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

2. 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.
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3. 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.
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4. 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.
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5. 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.

6. 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.

7. 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.
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8. 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.
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9. 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).
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10. Inflation Targeting in New Zealand, Canada, and the UK

11. 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.
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12. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies
© 2006 Pearson Addison-Wesley. All rights reserved

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