Welfare costs of monetary policy uncertainty in the economy with shifting trend inflation
| Author | To Trung Thanh,Le Thanh Ha,Doan Ngoc Thang |
| DOI | http://doi.org/10.1111/sjpe.12259 |
| Published date | 01 February 2021 |
| Date | 01 February 2021 |
126
|
wileyonlinelibrary.com/journal/sjpe Scott J Polit Econ. 2021;68:126–154.
© 2020 Scottis h Economic Societ y
Accepted: 2 June 2 020
DOI: 10 .1111/sjpe.1 2259
ORIGINAL ARTICLE
Welfare costs of monetary policy uncertainty in
the economy with shifting trend inflation
Le Thanh Ha1| To Trung Thanh1| Doan Ngoc Thang2
1National Economics University, Hanoi,
Vietnam
2Banking Aca demy of Vietnam, Ha noi,
Vietnam
Correspondence
Le Thanh Ha, Nat ional Economics
University, Hanoi, Vietnam.
Email: halethanh.kt@gmail.com
Funding information
National Foun dation for Science a nd
Technology Deve lopment (NAFOST ED) of
Vietnam, Grant/Award Number: 502.01-
2019.309; National Fo undation for Scien ce
and Technology Development, Grant/
Award Number : 502, 01-2019 and 309]
Abstract
We study welfare cost s of the uncertaint y about monetary
policy in the econo my featuring shifting trend inflation . We
follow Ruge-Murcia (J Econ Dy n Control 36: 914–-938,
2012) to employ the SMM appro ach to fit the model to
the US data (1979Q1-2015Q1). We find that the monetar y
policy uncert ainty affec ts economic welfa re through dif-
ferent dimensions. O n the one hand, the policy uncert ainty
itself distor ts the economic wel fare negligibly, not only by
increasing volatilitie s of consumption and leisur e, but also
by decreasing their aver age levels. A higher level of tren d
inflation then signif ies these changes to pr oduce greater
welfare costs. Fur thermore, the a dverse impact s of policy
uncertaint y on the economy, documented by th e impulse
response funct ions of macroeconomic v ariables to policy
uncertaint y shock, become lar ger when central bank s raise
their inflation tar gets. On the other hand, the cos ts of exog-
enous variations in tr end inflation are larger if there is pol icy
uncertainty.
KEYWORDS
policy risk, shifting trend inflation, time-varying volatility,
uncertainty, welfare costs
JEL CLASSIFICATION
C63; E31; E52
|
127
HA et Al.
|
Economists an d policy makers a like have seen the US eco nomy being simult aneously buf feted by larger-than-
usual uncertainty about future policy1 and a sustain ed rise in inflatio n. Although t heir consequen ces have sub-
sided, there re main concerns rel ated to the possibil ity of policy un certaint y as well as a persist ent increase in
inflation in the f uture. In the literature, the te rm “uncertainty,” referred to as “objec tive uncertainty” or “r isk,” is
defined as the di spersion or spread of econ omic shocks distrib ution. Rational consum ers and firms then resp onse
to the fact that f uture shocks a re widely distr ibuted (time-var ying varianc e). Following Fernand ez-Villaverde,
Guerron-Qu intana, and Uribe (2011) and B orn and Pfeifer (2014), we jointl y consider level shocks a nd uncertainty
shocks in our mo del. Moreover, we also incorporate a hig hly persistent shock to tren d inflation, regarded as the
central bank' s slowly moving imp licit inflation t argets, as arg ued by Kozicki and Tins ley (2001), Irelan d (2007),
Cogley and Sbor done (2008), an d Cogley, Primiceri, a nd Sargent (200 9). This study the n investigates wel fare
losses and the b usiness cycle implicatio ns of increased uncertain ty about future policy a nd whether the alterna-
tion in trend infl ation leads to changes in it s effects.
Figure 1 shows the evo lution of the US core PCE: Per sonal Consumption E xpenditures inflat ion from 1960:Q1
to 2015:Q1. Two striking point s should be menti oned here. Fir st, the mean val ue of inflation (the re d lines in
Figure 1) shift s over time. Evidence on changing tre nd inflation rates for several in dustrial countries and for th e
United States is als o provided by Levin and Piger (20 03) and Ireland (2007)2, res pectively. Second, we obser ve a
rise in inflation a s a gradual process instea d of a sudden increase to a high level . This implies that the rise i n infla-
tion was persis tent, particularly du ring the great inflation. The p roperty of high persis tence for inflation is docu-
mented by other emp irical studies, nam ely Cogley and Sbordone (2 008), Fuhrer (2010), and Nakat a (2014).
In addition, we al so show the existence of time-var ying volatility in the US econ omy. Figure 2 and 3 plot the
absolute deviat ions of the US real GDP grow th and core PCE from the ir means. There were th e big spikes from the
1970s to the early 1980s. Th ey disappeare d since 1984 and did not retu rn even briefly as s hown in Figure 3.
Moreover, the absolut e deviations of real GDP growt h and inflation rarely cros sed 0.2 and 2 points, res pectively,
since 1984, while they h ad done so rather o ften before. Th e evidence sugge sts the exist ence of time-var ying
volatility in th e US data. The existing l iterature has also docum ented a feature of the time-va rying volatility of th e
US data, for exam ple, Sims and Zha (2006), Fernan dez-Villaverde and Rub io-Ramirez (2007), and Just iniano and
Primiceri (20 08). Born and Pfeifer ( 2014) also show that the 1970s were plagued by h igh shock volatilities in m on-
etary poli cy shocks. Ob viously, the US economy i s characterize d by both time-var ying trend infl ation3 and
time-varyi ng volatility, which c auses us to develop t he model incor porating thes e features. Fur thermore,
Fernandez-Villaverd e, Guerron-Quintana, an d Rubio-Ramire z (2015) argue that th e presence of both s tochastic
volatility and parameter drifting4 successfully mod els the US economy.
So far, the existing l iterature has primari ly concentrated on the ag gregate effects of t he short-run fluctuat ions
in the volatilit y of various macroeconomic var iables, while little has be en investigated with regard to it s welfare
effect. Few p apers exploit the welfare a nalysis, but they only consid er a one-sided movement of volatilit y (a de-
crease in the cer tain level of volatility of l evel shocks to zero), for example L ester, Pries, and Sims (2014) and Cho,
Cooley, and Kim (2015). Th e recent work by Xu (2017) and Bachmann, Ba i, Lee, and Zhang (2018) examines th e
welfare conseq uences of time-varyi ng volatility. Research by Nak ata (2014) and Ha, Thanh, and T hang (2019) also
1Born and Pfe ifer (2014) argue th at the US data have be en plagued by hig h shock volatili ties since the 1970s . The evidence fo r shifts in th e variance
of innovation s is also provide d by Bernanke and Mi hov (1998), Cogley and S argent (2005), P rimiceri (20 05) and Sims and Zh a (2006).
2By using the mo del that allows i nferences conce rning the Fede ral Reserve's i nflation targ ets, Ireland ( 2007) shows cha nges from 1959 (1.25%) to
the late 1970s (8%) an d in 2004 (2.5% ).
3As in Nakata ( 2014), these welfa re costs can be in terpreted as th e consequence s when central b anks lack a commi tment to pursue a f ixed inflatio n
target or cent ral banks have a te ndency to let in flation change .
4Shifting t rend inflation i s a type of param eter driftin g, in which the st eady-state inf lation drift s over time.
Get this document and AI-powered insights with a free trial of vLex and Vincent AI
Get Started for FreeStart Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
Start Your Free Trial of vLex and Vincent AI, Your Precision-Engineered Legal Assistant
-
Access comprehensive legal content with no limitations across vLex's unparalleled global legal database
-
Build stronger arguments with verified citations and CERT citator that tracks case history and precedential strength
-
Transform your legal research from hours to minutes with Vincent AI's intelligent search and analysis capabilities
-
Elevate your practice by focusing your expertise where it matters most while Vincent handles the heavy lifting
