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Monetary Policy Strategies: Pros and Cons of Different Approaches

This chapter explores the advantages and disadvantages of various monetary policy strategies such as exchange-rate targeting, currency boards, dollarization, monetary targeting, inflation targeting, and nominal GDP targeting. It also discusses the importance of having a nominal anchor and the role it plays in tying down expectations and avoiding time-inconsistency problems.

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Monetary Policy Strategies: Pros and Cons of Different Approaches

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  1. chapter 20 Monetary Policy Strategy: The International Experience

  2. 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 time-inconsistency

  3. 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

  4. 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

  5. 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 • Dollorization • 1. Even stronger commitment mechanism • 2. No possibility of speculative attack • 3. Usual disadvantages of fixed exchange rtae • 4. Lose seignorage

  6. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies

  7. Summary: Advantages and Disadvantages of Different Monetary Policy Strategies

  8. 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

  9. 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

  10. 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

  11. Inflation Targeting in New Zealand, Canada, and the UK

  12. 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

  13. 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

  14. 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

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