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

Monetary Policy with a Nominal Anchor Role of a Nominal Anchor Promotes price stability by keeping inflation (expectations) under control. Helps avoid the time-consistency problem by limiting political pressure. The time-consistency problem arises when monetary policy conducted on discretionary basis pursues short-run goals (under political pressure) which lead to poor long-run outcomes. © 2006 Pearson Addison-Wesley. All rights reserved

Exchange-Rate Targeting Advantages Anchors inflation expectations by tying the inflation rate for traded goods to that of the anchor country. Automatic rule for conduct of monetary policy avoids the time-consistency problem. Simplicity and clarity of target → easy to understand by the public. Helps economic integration with the anchor country. Successful in reducing inflation in France, UK, and Mexico. © 2006 Pearson Addison-Wesley. All rights reserved

Exchange-Rate Targeting Disadvantages Loss of independent monetary policy. Inability of the central bank to act as lender-of-last resort. Increased exposure of the economy to shocks from the anchor country. Leaves the currency open to speculative attacks. Successful speculative attack are disastrous for emerging-market countries because they lead to financial crisis. Europe in 1992; Mexico in 1994; and Asia in 1997. Not an option for large countries or bloc of countries like the U.S., Japan, or Euro zone. © 2006 Pearson Addison-Wesley. All rights reserved

Exchange Rate Strategies Currency Boards Domestic currency is backed 100% by a foreign currency and is automatically exchanged at fixed rate for the foreign currency. Strong commitment by the central bank to the fixed exchange rate → effective in bringing down inflation quickly and decrease the likelihood of speculative attacks against the currency. Usual disadvantages of fixed exchange rate regime. The currency may still be subject to speculative attack.

Exchange Rate Strategies Dollarization Adopt a foreign currency like the U.S. dollar as the country’s money → even stronger commitment mechanism → no possibility of speculative attack. Usual disadvantages of fixed exchange rate regime. Lose seignorage (the revenue that a government receives by issuing money). Governments (or their central banks) do not pay interest on their currency, but use the currency to purchase income-earning assets such as bonds.

Monetary Targeting Advantages Disadvantages Independent monetary policy can focus on domestic considerations. Allows for immediate accountability of central bank. Disadvantages Relies on stable money-inflation relationship. In many countries, weak relationship between goal and monetary aggregate → poor communications and accountability. © 2006 Pearson Addison-Wesley. All rights reserved

Inflation Targeting Advantages Independent monetary policy can focus on domestic considerations. Does not rely on stable money-inflation relationship. Readily understood by public. Focus on transparency and communication → increased accountability of central bank. Demonstrated success in Canada, UK and Sweden during inflationary shocks. © 2006 Pearson Addison-Wesley. All rights reserved

Inflation Targeting Disadvantages Delayed signalling about achievement of inflation because of the long lags in the effects of monetary policy. Could impose rigid rule on monetary policy makers (though not in practice because central banks use all available information to achieve the inflation target). Potential for increased output fluctuations if sole focus on inflation (though not in practice because central banks set inflation target above zero and takes into account output fluctuations). © 2006 Pearson Addison-Wesley. All rights reserved

Inflation Targeting in New Zealand, Canada, and the UK

Monetary Policy with an Implicit Nominal Anchor Advantages Control inflation in the long run by careful monitoring for signs of future inflation using a wide range of information → forward-looking and preemptive to deal with long monetary policy lags. Independent monetary policy can focus on domestic considerations. Has worked very well in the U.S. Disadvantages Lack of transparency → constant guessing game regarding the course of monetary policy (uncertainty). Dependence on personalities. Low accountability → time-consistency problem. © 2006 Pearson Addison-Wesley. All rights reserved

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies © 2006 Pearson Addison-Wesley. All rights reserved

Summary: Advantages and Disadvantages of Different Monetary Policy Strategies © 2006 Pearson Addison-Wesley. All rights reserved