Empirical Essays on Monetary Policy Rules and Inflation

This dissertation is divided into four essays, each of them having its own structure and methodological framework. Although each of the essays making the chapters of the thesis is self-contained, their topics are very closely related. Consequently, the reader will be able to follow the thesis in its unity. Essay I is a selective survey of the extensive, mostly theoretic, literature dealing with monetary policy rules. We aim at contextualization of the monetary policy rules in the existing monetary economics literature. We explain the logic, the inspiration and the history of the rules for the monetary policy conduct. We distinguish between instrument rules and targeting rules as two basic categories. Finally, we resume specific issues related to policy rules for small open economies. Essay II studies the logic of short-term interest rate setting pursued by 15 EU countries before and after the launch of the EMU. We employ econometric estimation of the augmented Taylor rule (TR) for individual 15 EU countries and the Euro area. Although a vast empirical evidence is available for the major economies like the US, the UK or Germany, there is an important gap in our understanding of the factors behind the short-term interest rate dynamics in smaller economies. We find that in the period preceding the euro adoption, the TR is a poor representation of monetary policy setting in most EU countries and that many central banks considered decisions made by dominant economies rather than their domestic macroeconomic developments. The analysis of monetary policy rule of the ECB features additional problems related to the heterogeneity of the EMU. We argue that results based on Euro-area aggregated series, commonly presented in empirical studies, are subject to diverse econometric problems. We provide some evidence that the ECB is concerned also with national information and propose quasi-panel analysis as a viable framework. Essay III explores the relation between the existing monetary policy and domestic price stability in small open emerging economies, in particular the 12 EU new member states. This work has three principal objectives. First, it aims at revealing the logic of interest rate setting pursued by monetary authority of each country. The linear specification of the Taylor rule, applied already in the Essay II, is accompanied by an extensive analysis of nonlinearities in monetary policy rules and the inference on their possible sources. We find that the official monetary policy is sometimes inconsistent with the empirical evidence on the short term interest rate setting. The second objective consists in revealing the determinants of the inflation process. We have found that inflation rates are driven not only by backward persistency but also by the forward-looking component. Third, we employ analysis of the conditional inflation variance so as to give account on the viability of the existing monetary policy setting for price stability. We conclude that the policy of inflation targeting seems to be preferable to exchange rate peg because it allows decreasing not only inflation rate but also its conditional variance. Essay IV seeks to shed light on inflation dynamics of four CEEC (Czech Republic, Hungary, Poland and Slovakia) and test when the predominant model of inflation, the New Keynesian Philips Curve (NKPC), is consistent with the data of these countries. According to the microfounded NKPC, the current inflation is related to inflation expectations and the real marginal cost. The empirical validity of this model has recently become a subject of major controversy in the monetary economics. Although we find some favorable evidence for the NKPC, it seems to be too restrictive model for small open economies. In particular, the failure of the NKPC to explain the inflation dynamics of these countries may be related to the assumption that inflation is related to forward-looking price setting of domestic monopolist firms while our evidence suggests that prices in CEEC have an important backward-looking component and the inflation is significantly driven by external factors like the exchange rate and the foreign inflation rate.