Transcript Chapter 21

Chapter 21
Monetary Policy
Strategy: The
International
Experience
Monetary Policy
with a Nominal Anchor
Role of a Nominal Anchor
1. Promotes price stability by keeping inflation
(expectations) under control.
2. 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 longrun outcomes.
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Exchange-Rate Targeting
Advantages
1. Anchors inflation expectations by tying the
inflation rate for traded goods to that of the
anchor country.
2. Automatic rule for conduct of monetary policy
avoids the time-consistency problem.
3. Simplicity and clarity of target → easy to
understand by the public.
4. Helps economic integration with the anchor
country.
5. Successful in reducing inflation in France, UK,
and Mexico.
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Exchange-Rate Targeting
Disadvantages
1. Loss of independent monetary policy.
2. Inability of the central bank to act as lender-oflast resort.
3. Increased exposure of the economy to shocks
from the anchor country.
4. 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.
5. Not an option for large countries or bloc of
countries like the U.S., Japan, or Euro zone.
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Exchange Rate Strategies
Currency Boards
1. Domestic currency is backed 100% by a foreign
currency and is automatically exchanged at fixed
rate for the foreign currency.
2. 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.
3. Usual disadvantages of fixed exchange rate
regime.
4. The currency may still be subject to speculative
attack.
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Exchange Rate Strategies
Dollarization
1. Adopt a foreign currency like the U.S. dollar as
the country’s money → even stronger
commitment mechanism → no possibility of
speculative attack.
2. Usual disadvantages of fixed exchange rate
regime.
3. 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.
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Monetary Targeting
Advantages
1. Independent monetary policy can focus on
domestic considerations.
2. Allows for immediate accountability of central
bank.
Disadvantages
1. Relies on stable money-inflation relationship.
2. In many countries, weak relationship between
goal and monetary aggregate → poor
communications and accountability.
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Inflation Targeting
Advantages
1. Independent monetary policy can focus on
domestic considerations.
2. Does not rely on stable money-inflation
relationship.
3. Readily understood by public.
4. Focus on transparency and communication →
increased accountability of central bank.
5. Demonstrated success in Canada, UK and
Sweden during inflationary shocks.
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Inflation Targeting
Disadvantages
1. Delayed signalling about achievement of inflation
because of the long lags in the effects of
monetary policy.
2. Could impose rigid rule on monetary policy
makers (though not in practice because central
banks use all available information to achieve the
inflation target).
3. 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).
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Inflation
Targeting in
New
Zealand,
Canada, and
the UK
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Monetary Policy
with an Implicit Nominal Anchor
Advantages
1. 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.
2. Independent monetary policy can focus on domestic
considerations.
3. Has worked very well in the U.S.
Disadvantages
1. Lack of transparency → constant guessing game regarding
the course of monetary policy (uncertainty).
2. Dependence on personalities.
3. Low accountability → time-consistency problem.
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Summary: Advantages and Disadvantages
of Different Monetary Policy Strategies
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Summary: Advantages and Disadvantages
of Different Monetary Policy Strategies
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