5.15 Model parameter estimates (1975.01-1985.01) .......... ........ 123
5.16 Residual diagnostics for subperiod 1975.01-1985.01 ............. 123
5.17 Forecast error decomposition: 1975.01-1985.01 .. .. ..... ... ... .. 126
5.18 Parameter estimates and residual diagnostics: State space imple-
mentation of P* -model for West-Germany (1975.1-1990.lV) ..... 134
5.19 Parameter estimates and residual diagnostics: State space imple
mentation of P*-model for unified Germany (1975.1-1997.IV) ... . 135
5.20 Variance decomposition from state space implementation of P*-
model .... ..... ....... .... ... ...... .. .. ... ... ... ....... ... . 135
5.21 Parameter estimates and residual diagnostics: State space imple-
mentation of P*-model for unified Germany (1975.1-1997.IV) .... 137
5.22 Variance decomposition from Bundesbank-reaction-function ..... . 137
1. Introduction
1.1 Intermediate strategies for monetary policy
The launch of a single European currency in January 1999 has been sparking a
heated debate over what strategy the European Central Bank's policy should
be based on so as to distribute and maintain monetary stability in Europe.
In order to pass the Bundesbank's reputation as a tough inflation fighter on
to the European Central Bank there have been strong efforts to make the
ECB a close copy of the Bundesbank. It might be surmised that there will
be a lot of similarities in its intermediate strategies. Among other indicators,
the ECB's policy will be based on the growth rate of a broad monetary
aggregate consistent with its definition of price stability. As a key instrument
in the new central bank's instruments, REPO operations will constitute the
main refinancing source of private banks and, in addition, minimum reserve
requirements have been introduced to facilitate the authority's command over
the banking sector's liquidity by means of stabilising the demand for central
bank money.
After having introduced monetary targeting in the 1970s, in the 1980s,
the Bank of England and the Fed soon abandoned it again, because of distor
tions from financial innovations and currency substitution. But the Bundes
bank strongly defended its intermediate strategy of monetary targeting and
advocated its implementation in the European System of Central Banks.
The Fed announced a target for different monetary and credit aggregates
for the first time in spring 1975 (see Bernanke and Mishkin (1992)). It tar
geted the interest rate in the interbank money market in order to meet these
monetary targets but allowed fluctuations in the monetary base. On 6 Oc
tober 1979 the Fed's Chairman Paul Volcker announced a more pronounced
policy of monetary targeting: Henceforth, the Fed targeted the monetary base
using a "nonborrowed reserves procedure": it targeted the amount of central
bank credit excluding discount loans. Due to high and volatile interest rates
in the money market induced by this operating procedure, it was abandoned
in 1982 and the Fed began a gradual process of backing away from mone
tary targeting. Targets for monetary growth were dropped and, in February