Timothy Kam, Kirdan Lees and Philip Liu | Journal of Money, Credit and Banking

We estimate underlying structural macroeconomic policy objectives of three of the earliest explicit inflation targeters within the context of a small open economy dynamic stochastic general equilibrium model. We assume central banks set policy optimally, such that we can reverse engineer policy objectives from observed time series data. Joint tests of the posterior distributions of these policy preference parameters suggest that the central banks are very similar in their overall objective. None of the central banks showa concern for stabilizing the real exchange rate. All three central banks share a concern for minimizing the volatility in the change in the nominal interest rate. We also show that the resulting optimal policy rule responds to exchange rate movements, even in the case where the central banks do not explicitly care about exchange rate stabilization. This result is also corroborated by results from an alternative simple-rule characterization and estimation of central bank behavior. These last two findings point to the pitfalls of making inferences, from the level of ad hoc simple rules, about what central banks may care about.

Yifan Hu and Timothy Kam | Journal of Macroeconomics

We introduce a model of government bonds with transactions services into a standard dynamic stochastic general equilibrium sticky-price monetary economy. This additional feature results in an endogenous interest-rate spread and affects equilibrium allocations and inflation by altering the Ramsey planner's sequence of implementability and stickyprice constraints. Qualitatively, the trade-off confronting a planner in sticky-price models shown in recent literature, between using inflation surprise and labor-income tax, is eliminated by the liquid bond channel. We find that the more sticky prices become, the more the optimal fiscal-monetary policy stabilizes prices and also creates less distortionary and less volatile income taxes by taxing the liquidity service of bonds. Quantitatively, we show that the additional tax instrument created by the bond liquidity channel can yield a sizable welfare gain from an economy without this channel.

Timothy Kam | North American Journal of Economics and Finance

We extend the Monacelli [Monacelli, T. (2005). Monetary policy in a low pass-through environment. Journal of Money, Credit and Banking, 37(6), 1047-1066] model to allow for a central bank that penalizes nominal interest rate paths that are too close to the zero lower bound. We analytically derive the optimal interest-rate policy rule in each equilibrium under four policy regimes: (i) benchmark commitment to an ex-ante optimal monetary-policy plan; (ii) benchmark discretionary policy; (iii) optimal delegation to a discretionary policy maker with similar preferences to society; and (iv) optimal delegation to a discretionary policy maker with an additional taste for interest-rate smoothing. Under the commitment benchmark, the optimal interest-rate rule is proved to be intrinsically inertial, whereas this property is non-existent under discretionary policy. In the absence of commitment, there are gains to delegating policy to an interest-rate smoothing central banker. We show that while the endogenous lawof one price gap in the model exacerbates the optimal policy trade-off that arises under discretionary policy, the latter feature of interest-rate smoothing acts to weaken it, by mimicking intrinsic inertia under the commitment policy.

Timothy Kam and Yi-Chia Wang | Economic Record

We extend the deterministic growth model of Glomm and Ravikumar (1994) to a stochastic endogenous growth model which nests both exogenous and endogenous growth factors. By introducing simple shocks to production technology, private capital and public capital investment, we can derive testable time series properties of the analytical model. We find evidence of co-integration between per capita output, per capita private capital and public capital. A nested test of the strictly endogenous growth model is rejected statistically. We find that growth is exogenous even in the presence of significant and sizeable public capital spillover effects. Our long-run elasticity estimates help to inform the short-run dynamic transitions of the model. In particular, we are able to structurally rationalise other empirical findings of bi-directional short-run effects between public and private capital and also aggregate output.

Mark Crosby, Timothy Kam and Kirdan Lees | Economic Record

This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linear-quadratic formulation of inflation targeting, we append a term that penalises deviations in the exchange rate to the central bank's loss function. For a simple forward-looking new-Keynesian model, we show that the central bank can reduce volatility in the exchange rate relatively costlessly by aggressively responding to the real exchange rate. However, when we append correlated shocks to better match summary statistics the Australian data, we find that the costs associated with reducing exchange rate volatility are larger: output volatility increases substantially. Finally, we apply our method to a variant of a small backward-looking new-Keynesian model of the Australian economy. Under this model, large increases in inflation and output volatility accrue if the central bank attempts to mitigate exchange rate volatility.

Timothy Kam | Journal of Macroeconomics

In this paper, interest-rate smoothing under Taylor-type rules is considered for an empirically plausible two-sector small open economy. A simple Taylor-type rule that has sufficient response to output gap, coupled with interest-rate smoothing, can improve welfare relative to our benchmark historical rule. This result is robust to alternative values of the degree of habit persistence and nontraded- goods price stickiness in the model. Alternatively, the interest-rate smoothing result may not hold when an strictly inflation-forecast-based (IFB) rule is used. However, incorporating sufficient response to contemporaneous output gap and inflation in the IFB rule, interest-rate smoothing can also deliver superior welfare outcomes.