Working Papers

Date Published: 15/04/2024

Working Paper 2024-1: Analysis of company profitability in Cyprus: the case of the unit profit metric

Marios C. Polemidiotis. The aim of this paper is twofold: (a) to present an analysis of company profitability trends in Cyprus, focusing on post-pandemic developments, both at the aggregate and at the sectoral levels; and (b) to shed some light on whether companies in Cyprus put up prices post-pandemic beyond the surge in input costs, via the construction of a corporate pricing power proxy. The paper uses data from the income side of National Accounts to construct the unit profit metric, modified by excluding mixed income and capital depreciation. The aggregate and sectoral metrics are defined as the net operating surplus of the economy/sector in question divided by real GDP/sectoral GVA. The estimates at the aggregate level point to a surge in unit profits following the outbreak of the pandemic, reaching historically high levels in 2022, however in a context of strong pent-up demand pressures following the lifting of the COVID lockdowns. At the sectoral level, the rise in unit profits post pandemic was mainly driven by trade, tourism and leisure-related activities, coinciding with strong economic reopening effects. The corporate pricing power proxy was at an all-time high in 2022, coinciding with strong domestic demand, suggesting that companies raised prices beyond the strong corporate cost dynamics. Going forward, past high company profitability appears to allow firms to absorb any further cost pressures, including from the wage side, given the observed, albeit relatively contained thus far, drop in total economy unit profits, also coinciding with an ongoing unwinding of strong demand pressures. At the same time, the sectoral estimates of unit profits exhibit significant variation, with continued, albeit much more moderate, growth in services. Thus, possibly higher and/or more persistent than foreseen company profits in some sectors could pose an upside risk to the baseline inflation outlook.

Date Published: 14/11/2023

Working Paper 2023-3: The inefficiency of Quantitative Easing in the Euro Area

Nektarios A. Michail, Kyriaki G. Louka. We examine whether quantitative easing had an impact on output and inflation in the euro area. Using a BVAR model, over the March 2015 - December 2021 period, our results suggest that quantitative easing is an inefficient policy tool. In particular, following a shock that increases asset purchases by around 1% of euro area GDP, inflation increases by around 0.01%, while industrial production rises by 0.3%. The biggest beneficiary of quantitative easing is the stock market, rising more than 2% after the shock. Since only a very small share of the general populace holds stocks, this has adverse inequality effects.

Date Published: 14/11/2023

Working Paper 2023-2: The pass through of monetary policy to euro area bank interest rates

Kyriaki G. Louka, Nektarios A. Michail. We examine the transmission of monetary policy to bank interest rates in the euro area, using rolling 10-year samples. The results suggest that the pass through of policy rates to bank interest rates was relatively stable prior to the use of unconventional monetary policy measures, in which case the multiplier increased, especially for housing and short-term NFCs loans. It appears that Quantitative Easing (QE) operations allow for bank lending rates to further decline, however, this could lead to higher lending in those particular loan categories, with certain repercussions to the economy. In addition to the excess liquidity created by asset purchases, other factors such as credit risk and house price growth also appear to impact the pass through. 

Date Published: 14/11/2023

Working Paper 2023-1: Missed payments, renegotiations, and household consumption

Kyriaki G. Louka, Nektarios A. Michail. The paper examines how the consumption habits of borrowers are affected after missing one or more payments or when their loans are delayed by more than 90 days. In addition, we investigate how household consumption may be impacted by a successful loan restructuring. Using data from the Eurosystem Household Finance and Consumption Survey for 2017, we find that households with late or missed loan payments report a fall in consumption levels and those with loans in arrears register an increase in consumption. This suggests that a household's failure to fulfil its commitments may actually help it increase its consumption. Other determinants that affect household consumption and income disparities are also considered as explanatory variables.

Date Published: 27/12/2022

Working Paper 2022-5: Fiscal Multipliers with Sovereign Risk and Fragile Banks

Matthieu Darracq Pariès, Georg Müller, Niki Papadopoulou. We quantify the size of fiscal multipliers in an economy with sovereign and bank default risk. We build a DSGE model with financial frictions for the euro area in which the interplay of corporate, bank and sovereign solvency risk affects the transmission of government spending. Sovereign bonds carry a credit risk premium that depends on government indebtedness. The banking system is fragile through its direct and indirect exposure to sovereign risk and limited loss absorption capacity. Calibrating the model on sovereign and bank riskiness reminiscent of the euro area sovereign debt crisis period, we show that adverse financial channels may signifcantly depress the fiscal multiplier. The trade-off for the fiscal authority, between the macroeconomic stabilization objective and solvency risks, continues to be relevant in the euro area. We also evaluate the scope for monetary and macro-prudential policy to mitigate the financial setbacks and help restore the effectiveness of fiscal stimulus.

Date Published: 27/12/2022

Working Paper 2022-4: Estimation of the Medium-Term Macroeconomic Impact of the Cyprus Recovery and Resilience Plan

Chrystalleni Aristidou, Aris Avgousti, Niki Papadopoulou. This paper estimates the medium-term macroeconomic impact of the fscal stimulus of the Cyprus Recovery and Resilience Plan (RRP) under various scenarios, by using the CYMCM, a semi-structural macroeconometric model of the Cyprus economy developed by CBC staff. Scenarios differ in their assumptions about the extent to which the expenditure measures included in the RRP are additional to the ones planned or expected prior to the agreement for a recovery plan for Europe. The analysis takes into account the data of the published Cyprus RRP and makes prudent assumptions on the additivity of RRP expenditure measures. In the scenario in which all RRP-related spending is used for additional measures to the ones planned (“full additivity” scenario), the simulations show that the expected impact on real GDP level is around 0.71 percent and for HICP inflation 0.08 percentage points. The expected impact on employment is 0.22 percent, while public debt-to-GDP is expected to decrease by 0.75 percentage points. In the scenario in which spending under the RRP is partially used for additional measures (“partial additivity” scenario), which is considered a more realistic scenario in this paper, the simulations show that the expected impact on real GDP level is around 0.58 percent and for inflation 0.06 percentage points. The impact on employment is 0.18 percent and the reduction in public debt-to-GDP ratio is expected to be around 1.25 percentage points. The results are based only on the fscal stimulus of the Cyprus RRP, as the analysis does not incorporate spillover effects of NGEU measures in other EU countries or additional productivity gains due to reforms. Nevertheless, the analysis indicates that implementation of the RRP will have a meaningful impact on the Cyprus economy in the medium-term. Overall, the results of this paper are comparable to the results of other studies.

Date Published: 27/12/2022

Working Paper 2022-3: Historical decomposition of the Cyprus Residential Property Prices

Chryso Aristidou, George Thucydides. The aim of this paper is to examine the main driving force(s) of residential property prices during various periods, via historical decomposition. This is achieved by establishing the contribution of different structural shocks to the historical dynamics of the residential property price index. For every quarter in the sample, the growth rate of the residential property price index is decomposed into its different components in order to assess the driving forces behind residential property prices fluctuations. In effect, an insight into possible disconnection of property prices and economic fundamentals could potentially also be gained, thus providing indications of possible vulnerabilities building up in the sector, which would in turn impose risks on fnancial stability. Furthermore, emphasis is given on the recent surge in construction costs which is shown to play a predominant role in the recent residential property price dynamics.

Date Published: 09/08/2022

Working Paper 2022-2: The relationship between shipping freight rates and inflation in the Euro Area

Nektarios A. Michail, Konstantinos D. Melas, Lena Cleanthous. Consumer inflation across the globe has rebounded during 2021, also as a result of supply side disruptions, one of which is the increase in freight costs. To elaborate on the relationship between inflation and shipping costs, we employ a Vector Error Correction Model (VECM) and use disaggregated monthly data from January 2009 to August 2021, using both constant tax and the standard price indices. Following a shock in freight rates, the most hard-hit sectors appear to be garments and major household appliances, items that have traditionally been manufactured outside the euro area. In addition, using a threshold regression methodology we show that when freight rates rise more than $1,300-$1,500 per day, the sensitivity of inflation to freight changes increases.

Date Published: 21/07/2022

Working Paper 2022-1: Estimating the Mortgage Default Probability in Cyprus: Evidence using micro data

Savvas Antoniou, Ioanna Evangelou, Theodosis Kallenos, Nektarios A. Michail. As financial institutions are exposed to the mortgage market, the identification of the characteristics associated with high default risk is crucial for the economy’s financial stability and growth. In this paper, we examine for the determinants of mortgage default for households, using both their economic and socio-demographic characteristics. Using panel data from the Eurosystem Household Finance and Consumption Survey from 2009 to 2017, we find that the mortgage debt service to income ratio, as well as the debt to total household wealth ratio, are positively related with a higher mortgage default probability. In addition, salaried employment reduces such probability and households with more than four members are more prone to mortgage arrears.

Date Published: 15/07/2022

Working Paper 2021-1: Does Household Behaviour Depend on Monetary Policy? Evidence from Cyprus

Nektarios A. Michail, Agorasti Patronidou, Ioanna Evangelou. The paper examines whether euro area monetary policy was able to affect the consumption and investment behaviour of households in Cyprus, using household level data for Cyprus obtained from the Household Finance and Consumption Survey. Using a panel analysis, we find that monetary policy only affects the deposit and consumption behaviour of indebted households, suggesting that the main transmission channel of monetary policy is via the change in loan instalments. Households without loans appear to be, in general, unaffected by monetary policy changes. This suggests that monetary policy can paradoxically be less effective when most needed, as, in times of financial stress, households tend to focus on deleveraging. Additional avenues with regards to the potential impact of monetary policy on investing behaviour are also explored.

Date Published: 19/03/2021

Θεματική Mελέτη: Μέτρα και αποφάσεις που λήφθηκαν για την αντιμετώπιση των επιπτώσεων της πανδημίας COVID-19

Αλέξια Γιάγκου, Πάνη Καραμάνου, Άρτεμις Νικολάου, Χρυστάλλα Ξενοφώντος, Μαρία Παπαγεωργίου, Κωνσταντίνος Τρικούπης. Η πανδημία COVID-19 έχει προκαλέσει στο παγκόσμιο χρηματοπιστωτικό σύστημα υπέρμετρη αβεβαιότητα και κλυδωνισμούς. Βέβαια, μετά την οικονομική κρίση του 2008, ο εγχώριος τραπεζικός τομέας είναι σε πολύ καλύτερη θέση για να αντιμετωπίσει αυτή την κρίση. Συγκεκριμένα, ο τραπεζικός τομέας της Κύπρου εισήλθε σε αυτή την κρίση με χρηματοοικονομικά δεδομένα κατά πολύ καλύτερα από τα αντίστοιχα της κρίσης του 2013, και ως εκ τούτου είναι πιο ανθεκτικός και σε θέση να διατηρήσει τη διοχέτευση ρευστότητας στην πραγματική οικονομία. Ταυτόχρονα, η οικονομία έχει ανακάμψει σημαντικά, με το Ακαθάριστο Εγχώριο Προϊόν να βρίσκεται στο τέλος του 2019 σε επίπεδα υψηλότερα από αυτά που καταγράφηκαν πριν την κρίση του 2012-2013.

Date Published: 24/07/2022

Working Paper 2020-1: Conceptual note on inflation targeting types and their performance in anchoring inflation expectations

Lena T. Cleanthous. Since the early 1990s, inflation targeting has been widely adopted across the globe with the primary objective of maintaining price stability. Central banks formulate their inflation objective in a variety of ways: most of them use point targets, some use range targets, others a point with bands around it. A priori, the effect of adding tolerance bands or a range on how well inflation expectations are anchored is not clear. On the one hand, point targets are missed more often, which may undermine the public’s confidence in the inflation target, especially if realised inflation deviates from the point target consistently. On the other hand, missing a target range or a band could be even more detrimental to the credibility of the target, whilst the increased flexibility from these types might lead to more uncertainty about the exact future path of inflation, leading to less firmly anchored inflation expectations. In the wake of persistently low inflation for over a decade, the type of inflation target has received renewed interest in the academia. A proposed solution to the persistence of inflation at low levels has been to replace point targets for target ranges. Recent evidence in the literature, however, has not been strong enough to overrule the central conclusion from the past international debate between point target and range target, that monetary policy flexibility could be achieved even without an interval.

Date Published: 12/07/2019

Working Paper 2019-2: On the Credit and Exchange Rate Channels of Central Bank Asset Purchases in a Monetary Union

Matthieu Darracq Pariès, Niki Papadopoulou. Through the euro area crisis, financial fragmentation across jurisdictions became a prime concern for the single monetary policy. The ECB broadened the scope of its instruments and enacted a series of non-standard measures to engineer an appropriate degree of policy accommodation. The transmission of these measures through the currency union remained highly dependent on the financial structure and conditions prevailing in various regions. This paper explores the country-specific macroeconomic transmission of selected non-standard measures from the ECB using a global DSGE model with a rich financial sector: we extend the six-region multi-country model of Darracq Paries et al. (2016), introducing credit and exchange rate channels for central bank asset purchases. The portfolio rebalancing frictions are calibrated to match the sovereign yield and exchange rate responses after ECB's Asset Purchase Programme (APP) first announcement. The domestic transmission of the APP through the credit intermediation chain is significant and quite heterogeneous across the largest euro area countries. The introduction of global portfolio frictions on euro area government bond holdings by international investors opens up for a larger depreciation of the euro. The interaction between international and domestic channels affect the magnitude and the cross-country distribution of the APP impact.

Date Published: 12/07/2019

Working Paper 2019-1: Empowering Central Bank Asset Purchases: The Role of Financial Policies

Matthieu Darracq Pariès, Jenny Körner, Niki Papadopoulou. This paper contributes to the debate on the macroeconomic effectiveness of expansionary non-standard monetary policy measures in a regulated banking environment. Based on an estimated DSGE model, we explore the interactions between central bank asset purchases and bank capital-based financial policies (regulatory, supervisory or macroprudential) through its influence on bank risk-shifting motives. We find that weakly-capitalised banks display excessive risk-taking which reinforces the credit easing channel of central bank asset purchases, at the cost of higher bank default probability and risks to financial stability. In such a case, adequate bank capital demand through higher minimum capital requirements curtails the excessive credit origination and restores a more efficient propagation of central bank asset purchases. As supervisors can formulate further capital demands, uncertainty about the supervisory oversight provokes precautionary motives for banks. They build-up extra capital buffer attenuating non-standard monetary policy. Finally, in a weakly-capitalised banking system, countercyclical macroprudential policy attenuates banks risk-taking and dampens the excessive persistence of the non-standard monetary policy impulse. On the contrary, in a well-capitalised banking system, the macroeconomic stabilisation with central bank asset purchases outweigh the marginal financial stability benefits with macroprudential policy.

Date Published: 31/07/2018

Working Paper 2018-4: To Create or to Redistribute? That is the Question

Demetris Koursaros, Nektarios Michail, Niki Papadopoulou, Christos Savva. This study attempts to explain low corporate investment in the post-crisis period, which persisted despite aggressive easing of  financial conditions. Agents utilize available funding by either investing in new capital creation or by acquiring existing assets (asset redistribution). The former increases total income and employment, while the latter alters the distribution of wealth amongst agents. Theoretical explanations and empirical evidence are provided to support the argument that during recessions investors deem it more profitable and banks find it safer to fund re-purchases of existing assets, rather than create new assets. This trend exacerbates a recession and slows recovery as it deprives entrepreneurs of funding. Furthermore, this scenario provides an explanation of the phenomenon of rising inequality and social harm over the course of a recession. As asset redistribution is predominantly a privilege of the rich, an increase in inequality encourages more income redistribution, thus further exacerbating recessions. Finally, it is demonstrated that macroprudential policies promoting access to  finance for new capital investments can discourage asset redistribution and potentially boost recovery.

Date Published: 24/07/2018

Working Paper 2018-3: Does Housing Wealth Affect Consumption? The Case of Cyprus

Nektarios Michail, George Thucydides. In this paper we investigate the relationship between housing wealth and consumption in Cyprus. To this end, we employ a vector error correction mechanism to examine interlinkages among house prices, private consumption, disposable income, financial assets and financial liabilities. We find that house prices affect private consumption, particularly in the short term, albeit to a lesser extent than similar studies for other countries. Financial liabilities are found to be important for consumption behaviour, while financial assets of Cypriot households appear to not affect significantly their consumption. Distinguishing consumption between durable and non-durable goods, we find that an increase in house prices boosts consumption of durables, while non-durables are found to register an insignificant effect.

Date Published: 24/07/2018

Working Paper 2018-2: Measuring the Competitiveness of the Cyprus Economy: the Case of Unit Labour Costs

Marios Polemidiotis, Maria C. Papageorghiou, Maria G. Mithillou. The focus of this paper is on developments in unit labour costs (ULC) in Cyprus, an important indicator of competitiveness. The data points to a significant correction in the nominal ULC index in the period 2013-2016, almost exclusively driven by the significant wage declines observed in the public and private sectors, with the decline in the private sector driven mainly by construction and the trade, transport and tourism sectors. Once the index is adjusted for the impact of prices (to arrive at the real ULC index, a complementary indicator that is sometimes informative to analyse), the data points to an earlier and more pronounced correction in ULC. The marginal rise in the ULC index in 2017 is due to the small rise in wages, largely in the public sector, which still leaves the level of the index well below its pre-crisis level. Furthermore, developments in the ULC index are in line with recent macroeconomic performance. Overall, the significant wage moderation observed prior to the crisis, and especially the immediate and continuous adjustment of wages (as well as that of prices) following the March 2013 events, demonstrates the Cyprus economy’s potential to achieve internal devaluation as a mechanism for the correction of macroeconomic imbalances.

Date Published: 23/04/2018

Working Paper 2018-1: Inflation Expectations and Monetary Policy Surprises

Snezana Eminidou, Marios Zachariadis, Elena Andreou. We use monthly data across 15 euro area economies for the period 1985:1-2015:3 to obtain monetary policy changes that can be regarded as surprises for different types of consumers. A novel feature of our empirical approach is the estimation of monetary policy surprises based on changes in monetary policy that were unanticipated according to consumers’ stated beliefs about the economy. We look at how these surprises affect consumers’ inflation expectations. We find that such monetary policy surprises can have the opposite impact on inflation expectations to those obtained under the assumption that consumers are well-informed about a set of macroeconomic variables describing the state of the economy. When we relax the latter assumption and focus instead on consumers’ stated beliefs about the economy, unanticipated increases in the interest rate raise inflation expectations before the crisis. This is consistent with imperfect information theoretical settings where unanticipated increases in interest rates are interpreted as positive news about the state of the economy by consumers that know policymakers have relatively more information. This impact changes sign since the crisis and varies, e.g. across low versus high-income consumers in a manner consistent with the latter becoming rationally attentive in a period during which signal extraction is presumably more difficult  and the incentive to extract information greater.

Date Published: 18/12/2017

Working Paper 2017-3: Credit, House Prices and the Macroeconomy in Cyprus

Lena Cleanthous-Petoussi, Elena Eracleous and Nektarios A. Michail. This paper examines the existence of a link between house prices, credit and macroeconomic conditions in Cyprus, using a vector error correction model (VECM) and quarterly data from 2005Q4 to 2016Q4. Overall, the results suggest that a link exists and that house prices have a bi-directional relationship with loans and the unemployment rate. Macroeconomic conditions matter for the Cyprus economy as an unexpected shock in unemployment is found to have a persistent impact on all the variables in the model. The interest rate is also found to have an effect on wages and house prices.

Date Published: 18/12/2017

Working Paper 2017-2: Banking Crises, Bail-ins and Money Holdings

Martin Brown, Ioanna S. Evangelou and Helmut Stix. We study changes in deposit and cash holdings by households following the 2013 banking crisis in Cyprus. During this crisis the two largest banks in the country were resolved involving a bail-in of uninsured depositors and debt holders. Our analysis is based on anonymized survey data covering households with differential exposures to the resolved banks: uninsured deposits, subordinated debt and equity holdings. In line with the portfolio theory of money demand, we find that in the intermediate aftermath of the crisis households significantly reduced their holding of bank deposits and increased their cash holdings. This flight to cash was much stronger for clients which experienced a bail-in of deposits or subordinated debt than for households which held equity in the resolved banks or did not suffer any financial loss. In the medium term, however, there was no difference in depositor confidence or money holdings between households which suffered a bail-in and those which did not.

Date Published: 06/11/2017

Working Paper 2017-1: Wage Dynamics Network: SME Credit Constraints in Cyprus During the Period 2010-2013 and Effects on Employment, Wages and Prices

Charalambos P. Charalambous, Marios C. Polemidiotis. In the context of its participation in the ESCB Wage Dynamics Network (WDN), the Central Bank of Cyprus (CBC) conducted a survey regarding the wage- and price-setting policies of domestic firms covering the period 2010-2013. This paper focuses on the behaviour of small- and medium-sized enterprises (SMEs) employing between 3-19 workers driven by changes in financing conditions. This is particularly important given the unprecedented shock to the banking system following the March 2013 events. The survey results suggest that, in the run up to the crisis, SMEs focused primarily on the use of price reduction strategies in an attempt to increase or maintain their volume of sales as a response to a shift in demand from SMEs to larger firms. SMEs also resorted to cost reduction strategies, including wage cuts. Since 2012, SMEs increased the average wage cut to broadly match the reduction in prices. Overall, the survey suggests that SMEs’ ability to maintain adequate liquidity for operational purposes via significant price and cost reductions, allowed a share of SMEs to overcome the obstacles related to the tighter financing conditions following the crisis.

Date Published: 14/12/2016

Working Paper 2016-8: Synopsis of the Euro Area Financial Crisis

Matthieu Darracq Paries, Pascal Jacquinot and Niki Papadopoulou. The paper is putting forward a structural narrative for the euro area financial crisis and its asymmetric consequences through the monetary union. We conjecture three originating factors to the euro area financial fragmentation and discuss the role of specific financial frictions in transmitting and amplifying them: (i) the macroeconomic spillovers of sovereign market tensions through risky banks, (ii) the adverse real-financial feedback loop from rising corporate default to weak banks and credit supply constraints, (iii) bank deleveraging process at times of unprecedented regulatory overhaul. We develop global DSGE model featuring a sovereign-bank nexus, a granular set of relevant financial frictions. The model is calibrated for 6 regions in order to reflect the financial heterogeneity across the largest countries of the euro area. The counterfactual scenarios show that the interplay between sovereign, bank and corporate solvency risks generated sizeable procyclicality in some jurisdictions of the euro area during the crisis and severely impaired the transmission of the single monetary policy.

Date Published: 14/12/2016

Working Paper 2016-7: Parsing Financial Frictions Underlying Bank Lending Fragmentation during the Euro Area Crisis

Matthieu Darracq Paries, Pascal Jacquinot and Niki Papadopoulou. The euro area experience during the financial crisis highlighted the importance of financial and sovereign risk factors in macroeconomic propagation, as well as the constraints that bank lending fragmentation would pose for monetary policy conduct in a currency union. Focusing specifically on the credit intermediation process, we claim that sources of impairments in the monetary policy transmission mechanism can arise from five distinct segments, related both to the demand and the supply of credit, namely: (i) deposit spread, (ii) market-funding cost spread, (iii) bank capital charges, (iv) compensation for expected losses and (v) competitive wedge. These intermediation wedges constitute specific types of financial frictions which may independently be the epicenter of financial disturbances. Against this background we design a DSGE model spanning the relevant "financial wedges" at play during the crisis, together with its cross-country heterogeneity within the euro area, focusing on Germany, France, Italy, Spain, and rest-of-euro area. Our main results are the following. First, we show that the cross-country heterogeneity of micro-structure of financial frictions are relevant to explain the divergence in lending rates. Second, sovereign risk, bank risk and corporate risk have been the most relevant channels to explain the financial heterogeneity observed during the banking crisis (bank capital shock). Third, the corporate risk channel has been the main source of impairment of the monetary policy transmission across euro area countries. Fourth, a 10 pp increase in the annual debt-to-GDP ratio triggers a surge in sovereign yields by than 300 bps and 200 bps for Italy and Spain respectively. Fifth, cross-border financial linkages are more important for Italy and Germany and affect for both countries the transmission of bank capital shocks.

Date Published: 13/12/2016

Working Paper 2016-6: Examining the Time-Variation of Inflation Persistence in Ten Euro Area Countries

Nektarios A. Michail. Inflation persistence in ten Euro Area economies is examined, using a long series of monthly data. Full sample estimates find persistence to be close to unity and tests for structural breaks show that while these exist, they are rare. Rolling estimates of persistence, based on a mean reversion measure, suggest that even though persistence has been volatile, it has not reached values below 0.8. The findings lend support to the view that the introduction of the common currency has reduced inflation persistence in many countries. In contrast, the global financial crisis appears to have had a positive impact on persistence.

Date Published: 26/07/2016

Working Paper 2016-5: Mean Squared Prediction Error Reduction with Instrumental Variables

Antonis Michis. The mean squared prediction error of the linear regression model is examined when estimation is performed with instrumental variables. It is shown that increasing the number of instruments in the estimation procedure, can reduce the mean squared prediction error of the model through more efficient estimation of the coefficient vector.

Date Published: 27/06/2016

Working Paper 2016-4: Estimates of Public, Housing and Other Private Sectors' Net Capital Stocks for the Cyprus Economy: 1995Q1 - 2015Q4

Nektarios A. Michail and Marios C. Polemidiotis. The Cyprus Statistical Service (Cystat) computes annual data for the net capital stock and capital depreciation by NACE Rev. 2 classification using the Perpetual Inventory Method (PIM). This data is available with a two-year lag, whilst quarterly data, including a breakdown by institutional sector, is not produced. On the basis of the latest vintage of annual data, this paper provides a quarterly breakdown of net capital stock for the total economy and its depreciation for the period 1995-2015 in constant 2005 prices. We further present a quarterly breakdown by institutional sector, namely public, housing and other private sector.

Date Published: 06/05/2016

Working Paper 2016-3: Wage and Price Setting Practices of Cypriot Companies During the Period 2010-2013

Charalambos P. Charalambous, Marios C. Polemidiotis and Angelos Roussos. In the context of its participation in the ESCB Wage Dynamics Network (WDN), the Central Bank of Cyprus (CBC) conducted a survey of the wage and price setting policies of domestic firms. Companies were asked to respond on the impact of various shocks related to the economic environment over the period 2010-2013, leading to the implementation of labour cost reduction strategies, including wage-setting changes. The major shocks that affected companies’ activities negatively during 2010-2013 related primarily to changes in the level and volatility of demand and the ability of customers to pay and meet their contractual obligations. The survey results point both to a reduction in demand as well as to a shift of the latter from smaller to larger firms. Consequently, micro and very small firms reduced prices and implemented cuts in labour costs to a greater extent than larger ones in order to remain competitive. Also, companies initially responded by cutting prices more than wages until 2011. As of 2012, given the challenging economic environment, firms increased the average wage cut, almost matching the cut in prices. The general conclusion that emerges is that the private sector was able to adapt well to the unprecedented decisions of the Eurogroup in March 2013.

Date Published: 15/02/2016

Working Paper 2016-2: Bank Lending to the Private Sector and GDP Growth: Thresholds and Returns

Demetris Koursaros, Nektarios A. Michail and Christos S. Savva. We examine the relationship between lending to the private sector and GDP growth using a two-period model and test model conclusions through a Smooth Transition Conditional Correlation (STCC) model for the G7 countries. Theory suggests that the correlation between private lending and growth is positive and this relationship exhibits diminishing returns after a threshold. The empirical exercise confirms that this relationship holds, and while thresholds exist for most countries, the correlation between private lending and growth is never negative. Overall, the evidence indicates that policy should not emphasise the level of lending but its allocation in the economy.

Date Published: 09/02/2016

Working Paper 2016-1: The Lack of Persistence of Interest Rate Changes on Banks’ Lending and Risk Taking Behaviour

Nektarios Michail, Demetris Koursaros and Christos S. Savva. Using the shock persistence methodology of Lee, Pesaran and Pierse (1992), we examine whether monetary policy has persistent effects on bank lending behaviour, both directly through the credit channel and indirectly through the risk-taking and liquidity channels. The findings suggest that policy actions aimed at affecting credit risk and bank lending will not have any persistent effects if only the interest rate is employed. Macro-prudential policy should focus on other factors which affect lending decisions, notably the liquidity channel which appears to be an important determinant of the level of lending.

Date Published: 22/12/2015

Working Paper 2015-2: Examining the Stability of Okun’s Coefficient

Nektarios A. Michail. The stability of Okun’s coefficient in the US from 1949 to 2015 is examined using a GARCH model in order to capture the volatility in the series. Once the volatility is taken into account, rolling estimations suggest that the coefficient for the unemployment rate is very stable across time, irrespective of the specification (gap or growth model) or the length of the window. In addition, the results suggest that short-term shocks were more important to output fluctuations during the 1970s stagflation period while long-term shocks were significant only when data from the recent global financial crisis were incorporated.

Date Published: 12/08/2015

Working Paper 2015-1: Estimation and Prediction of Shipping Trends with the Data-Driven Haar Fisz Transform

Antonis A. Michis, Guy P. Nason. We describe the implementation of a computer-based automatic procedure to estimate the trends associated with debit and credit transaction flows in Cyprus’s shipping industry. The procedure was also extended to forecasting. Transactions in the shipping industry do not always coincide with the time the service is provided. The transactions are usually completed gradually throughout the financial year and occasionally involve large amounts for balance settlements. In addition, the transactions are subject to several market risks such as the freight rate and exchange rate changes. Consequently, the transactions frequently exhibit large values and changes in variance, which makes trend estimation and forecasting difficult. A key component of the procedure we implemented is a variance stabilization method based on the Data-Driven Haar-Fisz Transform that enables accurate estimation of trends in volatile time series data. This method is sufficiently flexible to accommodate data characteristics such as cyclical changes, shifts in trend and spikes that are frequently encountered in transaction flow data.

Date Published: 03/10/2014

Working Paper 2014-3: Back to Basics: Is Statistical Significance All That Matters?

Nektarios A. Michail, Constantinos I. Massouras. We examine whether statistical significance can convey all the information necessary for the econometrician to judge the performance of his models. We find that in some cases, the t-statistic and the R-squared can be biased due to high correlation between the variables and variables can appear significant even though their correlation with the dependent variable is very low. The solution we propose is a back-to-basics approach: examine correlations between variables and variable variances in order for a correct interpretation of the regression outcome.

Date Published: 11/06/2014

Working Paper 2014-2: Investing in Gold: Individual Asset Risk in the Long Run

Antonis Michis. This study examines gold’s contribution to portfolio risk over different time scales. The analysis is based on wavelet decompositions of the variances and covariances associated with a portfolio that includes gold, stocks, 10-year government bonds and three-month Treasury bills. The results suggest that gold provides the lowest contribution to portfolio risk only when considered over medium- and long-term investment horizons.

Date Published: 05/02/2014

Working Paper 2014-1: Time Scale Evaluation of Economic Forecasts

Antonis Michis. A maximal overlap discreet wavelet transform is used to obtain time scale decompositions of economic forecasts and their errors. The generated time scale components can be used in loss measures and tests for comparing forecast accuracy to evaluate whether the forecasts accurately capture the cyclical features of the data.

Date Published: 13/08/2013

Working Paper 2013-2: A Small Macroeconometric Model for the Cyprus Economy

Aris Spanos and Niki Papadopoulou. The single most crucial weakness of current macroeconometric modelling stems from the fact that modelers ‘quantify/estimate’ their structural model directly, ignoring the fact that behind every structural model there is a statistical model whose validity vis-a-vis the data underwrites the reliability of all inferences. This practice gives rise to two important inadequacies. First, the estimated model largely ignores the gap between theory data. Second, the estimated structural models do not properly account for the statistical information in the data. These failings render the reliability of any inference based on such models doubtful and their forecasting ability questionable. The main objective of this paper is to construct a small macroeconometric model for the Cyprus economy that pays due attention to statistical model validation and the gap between theory and data. It is shown that one can secure reliable inferences, including sensible forecasts and dependable policy simulations, despite the serious limitations arising from the small sample size [1995:1-2012:4] and the number of variables (28) involved. The estimated model, after validation, is used to forecast for the period 2013:1-2020:4 and its forecasts are compared with those published troika. A key difference between the two forecasts is the time profile of the recession.

Date Published: 26/06/2013

Working Paper 2013-1: Measuring Market Power in the Banking Industry in the Presence of Opportunity Cost

Antonis Michis. A conjectural variations model is developed to measure market power in the banking industry. Unlike previous studies, which use complete cost function specifications in the modelling framework, this study defines marginal cost based on an opportunity cost, which is represented by the interest rate on minimum reserves offered by the monetary authorities in a country. Deposits with the monetary authorities are considered to be an alternative use of available funds that are usually allocated to loans. The estimates of market power in the banking industry in Cyprus, using the proposed model, reject the monopoly hypothesis.

Date Published: 24/05/2012

Working Paper 2012-2: Monitoring Forecasting Combinations with Semiparametric Regression Models

Antonis Michis. In this study, a modelling framework is proposed for evaluating the accuracy of forecasting combinations when the number of available forecasts is large and changes in time. Squared forecast errors are modelled with a semiparametric additive regression model where the linear part involves indicator variables reflecting the time period when the forecast is performed and the nonparametric part involves a smooth function of the number of individual forecasts entering the combinations. The partial regression estimates permit two-dimensional plots of the relationship between squared forecast errors and the number of forecasts entering the combinations and can be used to assess the contribution of additional forecasts in reducing the forecast errors. The method is demonstrated with six empirical applications using macroeconomic forecasts published by Her Majesty’s Treasury.

Date Published: 07/02/2012

Working Paper 2012-1: R&D and Aggregate Fluctuations

Erhan Artuc and Panayiotis M. Pourpourides. Using US data for the period 1959-2007, we identify sectoral productivity shocks and capital investment-specific shocks by employing a Vector Autoregression whose shock structure is disciplined by a general equilibrium model. Controlling for real and nominal factors, we find that capital investment-specific shocks explain 70 percent of fluctuations of R&D investment while R&D technology shocks explain 30 percent of the variation of aggregate output net of R&D investment (i.e. the output of the non-R&D sector).

Date Published: 30/11/2011

Working Paper 2011-6: New Paradigms in Central Banking?

Athanasios Orphanides. This paper reviews whether and how the ongoing financial crisis has influenced central banking policy practice. Taking a historical perspective, it argues that throughout the existence of central banks the main objective has remained the same―stability. What has been evolving over time, and has been influenced by the crisis, is our understanding about how to achieve and maintain stability over time. The paper focuses on the role and relative importance of price stability, economic stability and financial stability arguing that while the crisis has not materially shifted views regarding the monetary policy framework, it has highlighted the need for greater emphasis on financial stability than was appreciated before the crisis. It further argues that central banks must not only have a strong role in macro-prudential supervision but have more direct involvement in micro-supervision of the banking sector. Lastly, the paper argues that the crisis has reaffirmed that strong economic governance is a prerequisite for stability in a monetary union and, in the context of the euro area sovereign crisis, discusses the tremendous costs stemming from of lack of sufficient progress regarding economic governance going forward.

Date Published: 30/11/2011

Working Paper 2011-5: Multiscale Analysis of the Liquidity Effect

Antonis Michis. This study examines the existence of a liquidity effect in Mexico over different time scales. This analysis draws from the liquidity preference framework, an approach to interest rate determination, and uses wavelet multiscale analysis in the context of a standardised regression model. The results suggest that, in short-term cycles, interest rates are influenced primarily by changes in the money supply (i.e., the liquidity effect). In medium- and long-term cycles, the liquidity effect becomes less important and interest rates are found to be more sensitive to income and price effects.

Date Published: 30/11/2011

Working Paper 2011-4: On the Cyclicality of Real Wages and Wage Differentials

Christopher Otrok and Panayiotis M. Pourpourides. In this paper we investigate the cyclicality of real wages. The approach we take is to search for the largest possible common cyclical component in a statistical sense. This contrasts with the existing literature which uses observable variables to proxy for a common cycle. We do so by using a Bayesian dynamic latent factor model and longitudinal microdata. We find that the comovement of real wages can be related to a common factor that exhibits a significant but far from perfect correlation with the national unemployment rate. Our findings indicate that (i) the common factor explains, on average, no more than 9% of wage variation, (ii) the common factor accounts for 20% or less of the wage variability for 88% of the workers in the sample and (iii) roughly half of the wages move procyclically while half move countercyclically. These facts are inconsistent with claims of a strong systematic relationship between real wages and the business cycle. We show that these results are inconsistent with models of Walrasian labor markets typically used in DSGE models. We also confirm findings of previous studies in which skilled and unskilled wages exhibit roughly the same degree of cyclical variation.

Date Published: 30/11/2011

Working Paper 2011-3: On Imperfect Competition with Occassionally Binding Cash-in Advance Constraints

Huw Dixon and Panayiotis M. Pourpourides. We provide extensive theoretical analysis of the general equilibrium of an economy with imperfect competition in the final goods sector, endogenous production and fully flexible prices in the presence of occasionally binding cash-in-advance (CIA) constraints, under general assumptions about the velocity of money. Whether the CIA constraint binds or not and the induced variability of the velocity of money depend on expectations of risk-averse consumers about the future relative value of money as well as the degree of imperfect competition. We establish the uniqueness of the equilibrium, the conditions under which money has real effects, even in the absence of other real assets, and examine the role of imperfect competition and welfare implications. With perfect foresight, in a zero-inflation steady state the CIA constraint strictly binds and output is less than would occur when the CIA constraint is non-binding. There is also an optimal negative steady-state inflation rate. Finally, we consider how the introduction of capital and bonds would fit into the framework.

Date Published: 29/06/2011

Working Paper 2011-2: A Comprehensive Comparison of Alternative Tests for Jumps in Asset Prices

Marina Theodosiou and Filip Zikes. This paper presents a comprehensive comparison of the existing tests for the presence of jumps in prices of financial assets. The relative performance of the tests is examined in a Monte Carlo simulation, covering scenarios of both finite and infinite activity jumps, stochastic volatility models with continuous and discontinuous volatility sample paths, microstructure noise, infrequent trading and deterministic diurnal volatility. The simulation results reveal important differences in terms of size and power across the different data generating processes and sensitivity to the presence of zero returns and microstructure frictions in the data. An empirical application to assets from different classes complements the analysis.

Date Published: 27/01/2011

Working Paper 2011-1: The ECB Monetary Policy and the Current Financial Crisis

Lena Cleanthous and Pany Karamanou. Our paper presents estimates of Taylor type rules for the euro area using quarterly data for the period 2004(Q4) to 2008(Q3). Unlike other studies, we employ a real-time data set using the quarterly ECB staff projections on inflation and output growth. Estimated realtime rules are also compared with a more conventional specification whereby ex-post data are employed. Our results suggest that: (i) the ECB monetary policy strategy can be represented with a simple interest-rate rule; (ii) the ECB takes into account the quarterly ECB staff projections when deciding on its monetary policy stance; (iii) the accommodative behaviour of the ECB often cited in the literature is related to differences between real-time and ex-post data; and (iv) the estimated simple interest-rate rule continues to capture the ECB monetary policy strategy during the recent financial crisis. In light of the above, we can draw three important policy conclusions. First, the ECB has a stabilising role in the economy. Second, the ECB has become rather hawkish in its monetary policy decision making, responding more to projected changes in inflation than to projected changes in the output growth gap. Finally, the ECB’s response during the recent financial crisis of reducing its interest rate to 1.00% by the first half of 2009 and undertaking non-standard measures to provide support to the financial sector is shown to be equivalent to following a simple interest-rate rule based on its previous practices.

Date Published: 29/12/2010

Δοκίμιο Εργασίας 2010-11: Η Σταθερότητα του Χρηματοπιστωτικού Τομέα: Προβληματισμοί και Συμπεράσματα από την Κρίση για την Ευρώπη

Αθανάσιος Ορφανίδης. Η πρόσφατη χρηματοοικονομική κρίση ανέδειξε την ανάγκη ολοκληρωμένης προσέγγισης για πρόληψη και διαχείριση κρίσεων με στόχο τη διασφάλιση της χρηματοπιστωτικής σταθερότητας. Το άρθρο επικεντρώνεται σε τρεις πτυχές των αλλαγών που πρέπει να γίνουν: οι δύο αφορούν την πρόληψη και η τρίτη τη διαχείριση και επίλυση κρίσεων. Όσον αφορά την πρόληψη κρίσεων, το άρθρο αναφέρεται στην ανάγκη διασυνοριακής συνεργασίας για βελτιώσεις του ρυθμιστικού και του εποπτικού πλαισίου για τα χρηματοπιστωτικά ιδρύματα στην Ευρώπη και διεθνώς, καθώς και στην ανάγκη ενδυνάμωσης του μακροπροληπτικού προσανατολισμού της εποπτείας, μεταξύ άλλων με ενίσχυση του ρόλου των κεντρικών τραπεζών. Όσον αφορά τη διαχείριση και επίλυση κρίσεων, το άρθρο πραγματεύεται την ανάγκη ανάπτυξης ενός αποτελεσματικού πλαισίου στην Ευρωπαϊκή Ένωση, ιδιαίτερα για τα ιδρύματα με διασυνοριακή παρουσία. Αναλύονται σχετικές εισηγήσεις, οι οποίες περιλαμβάνουν τη δημιουργία ενιαίου ταμείου εξυγίανσης για διασυνοριακές τράπεζες και ευρωπαϊκής αρχής εξυγίανσης με όρους εντολής και νομική εξουσία να χειρίζεται προβληματικές διασυνοριακές τράπεζες.

Date Published: 20/12/2010

Working Paper 2010-10: The Implementation of Scenarios using DSGE Models

Igor Vetlov, Ricardo Mourinho Felix, Laure Frey, Tibor Hledik, Zoltan Jakab, Niki Papadopoulou, Lukas Reiss and Martin Schneider. The new generation of dynamic stochastic general equilibrium (DSGE) models seems particularly suited for conducting scenario analysis. These models formalise the behaviour of economic agents on the basis of explicit micro-foundations. As a result, they appear less prone to the Lucas critique than traditional macroeconometric models. DSGE models provide researchers with powerful tools, which allow for the design of a broad range of scenarios and can tackle a large range of issues, while at the same time offering an appealing structural interpretation of the scenario specification and simulation results. This paper provides illustrations of some of the modelling issues that often arise when implementing scenarios using DSGE models in the context of projection exercises or policy analysis. These issues reflect the sensitivity of DSGE model-based analysis to scenario assumptions, which in more traditional models are apparently less critical, such as, for example, scenario event anticipation and duration, as well as treatment of monetary and fiscal policy rules.

Date Published: 18/10/2010

Working Paper 2010-9: Denoised Least Squares Forecasting of GDP Changes Using Indexes of Consumer and Business Sentiment

Antonis A. Michis. Indexes of consumer and business sentiment are frequently characterized by measurement errors and short-term cyclical fluctuations that can distort their predictive accuracy for GDP changes. While measurement errors arise due to the survey sampling procedures that characterize these surveys, short-term cyclical fluctuations are generally linked with various exogenous and irregular factors that are not necessarily related to the economy. This paper shows, using data on the US economy, that applying wavelet denoising on indexes of consumer and business sentiment in the context of the linear regression model can overcome these limitations and can provide: (a) efficient coefficient estimates in models that explain consumer sentiment index variation; and (b) consistent coefficient estimates and predictions in models for GDP changes when using consumer and business sentiment indexes as predictors.

Date Published: 15/10/2010

Working Paper 2010-8: Fixed Exchange Rates Regimes in Mediterranean Countries and the Experience of Cyprus

George Syrichas. Mediterranean countries following a fixed exchange rate regime have been confronted with some challenges that test the efficacy of the regimes in place. These challenges mostly arise from the combination of inflationary pressures and the need for further capital account liberalisation amid conditions of ample liquidity in the banking system and rapid money and credit growth. Theoretical and empirical considerations do not point to the superiority of a particular exchange rate regime, but provide broad guidance on the factors and conditions that are predisposed to a fixed exchange rate regime and its sustainability in a liberalised environment. The case of Cyprus confirms the view that, under certain conditions, it is possible to maintain a credible fixed exchange rate regime while advancing capital account liberalisation and still achieve the primary objective of monetary policy. Adherence to a simple monetary rule, such as an exchange rate target, can confer credibility on a central bank and deliver price stability. Another important lesson drawn from the Cyprus case is that this strategy requires an independent central bank and needs to be supplemented by additional measures. Capital account liberalisation requires that the authorities have in advance a well-prepared and comprehensive plan, including, first and foremost, reforms in the conduct of monetary policy and banking supervision.

Date Published: 29/09/2010

Working Paper 2010-7: Calendar Time Sampling of High Frequency Financial Asset Prices and the Verdict on Jumps

Marina Theodosiou. In the current paper, we investigate the bias introduced through the calendar time sampling of the price process of financial assets. We analyze results from a Monte Carlo simulation which point to the conclusion that the multitude of jumps reported in the literature might be, to a large extent, an artifact of the bias introduced through the previous tick sampling scheme, used for the time homogenization the price series. We advocate the use of Akima cubic splines as an alternative to the popular previous tick method. Monte Carlo simulation results confirm the suitability of Akima cubic splines in high frequency applications and the advantages of these over other calendar time sampling schemes, such as the linear interpolation and the previous tick method. Empirical results from the FX market complement the analysis.

Date Published: 10/09/2010

Working Paper 2010-6: Assessing the Equilibrium Exchange Rate of the Cyprus Pound at the time of Euro Adoption

George Kyriacou and Maria Papageorghiou. One of the landmark events in the recent history of Cyprus was the adoption of the euro on 1 January 2008. A crucial element of the preparatory discussions between the Cypriot authorities and the competent European bodies was the search for an agreement on the conversion rate of the Cyprus pound vis-a-vis the euro, which was decided by the Economic and Financial Affairs Council (ECOFIN) on 10 July 2007. This paper describes part of the work undertaken at the Central Bank of Cyprus as background material for these discussions. Using a qualitative and quantitative approach, the paper suggests that the exchange parity rate of the Cyprus pound vis-a-vis the euro which existed for a number of years prior to euro adoption was broadly in line with economic fundamentals. Evidence examined include the stability of the Cyprus pound vis-a-vis the euro within a credible exchange rate policy framework, robust growth, low levels of unemployment, high Foreign Direct Investment (FDI) coverage of the current account deficit as well as low and stable inflation. This conclusion is also supported by a model-based approach using the Fundamental Equilibrium Exchange Rate (FEER) framework.

Date Published: 09/07/2010

Working Paper 2010-5: Winners and Losers in House Markets

Nobuhiro Kiyotaki, Alexander Michaelides and Kalin Nikolov. This paper is a quantitatively-oriented theoretical study of the interaction between housing prices, aggregate production, and household behavior over a lifetime. We develop a life-cycle model of a production economy in which land and capital are used to build residential and commercial real estates. We find that, in an economy where the share of land in the value of real estates is large, housing prices react more to an exogenous change in expected productivity or the world interest rate, causing a large redistribution between net buyers and net sellers of houses. Changing financing constraints, however, has limited effects on housing prices.

Date Published: 11/06/2010

Working Paper 2010-4: Forecasting Issues: Ideas of Decomposition and Combination

Marina Theodosiou. Combination techniques and decomposition procedures have been applied to time series forecasting to enhance prediction accuracy and to facilitate the analysis of data respectively. However, the restrictive complexity of some combination techniques and the difficulties associated with the application of the decomposition results to the extrapolation of data, mainly due to the large variability involved in economic and financial time series, have limited their application and compromised their development. This paper is a re-examination of the benefits and limitations of decomposition and combination techniques in the area of forecasting, and a contribution to the field with a new forecasting methodology. The new methodology is based on the disaggregation of time series components through the STL decomposition procedure, the extrapolation of linear combinations of the disaggregated sub-series, and the reaggregation of the extrapolations to obtain estimation for the global series. With the application of the methodology to the data from the NN3 and M1 Competition series, the results suggest that it can outperform other competing statistical techniques. The power of the method lies in its ability to perform consistently well, irrespective of the characteristics, underlying structure and level of noise of the data.

Date Published: 03/06/2010

Working Paper 2010-3: Sovereign Default Risk in a Monetary Union

Betty C. Daniel and Christos Shiamptanis. A country entering a monetary union gives up the right to determine its own monetary policy, thereby relinquishing monetary instruments to assure fiscal solvency. In this paper, we develop a new theoretical model to address fiscal solvency risk. We show that when debt is subject to an upper bound and policy faces stochastic shocks, a government can find itself in a position for which the expected present value of future surpluses under current policy is less than debt. Agents refuse to lend into such a position, and the sudden stop of capital flows defines a fiscal solvency crisis. We model the dynamics of a fiscal solvency crisis in a monetary union under the assumption that the fiscal authority will respond to the crisis using default to reduce the value of debt. We simulate the model to estimate fiscal solvency risk in the European Monetary Union. We find that countries adhering to the Stability and Growth Pack limits are perfectly safe, while countries like Greece and Italy, whose debt relative to GDP has strayed far above the 60 percent limit, are not.

Date Published: 31/05/2010

Working Paper 2010-2: Monetary Policy Mistakes and the Evolution of Inflation Expectations

Athanasios Orphanides and John C. Williams. What monetary policy framework, if adopted by the Federal Reserve, would have avoided the Great Inflation of the 1960s and 1970s? We use counterfactual simulations of an estimated model of the U.S. economy to evaluate alternative monetary policy strategies. We show that policies constructed using modern optimal control techniques aimed at stabilizing inflation, economic activity, and interest rates would have succeeded in achieving a high degree of economic stability as well as price stability only if the Federal Reserve had possessed excellent information regarding the structure of the economy or if it had acted as if it placed relatively low weight on stabilizing the real economy. Neither condition held true. We document that policymakers at the time both had an overly optimistic view of the natural rate of unemployment and put a high priority on achieving full employment. We show that in the presence of realistic informational imperfections and with an emphasis on stabilizing economic activity, an optimal control approach would have failed to keep inflation expectations well anchored, resulting in highly volatile inflation during the 1970s. Finally, we show that a strategy of following a robust first-difference policy rule would have been highly successful in the presence of informational imperfections. This robust monetary policy rule yields simulated outcomes that are close to those seen during the period of the Great Moderation starting in the mid-1980s.

Date Published: 21/05/2010

Working Paper 2010-1: Monetary Policy Lessons from the Crisis

Athanasios Orphanides. This paper provides a policymaker's perspective on some lessons from the recent financial crisis. It focuses on questions in three areas. First, what lessons can be drawn regarding the institutional framework for monetary policy? Has the experience changed the pre-crisis consensus that monetary policy is best performed by an independent central bank focused on achieving and maintaining price stability? Second, what lessons can be drawn regarding the monetary policy strategy that should be followed by a central bank? How activist should a central bank be in dampening macroeconomic fluctuations? Should the "output gap" serve as an important policy guide? Are there lessons regarding the stability-oriented approach followed by the ECB? How activist should a central bank be in tackling perceived asset price misalignments? Does the ECB's monetary analysis pillar help incorporate the pertinent information in formulating policy? Third, is monetary policy pursuing price stability enough to ensure overall stability in the economy? Or is there room for improvement regarding how central banks can contribute to financial stability? Should the role of monetary policy be seen as completely separate from the broader institutional environment governing financial markets and institutions in our economy? Or would greater central bank involvement in regulation and supervision pertaining to credit and finnance allow better management of overall economic stability?

Date Published: 22/12/2009

Working Paper 2009-6: Quantifying the Distortionary Fiscal Cost of ‘The Bailout’

Francisco Gomes, Alexander Michaelides and Valery Polkovnichenko. We utilize an overlapping generations model with endogenous production and incomplete markets to quantify the distortionary costs associated with financing the increase in government expenditures directed to investments in the private sector in 2008 and 2009 (also known as ‘the bailout’), and its differential impact on different groups of the population (in the USA). In our baseline calibration, this distortion corresponds to a loss of approximately $300 billion dollars in total household consumption. For plausible alternative assumptions regarding both the expected and actual duration of this increase in expenditures, or the willingness of foreign institutions and/or investors in absorbing additional government debt, this number can increase to $800 billion. We find that the cost falls more dramatically on those households which are either older and/or wealthier. Retirees face approximately 50% of the cost, as younger agents still expect to be alive when the economy has returned to its steady-state. Across wealth groups, the top 25% of the wealth distribution bears almost two thirds of the cost.

Date Published: 02/11/2009

Working Paper 2009-5: How Deep is the Annuity Market Participation Puzzle?

Joachim Inkmann, Paula Lopes and Alexander Michaelides. Using UK microeconomic data, we analyze the empirical determinants of voluntary annuity market demand. We find that annuity market participation increases with financial wealth, life expectancy and education and decreases with other pension income and a possible bequest motive for surviving spouses. We then show that these empirically-motivated determinants of annuity market participation have the same, quantitatively important, effects in a life-cycle model of annuity and life insurance demand, saving and portfolio choice. Moreover, reasonable preference parameters predict annuity demand levels comparable to the data. For stockholders, a relatively strong bequest motive is sufficient to simultaneously generate balanced portfolios and low annuity demand.

Date Published: 29/10/2009

Working Paper 2009-4: Nonlinearities in the Real Exchange Rate and Monetary Policy: Interest Rate Rules Reconsidered

Konstantinos D. Mavromatis. Empirical research during the last ten years has found significant evidence in favour of a nonlinear-threshold type behaviour of the real exchange rate. Interest rate rules which include the exchange rate appear to have either an insignificant effect on or generate small coefficients for the real exchange rate. However, the empirical studies do not take into account the nonlinear behaviour of the exchange rate. The inclusion of nonlinearities in the real exchange rate could imply nonlinear behaviour in the interest rate rule, whenever the exchange rate is included. We use a two-country sticky price model to show that nonlinear Taylor-type rules where the exchange rate is included lead to lower variation in output and inflation.

Date Published: 19/10/2009

Δοκίμιο Εργασίας 2009-3: ‘Ιστορία του Επίσημου Νομίσματος και της Κεντρικής Τράπεζας της Κύπρου’ Προκαταρκτικά Αποτελέσματα για την Περίοδο 1960 – 2007

Σοφοκλής Μιχαηλίδης. Η παρούσα μελέτη εξετάζει το χρονικό διάστημα από το 1960 μέχρι το 2007 – που η Κυπριακή Λίρα κυκλοφορούσε ως νόμιμο χρήμα – και εντοπίζει τις κρίσιμες καμπές της συναλλαγματικής, της δημοσιονομικής και της χρηματοπιστωτικής πολιτικής σε συνάρτηση με αίτια και επακόλουθα. Γίνονται υποθέσεις και αντλούνται συμπεράσματα πέριξ: • των τεσσάρων περιόδων συναλλαγματικής πολιτικής (1960-1972, 1972-1992, 1992-1999, 1999-2007), • των τριών φάσεων της καθαρής θέσης του δημοσίου έναντι του τραπεζικού συστήματος (1960-1966, 1966-1975, 1975-2007), • των πέντε ταλαντεύσεων των τραπεζικών πιστώσεων σε ιδιώτες (1960-1965, 1965-1975, 1975-1984, 1984-2007), • των πέντε διακυμάνσεων του ξένου ενεργητικού του τραπεζικού συστήματος (1960-1971, 1971-1980, 1980-1989, 1989-1998, 1998-2007), • των παράλληλων σχέσεων του ΑΕΠ προς τον δείχτη τιμών καταναλωτή και τον μέσο ετήσιο μισθό κατά τα 47 υπό ανασκόπηση έτη. Η ίδια μεθοδολογία εφαρμόζεται σε όλα τα στάδια ανάλυσης και σύνθεσης της υπό συγγραφή νομισματικής και χρηματοπιστωτικής ιστορίας της Κύπρου από το 1878 μέχρι το 2007.

Date Published: 31/08/2009

Working Paper 2009-2: Unemployment in Cyprus: Comparison Between Two Alternative Measurement Methods

George Kyriacou, Marios Louca and Michalis Ktoris. Unemployment in Cyprus is measured by the Statistical Service of Cyprus using two alternative methodologies: Registered Unemployment (RU), as calculated by the number of unemployed registered with the district labour offices on a monthly basis, and unemployment as calculated by the Labour Force Survey (ULFS), which is conducted on a quarterly basis. The RU series dates back to 1960 whereas the ULFS series began in 1999. The two methodologies lead to different results, mainly because of measurement differences in three unemployment categories: long-run unemployed, unemployed newcomers and recently retired unemployed. The differences in the first category appear to be associated with the counter cyclicality of the unemployment series, which is reflected in the ULFS but not in RU. In the other two categories, the differences reflect demographic and structural factors. This paper reconciles the data from the two methodologies, thus providing an indispensable tool for further work on: (a) the construction of a longer historical series for ULFS, which will be useful for economic analysis; and (b) the creation of a flash estimate of ULFS based on RU, given the time lag of the published ULFS, which is the internationally accepted unemployment measure.

Date Published: 14/09/2009

Working Paper 2009-1: Fiscal Policy in the European Monetary Union

Betty C. Daniel and Christos Shiamptanis. An EMU country that adheres to the Maastricht and the Stability and Growth Pact limits is implicitly promising not to allow its fiscal stance to deteriorate to a position in which it places pressure on the European Central Bank to forgo its price level target to finance fiscal deficits. Violation of these limits has raised questions about potential fiscal encroachment on the monetary authority’s freedom to determine the price level. We show that for the monetary authority to have the freedom to control price, the primary surplus must respond strongly enough to lagged debt. Panel estimates are consistent with monetary control of the price level.

Date Published: 23/10/2008

Working Paper 2008-6: Monetary Policy Strategy And The Euro: Lessons from Cyprus

George Syrichas. This paper examines how the fixed exchange rate policy followed in Cyprus for more than 40 years helped to deliver price stability amid high growth rates and low unemployment, and contributed to the successful adoption of the euro. The paper identifies some critical elements for the success of this strategy. Firstly, this policy was pursued by the Central Bank with no devaluations even in the most adverse conditions. This hard earned credibility of the Central Bank, along with the fact that the Bank’s decisions were taken independently from political interference, reinforced people’s belief in this strategy and thus anchored inflation expectations. Secondly, in order to ensure the sustainability of the regime, the authorities followed prudent economic policies for most of the time. The developments in credit and the current account served as warning indicators signalling possible threats to the sustainability of the fixed rate regime. Thirdly, in cases of imbalances the Central Bank resorted to the temporary use of non-traditional tools such as credit ceilings. The paper shows how this strategy was used to confront the new challenges arising from the road to the European Union (EU). Although the fixed exchange rate strategy remained in essence unchanged, it became more focused on the European orientation of the economy by switching to new anchor currencies (the ecu and the euro) well before accession. At the same time, a well thought out programme of structural reforms was underway in preparation for accession to the EU. Once in the EU the fixed exchange rate policy continued but greater flexibility was allowed so as to meet the challenges of the new liberalised environment.

Date Published: 08/09/2008

Working Paper 2008-5: Imperfect Knowledge and the Pitfalls of Optimal Control Monetary Policy

Athanasios Orphanides and John C. Williams. This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations formation and uncertainty about the natural rates of interest and unemployment. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We also allow for central bank uncertainty regarding the natural rates of interest and unemployment. We find that the optimal control policy derived under the assumption of perfect knowledge about the structure of the economy can perform poorly when knowledge is imperfect. These problems are exacerbated by natural rate uncertainty, even when the central bank's estimates of natural rates are efficient. We show that the optimal control approach can be made more robust to the presence of imperfect knowledge by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to the presence of imperfect knowledge about the economy provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to the alternative models of learning that we study and natural rate uncertainty and outperform the optimal control policy and generally perform as well as the robust optimal control policy that places less weight on stabilizing economic activity and interest rates.

Date Published: 26/08/2008

Working Paper 2008-4: Sticky Prices, Limited Participation, or Both?

Niki X. Papadopoulou. This paper investigates the micro mechanisms by which monetary policy affects and is transmitted through the US economy, by developing a unified, dynamic, stochastic, general equilibrium model that nests two classes of models. The first sticky prices and the second limited participation. Limited participation is incorporated by assuming that households are faced with quadratic portfolio adjustment costs. Monetary policy is characterized by a generalized Taylor rule with interest rate smoothing. The model is calibrated and investigates whether the unified model performs better in replicating empirical stylized facts, than the models that have only sticky price or limited participation. The unified model replicates the second moments of the data better than the other two types of models. It also improves on the ability of the sticky price model to deliver the hump-shaped response of output and inflation. Moreover, it also delivers on the ability of the limited participation model to replicate the fall in profits and wages, after a contractionary monetary policy.

Date Published: 08/04/2008

Working Paper 2008-3: Learning, Expectations Formation, and the Pitfalls of Optimal Control Monetary Policy

Athanasios Orphanides and John C. Williams. This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We find that the optimal control policy derived under the assumption of rational expectations can perform poorly when expectations deviate modestly from rational expectations. We then show that the optimal control policy can be made more robust by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to learning provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to empirically plausible parameterizations of the learning models and perform about as well or better than optimal control policies.

Date Published: 08/04/2008

Working Paper 2008-2: Mortgage Debt, Social Customs and Financial Innovation

Michael Haliassos, Pany Karamanou, Constantinos Ktoris, George Syrichas. Although housing can be a powerful channel of monetary policy transmission this channel can be weakened by social customs and financial liberalization as well as accompanying innovation that create alternatives to bank mortgages controlled by a central bank. This paper utilizes some unique questions in the 1999 and 2002 Cyprus Surveys of Consumer Finances, as well as data from the 1998 and 2001 US Surveys of Consumer Finances, in order to study the role of social customs (in the form of parental housing gifts) and financial liberalization for the incidence of homeownership rates, mortgage debt and borrowing constraints. Unlike existing studies of financially developed countries, the data from the Cyprus Surveys suggest that only a very small proportion of Cypriot households are credit constrained and that a number of important economic characteristics of the household are irrelevant for homeownership and for the use of mortgages. Our findings suggest that the presence of such customs may interfere with the monetary transmission mechanism by limiting the sensitivity of housing investment to changes in credit market conditions. Financial liberalization leading to innovation could work in the opposite direction if it leads to increased household participation in formal loans controlled by the central bank.

Date Published: 31/03/2008

Working Paper 2008-1: Imperfect Central Bank Communication: Information versus Distraction

Spencer Dale, Athanasios Orphanides and Par Osterholm. Much of the information communicated by central banks is noisy or imperfect. This paper considers the potential benefits and limitations of central bank communications in a model of imperfect knowledge and learning. It is shown that the value of communicating imperfect information is ambiguous. If the public is able to assess accurately the quality of the imperfect information communicated by a central bank, such communication can inform and improve the public’s decisions and expectations. But if not, communicating imperfect communication has the potential to mislead and distract. The risk that imperfect communication may detract from the public’s understanding should be considered in the context of a central bank’s communications strategy. The risk of distraction means the central bank may prefer to focus its communication policies on the information it knows most about. Indeed, conveying more certain information may improve the public’s understanding to the extent that it "crowds out" a role for communicating imperfect information.