Critically Evaluate Three Monetary Strategies

– Critically evaluate three monetary strategies of central banks: exchange rate targeting, monetary targeting, and inflation targeting. On this essay I am going to evaluate the three basic frameworks of the strategies for monetary policy used by central banks. Here we are going to look at the advantages and disadvantages of each of these strategies. Exchange Rate Targeting: First of all, lets define peg: “ is a system where countries stabilize their exchange rates around par values they retain the right to change.

Under this system a country undertakes to intervene in the foreign exchange market to keep its currency within some margin, for example 1 per cent, of some given exchange rate parity, the ‘peg’ ”[1] There are two types of peg regimes for monetary policy: a currency board and full dollarization. In a currency board, the domestic currency is backed 100% by a foreign currency and the central bank or government, who fixes a conversion rate to this currency and stands ready to exchange domestically issued notes for the foreign currency on demand.

Full dollarization involves eliminating altogether the domestic currency and replacing it with a foreign currency ( the U. S. dollar ). It represents a stronger commitment to monetary stability than a currency board because it makes it much more costly for the government to recover control over monetary policy and/or change the parity of the domestic currency. The main purpose of exchange rate targeting is to maintain the real exchange rate at some specific level. “ The target zone is a non-linear compromise between fixed exchange rates and freely flexible exchange rates.

”[2] In an exchange rate target zone, a country or group of countries sets explicit margins within exchange rates will be allowed to fluctuate. While the exchange rate is within those margins, the policy can be directed toward other goals. When some limit is reached, the central bank focuses resources on maintaining the limits. The target zone does not preclude foreign exchange interventions inside the limits. “ Finite interventions produce counter – intuitive policy behaviour. For example, to implement a target zone, a central bank would impose a large monetary contraction when the exchange rate is appreciating. ”[3]

There is full cooperation between central banks to try to make the target zone credible, the intervention is equitable. For example; if the country whose currency is weak has run out of reserves, the other central bank has to intervene printing money. The advantages of exchange rate targeting are that it provides a nominal anchor that helps keep inflation under control by tying the prices of domestically produced tradable goods to those in the anchor country, attenuating the component of inflation that feeds into wages and prices of non-tradable goods, and making inflation expectations converge to those prevailing in the anchor country.

(e. g. Mexico). Exchange rate targeting reduces the currency risk component from domestic interest rates thus lowering the cost of funds for the government and the private sector and improving the outlook for financial investment and growth. It helps economic integration ( European Union ). It has the advantage of simplicity and clarity, which make them easily understood by the public. The main disadvantages are the loss of independent monetary policy; and countries with exchange rate targeting are open to speculative attacks ( e. g. Mexico 1994 ).

Successful speculative attack for emerging market countries because it leads to financial crisis; plus weakened accountability because there is no exchange rate signal for developing countries. Currency Board Versus Full Dollarization: the main disadvantage of a currency board relative to full dollarization is that the currency board does not eliminate completely the possibility of a devaluation. If investors sentiment turns against a country with a currency board and speculators launch an attack, they are presented with a one way bet because the only direction the value of the currency can go is down.

These problems are mitigated under full dollarization, because there is no uncertainty about the value of the currency circulating in the country (dollars will always be dollars) the currency risk component of domestic interest rates will necessarily disappear, and interest rates will be lower. However, this does not mean that under full dollarization domestic interest rates will converge to those prevailing in the U. S.. Domestic interest rates will continue to carry a country risk premium. Lets see the following example to understand a little more how does the exchange rate targeting works:

In the International Monetary System the dollar is the main reserve currency. This gives some comparative advantage to the US currency because they could let the currency depreciate in order to favor American Exports. With the arrival of the euro, the weight of the European currency in terms of GDP or world trade is about the same as that of the USA. In this context, an unexpected depreciation of the dollar against the euro will still have a negative impact on European growth, at least in the short run.

But the European Monetary Union may retaliate by implementing policies that would lead to a depreciation of the euro. The main objective of the European Central Bank must be the stability of the general price level. Monetary Targeting: A monetary targeting has three elements “ 1) reliance on information conveyed by a monetary aggregate to conduct monetary policy, 2) announcement of targets for monetary aggregates, and 3) some accountability mechanism to preclude large and systematic deviations from the monetary targets.

In addition, the strategy presupposes that monetary policy is not dictated by fiscal considerations – i. e. , lack of fiscal dominance – and that the exchange rate is flexible “[4] I think that the use of monetary targeting is problematic because the relationship between monetary aggregates and goal variables, as inflation and nominal income, is very unstable. For example, the weak relationship between money and nominal income implies that if you hit a monetary target it will not produce the same effect in inflation. It will not help to fix inflation expectations.

“ The key to success for monetary targeting is an active engagement in communication which Enhances Transparency and Accountability of the Central Bank. ”[5] It means that monetary targeting can be used successfully if it is used to communicate a long-run strategy of inflation control. The two major advantages of monetary targeting over exchange rate targeting are that it allows the central bank to choose goals for inflation that may differ from those of other countries, and that it allows some opportunity for monetary policy to deal with output fluctuations and external shocks.

The comparison between targeted and actual monetary aggregates might send some signals to the public and markets about the way of standing of monetary policy and the intentions of the authorities to keep inflation in check. These signals might help consolidate inflation expectations and produce less inflation. Targets on money aggregates might be propitious to making the central bank accountable for meeting its low inflation objective, and helping to make less harder the time – inconsistency problem of monetary policy.

The most important disadvantage of monetary targeting is that in many countries there’s a weak relationship between goal variable and monetary aggregates. A weak and unstable relationship between money and inflation will contribute to situations where if the central bank does not hit the monetary target will not produce the desired inflation. If there is a weak relationship between the targeted monetary aggregate and inflation, the central bank will not be transparent and accountable to the public. Inflation Targeting:

Inflation targeting has five elements: “ 1) public announcement of medium-term numerical targets for inflation; 2) an institutional commitment to price stability as the primary, long-run goal of monetary policy and a commitment to achieve the inflation goal; 3) an information inclusive strategy in which many variables and not just monetary aggregates are used in making decisions about monetary policy; 4) increased transparency of the monetary policy strategy through communication with the public and the markets about the plans and objectives of monetary policymakers; and 5) increased accountability of the central bank for attaining its inflation objectives. ”[6] The procedure of inflation targeting is that the central bank makes an inflation forecast based on unchanged monetary policy.

If the forecast suggests that inflation ( for example in the next two years ) will move outside the target zone, the central bank then decides what to do for achieving its objectives. If a country wants to use an inflation targeting should has greater transparency of monetary policy and on central bank accountability for its actions. Accountability and the need to explain deviations from targets should promote transparency, allowing the public to understand the basis for monetary policy decisions, and to form more expectations. In most cases , the inflation target is set in the range of 1% – 3%; except in countries which have been dealing with higher inflation rates, where the target has been lowered slowly. “ The inflation targeting is based on the Consumer Price Index ( CPI ).

”[7] The main advantage of the Consumer Price Index is that the index has a long history and is well known among the public. If the target is the price level, he central bank will have to compensate for missing the target in previous years. For example, if the inflation target rate is 2 per cent and inflation last year was 4 per cent, under inflation targeting, the goal this year would be less than 2 per cent (1%, 1. 5%) because the central bank has the obligation to return to its target for prices. We must understand that if the inflation rate is less controllable and predictable; the inflation targeting will become less effective. As we can see, flexibility, transparency and accountability are important elements in inflation targeting and monetary targeting.

Inflation targeting has several advantages over exchange rate targeting and monetary targeting as a medium – term strategy for monetary policy. In contrast to the exchange rate targeting, inflation targeting allows monetary policy to focus on domestic considerations and to respond to domestic and foreign shocks. . But the most important is that it grants a certain degree of flexibility in monetary policy; because it imposes an inflationary ceiling and a floor which gives the opportunity to respond to negative and positive shocks. Inflation targeting also has the advantage that stability in the relationship between money and inflation is not critical to its success because it does not depend on this relationship.

An inflation targeting strategy allows the monetary authorities to use all available information, and not just the information contained in one or two variables, to determine the best background for the instruments of monetary policy. Inflation targeting, like exchange rate targeting, also has the advantage that it is easily understood by the public and thus highly transparent. In contrast, monetary targets, although visible, are less likely to be well understood by the public. Inflation targeting regimes also put great stress on the need to make monetary policy transparent and to maintain regular channels of communication with the public; in fact, these features are basic to the strategy’s success. The central banks whit inflation targeting have frequent communications with the government.

They publish some documents to keep the general public, financial markets and the politicians permanently informed about the goals and limitations of monetary policy; the numerical values of the inflation targets and how they were determined; how the inflation targets are going to be achieved, and reasons for any deviations from targets. This emphasis on communication has improved private – sector planning by reducing uncertainty about monetary policy, interest rates and inflation; has promoted public debate of monetary policy, in part by educating the public about what a central bank can and can not achieve; and has helped to clarify the responsibilities of the central bank and of politicians in the conduct of monetary policy.

Some disadvantages of inflation targeting are that inflation targeting can only produce weak central bank accountability because inflation is hard to control and because there are long delays from the monetary policy instruments to the inflation outcome. Inflation targeting can not prevent fiscal dominance, and the exchange rate flexibility required by inflation targeting might cause financial instability. Actually, in practice inflation targeting is far from a rigid rule. It does not imply simple or mechanical instructions as to how the central bank should conduct monetary policy. Rather, inflation targeting requires that the central bank uses all the information available at a given point in time to determine what are appropriate policy to achieve its preannounced inflation target.

Inflation targeting lead to low growth in output and employment; but it is not harmful to the real economy after the disinflation has occurred. In contrast to exchange rates and monetary aggregates, the inflation rate can not be easily controlled by the central bank. To address this problem an inflation targeting strategy should place a high value on transparency; periodic releases of the central bank’s inflation forecasts and explanations of its policy decisions, for example, become crucial for guiding inflation expectations and building credibility in the regime. Two other factors that affect inflation controllability are the incidence of government – controlled prices on the index used to compute headline inflation, and the exchange rate depreciations.

The first one suggests that inflation targeting may demand a high degree of coordination between monetary and fiscal authorities on the timing and magnitude of future changes in controlled prices, while the second one suggests that the central banks of the region probably can not afford an attitude of “ benign neglect ” towards exchange rate depreciations, at least until low inflation induces a change in the expectations and in the price setting practices of households and firms. Conclusions: As we can see above, each one of the strategies has advantages an disadvantages; so the question we have to answer now is which one is better ? There is no an specific answer to this, we must say that “ it depends ” because the key to the answer lies on the institutional environment in each country.

There are some countries which do not appear to have the political and other institutions to constrain monetary policy if it is allowed some discretion. For example, the monetary targeting is not viable for Latin America because of the likely instability of the relationship between monetary aggregates and inflation. A monetary policy strategy, no matter if it involves an exchange rate or an inflation target, will not be successful in maintaining low inflation over the medium term unless government policies create the right institutional environment. Rigorous supervision of the financial system is crucial to the success of an inflation targeting regime just as it is for exchange rate targeting.

An exchange rate objective is not considered appropriate; only for an area potentially as large as the euro area, such an approach might be inconsistent with the internal goal of price stability. The use of an interest rate as an intermediate target is not considered appropriate given difficulties in identifying the equilibrium real interest rate which would be consistent with price stability. Monetary targeting and inflation targeting are based on the same final objective, price stability; they are forward looking; and in practice a wide range of indicators are employed under both strategies to assess the monetary policy. The main factor distinguishing the two strategies is the role played by monetary aggregates. BIBLIOGRAPHY – Bernanke, B. and F.

Mishkin, 1997, “ Inflation Targeting: Lessons from the International Experience ”, Princeton, Princeton University Press. – Black, John. “ A Dictionary of Economics ”, Oxford University Press 1997. – Griffiths, B. and Geoffrey E. Wood, 1981, “ Monetary Targets. ” Centre for Banking and International Finance at the City University. – Krugman & Miller. “ Exchange rate targets and currency bands. ” Cambridge University, Printed in Great Britain ( 1992 ). – http://econ. worldbank. org/files/2458_wps2684. pdf ( Frederic S. Mishkin, From Monetary Targeting to Inflation Targeting: Lessons from the Industrialized Countries. ) ———————– [1] Black, John. “A Dictionary of Economics”, Oxford University Press 1997, pp.

4-5 [2] Kurgman & Miller. “Exchange rate targets and currency bands. ” Cambridge University, Printed in Great Britain (1992), pp. 18 [3] Kurgman & Miller. “Exchange rate targets and currency bands. ” Cambridge University, Printed in Great Britain (1992), pp. 26 [4] http://econ. worldbank. org/files/2458_wps2684. pdf [5] Griffiths, B. and Geoffrey E. Wood, 1981, “ Monetary Targets. ” Centre for Banking and International Finance at the City University, pp. 51-52 [6] http://econ. worldbank. org/files/2458_wps2684. pdf [7] Bernanke, B. and F. Mishkin, 1997, “ Inflation Targeting: Lessons from the International Experience ”, Princeton, Princeton University Press.