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Modern monetary policy: Exchange rate targeting or inflation rate targeting
Theme 5: Macroeconomic policy.
Part 2: Monetary policy (II)
Reduced fiscal independence
Reduced the belief in fiscal policy for macroeconomic stabilisation
Increasing degree of capital mobility: ”Impossible trilogy”
Two (opposite) responses to this:
Øystein Børsum
Temporary lecturer, University of Oslo
April 25, 2005
• Adopt a floating exchange rate in order to re-install monetary policy independence. Set the price level or the inflation rate as the direct target of
monetary policy.
• Adopt a hard peg (completely fixed exchange rate) and do away with all
monetary policy. Over time, domestic inflation must be roughly equal to
inflation in the zone of the peg (PPP) for the fixed rate to be sustainable.
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1.1
Hard pegs:
Target choice: Consequence for output stability (OEM Ch
10.1)
— Monetary union
— Currency board
A currency board almost means adopting another country’s currency. Compare with ”dollarisation”.
A main issue is which target (exchange rate or inflation rate) serves better to
obtain the ultimate targets of economic policy, in particular output stabilization.
Conclusions from the AS-AD diagram are:
Price level vs. inflation rate target: Should past inflation count?
• A price stability target, allowing the exchange rate to float freely, reduces
the impact of demand shocks
— Long term vs. short term
— May not be very different in practice in times of moderate inflation
— We will focus on inflation rate targets because they are more common
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• An exchange rate stability target reduces the impact of supply-side shocks.
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A positive demand shock leads to i % and σ % in the case of a clean float.
Both effects reduce the expansionary effect relative to a fixed exchange rate.
Even if a rise in π above the target is tolerated for some time (flexible inflation
targeting), the effect on Y will be less than with a fixed exchange rate.
A negative supply shock would lead to π % if there were no policy response.
The inflation target prescribes contractionary monetary policy, thereby amplifying the effect on Y relative to a fixed exchange rate. However, if a rise in π
above the target were tolerated for some time, the effect on Y could be smaller
than with a fixed exchange rate because the ADfloat-curve is steeper.
Note: AD-curve in OEM ch 10.1 differs from AD-curves in previous lecture
notes and B&W. Includes a reaction function (eq. 10.6): How the central bank
will set it’s interest rate in order to reach the selected target. I.e. monetary
policy response is endogenised. Impacts on the slope. Previous lecture notes:
ADfloat is steeper. OEM: ADfloat is flatter. Conclusions still hold.
The choice of target presumes an analysis of which type of shock is the more
important or more typical. Factors:
• General structure of the economy. The Keynesian tradition emphasises
demand shocks
• Domestic business cycles positively or negatively correlated with international business cycles? Norway and the oil
Conceivable that the reaction function should depend on a wider analysis, and
on several variables, not only on the observed or forecasted deviation from a
single target.
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1.2
FIX
FLOAT
Hard pegs
Strict monetary targets
Low target
Narrow band
Short horizon
Simple reaction function
Strict vs. flexibile monetary policy
STRICT
Modern monetary policy can be characterized along other dimensions than fixed
vs. floating exchange rate:
examples:
Monetary union
Currency board
• How simple/complex is the reaction function?
“flexible fixed”
• How ambitious is the target?
FLEXIBLE
• Is there a target zone? How wide is it?
Wide target zone (> 4%)
Allow E outside zone
Reaction function:
- multivariate
flexible inflation targeting
Wide band
π-forecast is target
2 − 3 year horizon
Reaction function
- multivariate
Table 2: A typology of monetary policy regimes
Depending on the answer, monetary policy is more or less strict/flexible.
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Flexible exchange rate targeting
2.1
Issues with flexible exchange rate targeting
The target zone creates uncertainty about depreciation/appreciation within the
zone. Note: Speculation against a peg with no target zone is a ”one way bet”:
If the peg breaks, you gain. If the peg holds, you lose nothing.
Attributes:
1. Wide target zone (> 4%)
2. Allow exchange rate E outside zone
3. Reaction function both contingent and multivariate
Focus on domestic real economy when E inside zone. When outside priority
to E-target.
If 100% credible, the target zone has a stabilising effect: As E approaches the
boundary, speculators would stand to gain from an expected reversal.
When successful, a wide target zone creates some room for monetary policy
manoeuvre, in spite of capital market deregulation.
Instrument mix: Use reserves when E hits boundaries. Use interest rate when
outside.
However, if E changes too little and too seldom within the zone, the expected
rate of depreciation may become uniformly zero. UIP holds with i = i∗ and
capital mobility is perfect.
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If E outside zone: Very high overnight/short-term interest rates may undermine
credibility of regime due to high costs for the real economy.
Flexible inflation targeting
Estimated effect of monetary policy. Source: Christiano, Eichenbaum and
Evans (1999) on US data by using vector autoregression methods. Effect of a
monetary policy shock to output and price growth.
Shock to M1 equivalent to a 0.7 percentage point increase in the Fed funds
rate. Graphs with 95% confidence intervals.
• The effect on the interest rate persists for several quarters.
• The first dynamic multipliers of inflation with respect to the contractive
policy are low: Roughly no effect during the first 1-1 12 years. Implications:
— An inflation target with a short horizon would necessitate large movements in the interest rate
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Demand shocks: Output stabilisation and inflation stabilisation point to the
same policy response. Opposite with supply shocks.
— Inflation targeting is necessarily forward-looking. The interest rate today is an appropriate instrument for influencing deviations from the
inflation target tomorrow
Flexible inflation targeting is thought of as minimising a weighted loss function
of both output gap and inflation gap:
Lt = (yt − ȳt)2 − λ(πt − π ∗)2
• The dynamic multipliers of output with respect to the contractive policy
show that the effects appear more quickly. Takes between 1 and 2 years
to obtain full effect on output
where ȳ is trend level of output, π ∗ is the inflation target and λ represents the
emphasis given to inflation stabilisation relative to output stabilisation.
Longer time horizon: Accept to spend more time to reach the inflation target.
Supposition: Reason it should take longer is to avoid adverse effects on output.
Longer horizon = more weight on production and employment stabilisation =
“more flexible”
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3.1
In a small, open economy, most of the short-term impact on inflation and
the real economy will be through the exchange rate channel: i % and E &
presumably leading to a fall in imported goods prices. High burden on the
traded goods industry/exposed sector when horizon is short.
Case: Suppose wage claims increase because of high electricity prices (living
costs). Increase interest rates despite loss of competitiveness in exposed sector?
The effect on the domestic economy depends the degree of labour mobility
between the sheltered and the traded goods industries.
Inflation targeting at Norges Bank
2001: New regulation on monetary policy:
• — Target: 2,5 per cent in CPI-ATE. Equalled average inflation in the 90s,
and a common target at the time. Concern about the economic costs
of a target that was too low
— Horizon: Initially 2 years, now “normally within 1-3 years”
Short history from the establishment of the new regulation:
2002: CPI-ATE inflation on target. Tight labour market. Signs of high wage
increases. Longer term inflation forecast above target. Norwegian key rate 67%. International level: adverse demand shock in the wake of the stock market
collapse. Key rates cut in US and EMU. Strong krone appreciation.
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3.2
Appendix
2003: Outlook for adverse demand shock in Norway as well. Key rate cut by
4+ percentage points. Surprisingly steep fall in imported price inflation.
2004: Increasing inflation on imported goods. However low inflation on goods
and services produced in Norway. CPI-ATE inflation and nominal interest rates
at record low levels. Signs of improvement in the domestic economy. Horizon
for target achievement prolonged.
2005: CPI-ATE inflation below forecasted development.
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Figure 1: Norway: empirical multipliers of 1 pp interest rate increase on annual rate of inflation, nominal exchange rate, GDP growth rate, and rate of
unemployment.
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