ESTUDIOS SOBRE LA ECONOMÍA ESPAÑOLA

EEE 209

June 2005

ftp://prinfed.fedea.es/pub/eee/eee208.pdf ISSN 1696-6384

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The opinions in the EEE Series are the responsibility of the authors an therefore, do not necessarily coincide with those of the FEDEA.

Carmen Díaz-Roldán

Universidad de Castilla-La Mancha

** Alberto Montero-Soler

Universidad de Málaga

Abstract

Starting from inflation rates above the European average, Spain was able to conduct her monetary policy and control inflation in order to join the EMU from its start. In this paper we explore whether the credibility of the monetary policy performed by the Bank of Spain would have contributed to these developments.

Keywords: Monetary policy rules, inflation, credibility.

JEL Classification: E52, E58

Carmen Díaz-Roldán acknowledges financial support from Fundación BBVA and the Spanish Ministry of Science and Technology, through the project SEC2002-01892. The authors are the only responsible for errors.

** Address for correspondence: Departamento de Economía Política, Universidad de Málaga, Campus de Teatinos s/n, 29071 Málaga (Spain), e-mail: amontero@uma.es

1 Introduction

The role of monetary policy rules to explain the behaviour of central banks has received an increasing attention during the last few years. In particular, Taylor’s (1993) contribution has attracted a considerable interest of policymakers, central banks' governors and the academic community.

Taylor-type rules can be understood as rules of behaviour which respond to deviations of real output and inflation from their desired levels. For that reason, many contributions to the literature on monetary policy have tried to assess how Taylor rules can explain the behaviour of central banks (see Clarida, Galí and Gertler (1998, 2002), and Gerlach and Schnabel (2000), among others).

The Spanish case could be of particular interest given that, starting from inflation rates above the European average, she was able to control inflation in order to participate in the European Economic and Monetary Union (EMU) from its start. During the previous years, there were several changes in the instrumentation of monetary policy in Spain, which turned to be more concerned about controlling inflation. But after the adoption of a common monetary policy, a continuous increase in inflation can be observed. Figure 1 shows the evolution of the inflation rate in Spain and the eurozone. As can be seen, in the years before the adoption of the European Central Bank’s monetary policy in January 1999, the Spanish inflation rate tended to approach the eurozone average; but after that date the differential with the eurozone turned to grow again.

FIGURE 1

The extent to which the change in the policy regime before 1999 was key in order to decrease inflation is a non trivial question. The literature on monetary policy has stressed the role played by credibility when dealing with inflation: if monetary policy is conducted through stable and announced rules, the credibility of monetary authorities will rise, which would contribute to decrease inflation (see Barro and Gordon,1983). In addition, as stressed by Giavazzi and Pagano (1988), the increase in Central Bank credibility would be an essential requirement to form a monetary union.

In this paper, we explore the implications of monetary policy rules on credibility and inflation in Spain, before and after EMU.

2 The usefulness of a monetary policy rule to deal with inflation

In a previous paper, Díaz-Roldán and Montero-Soler (2004) analyzed monetary policy in Spain in terms of Taylor-type rules, from 1978, when the Bank of Spain announces its monetary control target, to 1998, the year before joining EMU. The baseline reaction function estimated was:

\[r _ {t} = (1 - \rho) \alpha + (1 - \rho) \beta \pi_ {t + i} + (1 - \rho) \gamma \widetilde {y} _ {t + j} + \rho r _ {t - 1} + v _ {t}\tag{1}\]

where is the nominal interest rate, is the inflation rate, is the output gap, and is the error term. According to the Taylor rule, , where and are the defined target for nominal interest rate and inflation, respectively; , and is an indicator of the degree of smoothing of nominal interest rate. This equation was estimated by the Generalized Method of Moments (GMM), using quarterly data for the interbank monetary market interest rates, the percent change in the Consumer Price Index, and the output gap computed from a linear trend.

Monetary policy proved to be properly described by a Taylor-type rule only for the period after joining the European Monetary System (EMS), i.e., from 1989:3 to 1998:4. The results from the estimation can be seen in Table 1 (t-statistics in parentheses). Several other additional variables were included in the baseline specification, but none of them proved to be significant. In particular, this was the case of the German interest rate, which would question the strong version of the German dominance hypothesis in the EMS (see, e.g., Bajo-Rubio et 2001). Looking at the value obtained for the coefficient on inflation target, , could be concluded that the Spanish effort on controlling inflation would have been greater than in other countries; see the comparative results in Table 2.

TABLE 1 Sample period: 1989:3-1998:4

In order to check the stability of that coefficient, Figure 2 shows the recursive estimations of β in the preferred specification (i.e., the backward looking one). Its value would have been always above 2, reaching the highest values in the middle of 1994 and in 1998. After that date, the lower values of β could indicate a certain degree of “relax” of monetary policy, given the imminent formation of EMU.

FIGURE 2

Overall, according to these results the Spanish monetary authorities would have followed a Taylor-type rule, and would have been relatively more concerned about inflation.

However, in the last years, and after the adoption of a common monetary policy, we can observe a continuous increase of inflation in Spain (see Figure 1). Could this fact be due to a (common) “more relaxed” monetary policy? What would have happened if the Bank of

Spain would have conducted an independent monetary policy after 1999? In order to answer these questions, we have computed the forecast for the nominal interest rate following the Taylor-type rule of the preferred baseline specification, four years ahead from 1999.

As can be seen in Figure 3, the rule followed by the Bank of Spain before joining EMU would parallel the actual evolution of the interest rate, but at a higher level. This evidence would reflect the more anti-inflationary stance of the Spanish monetary policy, and would be in line with Mihov’s (2001) findings that the European Central Bank (ECB), in the first years of its operation, would have been closer to an aggregate of the central banks in Germany, France, and Italy than to the Bundesbank alone.

FIGURE 3

3. Conclusions

Before the formation of EMU, and particularly after joining the SME, Spanish monetary policy would have follow a Taylor-type rule with a high coefficient on the inflation target. This behaviour would have led to a significant fall in the inflation rate, which might have allowed Spain to be able to join EMU from its start. This result would reveal the importance of rules and credibility of monetary policy to control inflation.

In contrast, the increase in both inflation rates and the differential with the eurozone, observed in recent years, might be due in part to a more relaxed common monetary policy. From this we can conclude that, given the lack of monetary policy independence, some structural reforms should be performed.

References

1. Bajo-Rubio, O.; Sosvilla-Rivero, S. and Fernández-Rodríguez, F. (2001): “Asymmetry in the EMS: new evidence based on non-linear forecasts”, European Economic Review 45, 451-473.

References

1. Barro, R. and Gordon, D. (1983): “Rules, discretion and reputation in a model of monetary policy”, Journal of Monetary Economics 12, 101-121.

References

1. Clarida, R.; Galí, J. and Gertler, M. (1998): “Monetary policy rules in practice: some international evidence”, European Economic Review 42, 1033-1067.

References

1. Clarida, R.; Galí, J. and Gertler, M. (2002): “Monetary policy rules and macroeconomic stability: evidence and some theory”, Quarterly Journal of Economics 115, 147-180.

References

1. Díaz-Roldán, C. and Montero-Soler, A. (2004): “Las reglas de política monetaria en la actuación del Banco de España: 1978-1998”, Revista de Economía Aplicada 34, 39- 51.

References

1. Gerlach, S. and Schnabel, G. (2000): “The Taylor rule and interest rates in the EMU area”, Economics Letters 67, 165-171.

References

1. Giavazzi, F. and Pagano, M. (1988): “The advantage of tying one’s hands. EMS discipline and Central Bank credibility”, European Economic Review 32, 1055-1075.

References

1. Mihov, I. (2001): “Monetary policy implementation and transmission in the European Monetary Union”, Economic Policy 33, 371-406.

References

1. Taylor, J.B. (1993): “Discretion versus policy rules in practice”, Carnegie-Rochester Conference Series on Public Policy 39, 195-214