The Role of Policymakers in Open Economies: Stylized International Patterns

1. The Role of Policymakers in Open Economies: Stylized International Patterns Jim Granato, Melody Lo, and M.C. Sunny Wong

2. The Goal of Our Research Project • Provide monetary authorities with cross-country evidence on the relation between the conduct of open economy monetary policy and business cycle outcomes. • Methodology: • Develop a formal theoretical framework and derive a variety of empirical implications. • Link the theory to the test in a direct way (We follow the spirit of empirical implications of theoretical models (EITM)). • The significance of this linkage would help identify stylized international patterns and is more informative to policymakers than conventional formal and empirical practice.

3. Background • This research project builds on Granato and Wong (2006). In that book: • We derive a closed economy policy rule to determine how an emphasis (and de-emphasis) on inflation stabilization affects business cycle stability. • Findings: • According to our theoretical model, we find that when policymakers place greater relative weight in stabilizing inflation, this leads to the simultaneous reduction in both inflation and output volatility -- Inflation-Output Co-stabilization (IOCS). • The theoretical result is supported by empirical tests of inflation and business-cycle performance in the U.S. for the period 1960 to 2000.

4. Background (cont.) • Theory and Testable Implications • Policymakers coordinate information using a policy rule (Taylor Rule) to reduce inflation uncertainty. • Aggressive inflation target (explicit or implicit) supplants prior information used to forecast prices (inflation persists less). • Future plans are made with greater certainty and IOCS achieved. • Consequence: relation between IOCS and Aggressive Policy. • IOCS and “coordination” view of policy is a challenge to existing orthodoxy (i.e., Time Consistency).

5. Estimated Taylor Policy Rule Aggressive Aggressive Non-Aggressive

6. Figure 2.1. IOCS, 1960-2000 (5-year moving standard deviation). Aggressive Non-Aggressive Aggressive

7. 1.0 5.0 0.9 4.5 I n f l 0.8 4.0 a e t i c o n Aggressive Policy Rule n e 0.7 3.5 t S s t i a s r n e 0.6 3.0 d P a r n d o 0.5 2.5 i D t a e l f v i n a 0.4 2.0 I t i o n 0.3 1.5 0.2 1.0 1960 1965 1970 1975 1980 1985 1990 | | | | | | | 1 9 7 0 1 9 7 5 1 9 8 0 1 9 8 5 1 9 9 0 1 9 9 5 2 0 0 0 I n f l a t i o n P e r s i s t e n c e I n f l a t i o n S t a n d a r d D e v i a t i o n Figure 7.7. Inflation Persistence and Volatility

8. In This Research Project • We explore the necessary condition between inflation stabilization policy and inflation performance --- in an open economy model. • We follow Granato and Wong (2006), Granato, Lo and Wong (2006 and Forthcoming) to study open economy influence(s) on monetary policy regime shifts. • In this particular paper/chapter we examine if open economies are more likely to engage in inflation stabilizing policy.

9. An Illustrative StudyWhat Explains Recent Changes in Monetary Policy Attitudes Toward Inflation? Evidence from Developed Countries • Focus: • Did a universal monetary policy regime shift occur? • What economic fundamentals drive such shifts? • The literature: • Since Alogoskoufis and Smith (AER, 1991), several studies have stated that there are seemingly universal shifts in monetary policy attitudes toward inflation due to the implementation of a floating exchange rate regime. • The major problem: difficulty in isolating the exchange rate shift effect, if any, on monetary policy intentions. • Burdekin and Siklos (JMCB, 1999)and Bleaney (IMF, 2001) both show that inflation persistence has changed over time for ‘unknown’ reasons --- and that are unconnected to an exchange rate regime shift.

10. Our Argument • Economic Openness is a compelling candidate to account for observed changes in the monetary policy responses to inflation shocks. • A line of literature starting with Romer (QJE, 1993) has used economic openness to explain “cross-country” differences in monetary policy implementation: A negative economic openness-inflation relation • This result, it is argued, derives from the fact that monetary authorities in more open economies face greater costs for high and variable inflation. • We argue that, within a country, policymakers can also be expected to react to inflationary pressures more strongly as its economy grows more open.

11. Our Methodology • Our empirical results are based on both cross-country and individual-country analyses on a group of 18 developed countries. • Our policy aggressiveness estimate: The size of coefficient indicates the average "die-out-rate“ of the inflation shock (hereafter DOR). • Our economic openness estimate: This estimate is based on both Purchasing Power Parity and Quantity Theory of Money arguments. • We examine: (Cross-country) (Individual-country)

12. Empirical Results • Table 1: Cross-country analysis: • We use cutoff points of 1973 and 1990. The results show that it is primarily after the 1990s when inflation shocks die out faster in more economically open countries. • Table 2: Individual-country analysis (pre-specified cutoff points): • About 61% of the sample countries seem to have shifted, around 1985-1990, in their monetary policy making. • Policymakers in more recent years conduct monetary policy in reaction to changes in the degree of economic openness. • To validate this emerging shift, we also apply Bai and Perron's (1998, 2003, henceforth BP) methodology. The BP method is designed to test and date multiple structural breaks.

13. Empirical Results (cont.) • Table 3: • Panel A: Many countries did have a monetary regime shift in the neighborhood of the 1985 to 1990s period. • Panel B: 13 (out of 18) countries have their inflation shocks die out faster in the latter regime shift period. • Monetary regime shifts in recent years is more universal: policy aggressiveness is increasing! • Table 4: • Panel A: The majority of countries did have their most recent break dated in the neighborhood of 1985-1990. • Panel B: (1)14 out of 18 country's have their openness parameter from the "last" regime period become significantly negative. (2) In 12 out of 14 countries, this emerging negative DOR-openness relation has no precedent (prior to the last regime period).

14. Conclusion • Taking all evidence together, this study documents that changes in the DOR in recent years is a stylized international phenomena that has a coherent explanation. • The recent universal decrease in the persistence of inflation shocks is a reflection of monetary authorities in many (developed) countries becoming more aggressive (w.r.t. inflation shocks) due to changes in the degree of openness within their economies. • This universal change in monetary policymaking at the individual country level is fundamental for the documented cross-country pattern that more aggressive monetary policies were adopted in more open economies (primarily) in the 1990s.