Chapter 21

Monetary Policy
Strategy: The
International
Experience

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 Role of a Nominal Anchor

Ties Down  Expectations

Helps Avoid Time-Consistency Problem

1. Arises from pursuit of short-term goals which lead to
bad long-term outcomes
2. Time-consistency resides more in political process
3. Nominal anchor limits political pressure for time-
consistency

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 Exchange-Rate Targeting

Advantages
1. Fixes  for internationally traded goods
2. Anchors  expectations
3. Automatic rule, avoids time-consistency
4. Easy to understand: “sound currency” as rallying cry
5. Helps economic integration
6. Successful in reducing 
France, UK, Mexico

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 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

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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

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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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 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 then reverses overshoots
4. Key elements: flexibility, transparency, and accountability
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 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

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 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

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Inflation
Targeting in
New Zealand,
Canada, and
the UK

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 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-consistent 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

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 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

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 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

© 2005 Pearson Education Canada Inc. 21-14