Accounting undergraduate Honors theses: Essays on monetary policy rules and inflation dynamics

My aim in accounting for potential nonlinearity is to get a better understanding of the policy makers’ opportunistic approach to monetary policy and evaluate the inflation globalization hypothesis, which basically predicts that global factors will eventually replace the domestic determinants of inflation.
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Accounting undergraduate Honors theses: Essays on monetary policy rules and inflation dynamics University of Arkansas, Fayetteville ScholarWorks@UARK Theses and Dissertations 8-2016 Essays on Monetary Policy Rules and Inflation Dynamics Saad Ahmad University of Arkansas, Fayetteville Follow this and additional works at: http://scholarworks.uark.edu/etd Part of the Macroeconomics Commons Recommended Citation Ahmad, Saad, Essays on Monetary Policy Rules and Inflation Dynamics (2016). Theses and Dissertations. 1635. http://scholarworks.uark.edu/etd/1635 This Dissertation is brought to you for free and open access by ScholarWorks@UARK. It has been accepted for inclusion in Theses and Dissertations by an authorized administrator of ScholarWorks@UARK. For more information, please contact scholar@uark.edu, ccmiddle@uark.edu. Abstract There has been a growing trend to utilize nonlinear models to analyze key issues in mon- etary policy and international macroeconomics. Using traditional linear models to under- stand nonlinear relationships can often lead to inaccurate inference and erroneous policy recommendations. The three essays in this dissertation explore nonlinearity in the Federal Reserve’s policy response as well as between a country’s inflation dynamics and integration in the global economy. My aim in accounting for potential nonlinearity is to get a better understanding of the policy makers’ opportunistic approach to monetary policy and evalu- ate the inflation globalization hypothesis, which basically predicts that global factors will eventually replace the domestic determinants of inflation. In the first essay I develop a broad nonlinear Taylor rule framework, in conjunction with real- time data, to examine the Fed’s policy response during the Great Moderation. My flexible framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis. The second essay uses a threshold methodology to investigate the importance of nonlinear effects in the analysis of the inflation globalization hypothesis. Finally the third essay investigates the relationship between inflation and globalization, under an open-economy Phillips Curve framework, for a panel of OECD countries with a dynamic panel GMM methodology. Contrary to most of the previous literature, which ignores such nonlinearities, my new approach provides some interesting empirical evidence supportive of the effect globalization has on a country’s inflation dynamics. Acknowledgements I am deeply grateful to my dissertation committee chair, Andrea Civelli, for his continued guidance and support during my graduate studies. I owe profound thanks to my committee members, Jingping Gu and Tim Yeager, who helped improve my work and increased my research capabilities. Lastly, this dissertation and my academic studies would not be possible without the constant support and belief of my parents, Ahmad and Nausheen. 1 Introduction There has been a growing trend to utilize nonlinear models to analyze key issues in mone- tary policy and international macroeconomics. Using traditional linear models to understand nonlinear relationships can often lead to inaccurate inference and erroneous policy recommen- dations. The three essays in this dissertation explore nonlinearity in the Federal Reserve’s policy response as well as between a country’s inflation dynamics and integration in the global economy. My aim in accounting for potential nonlinearity is to get a better under- standing of the policy makers’ opportunistic approach to monetary policy and evaluate the inflation globalization hypothesis, which basically predicts that global factors will eventually replace the domestic determinants of inflation. The validity of the inflation globalization hypothesis could eventually lead to prominent changes in the conduct of monetary policy, so it is imperative to identify the exact role global forces play in the inflation process. In the first essay, A multiple threshold analysis of the Fed’s balancing act during the Great Moderation, I develop a broad nonlinear Taylor rule framework, in conjunction with real- time data, to examine the Fed’s policy response during the Great Moderation. My analysis finds that standard two-regime smooth transition models are unable to fully capture the Fed’s nonlinear response. I therefore utilize the Multiple Regime Smooth Transition model (MRSTAR) to get a better understanding of the Fed’s asymmetric preferences and oppor- tunistic conduct of monetary policy. With the MRSTAR model I am able to use both inflation and the output gap as concurrent threshold variables in the Fed’s policy response function and am able to determine that policy makers prioritize loss of output over infla- tionary concerns. My flexible nonlinear framework is also able to convincingly show that the Fed departed from the Taylor rule during key periods in the Great Moderation as well as in the recent financial crisis. 1 The second essay, Globalization and inflation: A threshold investigation, uses a threshold methodology to investigate the importance of nonlinear effects in the analysis of the inflation globalization hypothesis. Accounting for potential nonlinearities in the Phillips Curve, I show that trade openness is not rejected as a threshold variable for the effects of domestic and foreign slack on inflation in many advanced economies, and also find a switch of the output gap slopes from one regime to the other that is consistent with the key predictions of the inflation globalization hypothesis. For some countries the threshold Phillips Curve model also leads to improvements in out-of-sample forecasts over t ...