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chapter 20 Monetary Policy Strategy: The International Experience Role of a Nominal Anchor Ties Down Expectations Helps Avoid Time-Inconsistency Problem 1. Arises from pursuit of short-term goals which lead to bad long-term outcomes 2. Time-inconsistency resides more in political process 3. Nominal anchor limits political pressure for timeinconsistency Copyright © 2002 Pearson Education Canada Inc. 20- 2 Exchange-Rate Targeting Advantages 1. Fixes for internationally traded goods 2. Anchors expectations 3. Automatic rule, avoids time-inconsistency 4. Easy to understand: “sound currency” as rallying cry 5. Helps economic integration 6. Successful in reducing France, UK, Mexico Copyright © 2002 Pearson Education Canada Inc. 20- 3 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 Copyright © 2002 Pearson Education Canada Inc. 20- 4 Currency Boards vs. Dollarization Currency Boards 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 Copyright © 2002 Pearson Education Canada Inc. 20- 5 Summary: Advantages and Disadvantages of Different Monetary Policy Strategies Copyright © 2002 Pearson Education Canada Inc. 20- 6 Summary: Advantages and Disadvantages of Different Monetary Policy Strategies Copyright © 2002 Pearson Education Canada Inc. 20- 7 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 them reverses overshoots 4. Key elements: flexibility, transparency, and accountability Copyright © 2002 Pearson Education Canada Inc. 20- 8 Monetary Targeting Advantages 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 Copyright © 2002 Pearson Education Canada Inc. 20- 9 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 Copyright © 2002 Pearson Education Canada Inc. 20- 10 Inflation Targeting in New Zealand, Canada, and the UK Copyright © 2002 Pearson Education Canada Inc. 20- 11 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-inconsistent 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 Copyright © 2002 Pearson Education Canada Inc. 20- 12 Inflation Targeting Disadvantages 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 Copyright © 2002 Pearson Education Canada Inc. 20- 13 Monetary Policy with an Implicit Nominal Anchor Forward-Looking and Pre-emptive 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 Copyright © 2002 Pearson Education Canada Inc. 20- 14