Monetary Policy Strategy: The International Experience Chapter 21 Monetary Policy Strategy: The International Experience

Role of a Nominal Anchor Ties Down  Expectations Helps Avoid Time-Consistency Problem 1. Arises from pursuit of short-term goals which lead to bad long-term outcomes 2. Time-consistency resides more in political process 3. Nominal anchor limits political pressure for time-consistency © 2004 Pearson Addison-Wesley. All rights reserved

Exchange-Rate Targeting Advantages 1. Fixes  for internationally traded goods 2. Anchors  expectations 3. Automatic rule, avoids time-consistency 4. Easy to understand: “sound currency” as rallying cry 5. Helps economic integration 6. Successful in reducing  France, UK, Mexico © 2004 Pearson Addison-Wesley. All rights reserved

Exchange-Rate Targeting Disadvantages 1. Loss of independent monetary policy Problems after German reunification: UK, French monetary policy too tight 2. Open to speculative attacks Europe, Sept. 1992; Mexico: 1994; Asia: 1997 3. Successful speculative attack disastrous for emerging market countries because it leads to financial crisis 4. Weakened accountability: lose exchange-rate signal © 2004 Pearson Addison-Wesley. All rights reserved

Currency Boards vs. Dollarization 1. Domestic currency exchanged at fixed rate for foreign currency automatically 2. Fixed exchange rate with very strong commitment mechanism and no discretion 3. Usual disadvantages of fixed exchange rate 4. Still subject to speculative attack 5. Lose ability to have lender of last resort Dollarization 1. Even stronger commitment mechanism 2. No possibility of speculative attack 3. Usual disadvantages of fixed exchange rtae 4. Lose seignorage

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies © 2004 Pearson Addison-Wesley. All rights reserved

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies © 2004 Pearson Addison-Wesley. All rights reserved

Monetary Targeting Canada 1. Targets M1 till 1982, then abandons it 2. 1988: declining  targets, M2 as guide United Kingdom 1. Targets M3 and later M0 2. Problems of M as monetary indicator Japan 1. Forecasts M2 + CDs 2. Innovation and deregulation makes less useful as monetary indicator 3. High money growth 1987-1989: “bubble economy,” then tight money policy Germany and Switzerland 1. Not monetarist rigid rule 2. Targets using M0 and M3: changes over time 3. Allows growth outside target for 2-3 years, but then reverses overshoots 4. Key elements: flexibility, transparency, and accountability

Monetary Targeting Advantages Disadvantages 1. Able to cope with domestic considerations 2. Signals are immediate 3. Immediate accountability of central bank Disadvantages 1. Big if: all advantages require reliable relationship between goal and targeted aggregate 2. In many countries, weak relationship between goal and M-aggregate Poor communications device and accountability © 2004 Pearson Addison-Wesley. All rights reserved

Inflation Targeting Five Elements 1. Public announcement of medium-term š-target 2. Institutional commitment to price stability 3. Information inclusive strategy 4. Increased transparency through public communication 5. Increased accountability © 2004 Pearson Addison-Wesley. All rights reserved

Inflation Targeting in New Zealand, Canada, and the UK

Inflation Targeting Advantages 1. Allows focus on domestic considerations 2. Not dependent on reliable relationship between M-aggregate and inflation 3. Readily understood by public 4. Reduce political pressures for time-consistent policy 5. Focus on transparency and communication 6. Increased accountability of central bank 7. Performance good:  and e  , and stays low in business cycle upturn © 2004 Pearson Addison-Wesley. All rights reserved

Inflation Targeting Disadvantages Nominal GDP Targeting 1. Delayed signalling 2. Too much rigidity 3. Potential for increased output fluctuations 4. Low economic growth Nominal GDP Targeting 1. Close to inflation targeting with concern about output fluctuations 2. Problem of announcing specific target for real GDP growth 3. Harder for public to understand © 2004 Pearson Addison-Wesley. All rights reserved

Monetary Policy with an Implicit Nominal Anchor Forward-Looking and Preemptive to Deal With Long Lags Advantages 1. Focus on domestic considerations 2. Has worked very well in the U.S. 3. If It Ain’t Broke Why Fix It? Disadvantages 1. Lack of transparency and accountability 2. Dependence on personalities 3. Inconsistent with democratic principles © 2004 Pearson Addison-Wesley. All rights reserved