The New Face of Central
Bank Policies and Its
Reflections on
Developing Countries
Dr. Aylin Abuk Duygulu
Dokuz Eylul University, Department of Economics
aylin.duygulu@deu.edu.tr
Old-Fashion Central Banking

Central Banks (CBs) consider developmental
issues.
 Monetary policy has a critical role to play in
growth (Epstein and Yeldan, 2006).
 CBs have some monetary policy tools which are
direct instruments to affect the economic sectors
of high priority.
 Direct instruments: such as credit allocation
techniques (subsidized interest rates, credit
ceilings) and capital controls.
2

CBs have more than one goals (employment,
growth, price stabilization) so need more
instruments (Jan Tinbergen: you need to have
as many instruments as targets)
 Virtually CBs are
-financing governments( so they are not
independent),
- managing exchange rates,
- supporting economic sectors (Epstein, 2006).
3








Most historians identify the following functions
as being historically essential to the operations
of CBs (Epstein,2006):
Unifying and issuing the country’s bank notes,
Acting as the government’s bank,
Acting as the commercial banks’ bank,
Serving as a lender of last resort to the banking
and even the financial system as a whole,
Conducting monetary policy to manage the
foreign exchanges and the price level,
Conducting monetary policy to manage the
overall level of economic activity,
Allocating credit to promote national goals.
4

In addition to these, there are at least three other
roles of CBs:
-The Distributive role (the effects of CB policies
on different class and groups)
-The Political role (whether or not the CB is
independent from the government)
-The Allocative role (the effects of CB policies on
the profitability and accessibility to credits)
5
Modern Central Banking

In modern central banking, CBs attempt to
(Epstein,2005):
- keep inflation at a very low level,
- reduce central bank support for government
fiscal deficits,
-help manage the country’s integration into world
trade and financial markets,
-reduce the influence of democratic, social and
political forces on CB policy.
6
We can name these attempts as “neo-liberal
approach to central banking” (Epstein, 2006).
 This neo-liberal approach has following key
features:
- CB independence,
- a focus on inflation targeting,
- the use of indirect instruments of monetary
policy.

7
Why modern central banking can be
named as a neo-liberal approach?

The main points of neo-liberalism include
(Martinez and Garcia,2000):
- The Rule of the market
- Cutting public expenditure for social services
- Deregulation
- Privatization
- Eliminating the concept of “the public good” or
“community” and replacing it with “individual
responsibility”.
8
Key features of neo-liberal approach to
central banking
9
CB Independence

Monetary policy conducted by independent CBs
played an important role in reducing inflation
rates.
 What is CB independence?
 “CB independence implies first and foremost
that the CB should not be subject to pressure
from the government to finance government
activities (deficits)” (Epstein, 2006)
10
Inflation targeting

Inflation targeting is a monetary policy strategy
which focuses on only low inflation rates.

The focus on inflation means that the CB should
not be concerned with other goals such as
promoting full employment, supporting industrial
policy or allocating credit to the sectors of high
priority.
11

Rational behind the inflation targeting stems
from the old monetarist argument that in the long
run, monetary policy can only affect inflation.
However this theoretical tradition depends on
invalid assumptions such as neutrality of money.
12

It’s expected that inflation targeting will
(Epstein,2005);
- reduce the rate of inflation,
- enhance the credibility of monetary policy,
- reduce the sacrifice ratio associated with
contractionary monetary policy,
- help to attract foreign investment.
13
Argument 1: Reduce the rate of inflation

Michael Kumof (2000) stated that the suitability
of inflation targeting was first discussed in
Masson, Savastano and Sharma’s (1997)
studies. They find that the policy is unsuitable
for most emerging markets (i.e. developing
countries), based on two objections:
14

First:
for emerging markets the exchange rate remains
an important additional objective of monetary
policy which is bound to lead to conflicts with the
inflation target.
 Second:
inflation targeting may no longer be applicable to
all emerging markets what it means for the
majority of them is fiscal dominance.
15

In the introduction of their research paper, Victor
Polterovich and Vladimir Popov argue that
considerable number of empirical studies
demonstrated that inflation has a negative
impact on growth only if it exceeds a certain
threshold. Otherwise low inflation has no impact
or even accelerates growth (in accordance with
the World Bank’s classification of countries - low
income: inflation rate %11-16; lower middle:
inflation rate %15-21; upper middle: inflation rate
%4-5).
16
Argument 2: Reduce the sacrifice ratio
associated with contractionary monetary
policy
 Countries that adopt inflation targeting achieve
lower inflation rates by causing recessions and
by throwing people out of work (the increase in
productivity ???).
 It’s seen that inflation targeting strategy has
been apparent inability to reduce the sacrifice
ratio (Epstein, 2005).
______________
 Sacrifice ratio: the loss of output or employment
associated with a given reduction in inflation
(Heintz, 2006) or the unemployment costs of
fighting inflation (Epstein, 2005).
17
Some Problems Originating from the
Inflation Targeting Strategy
18
Instrument Problem

A CB that adopt inflation targeting has only one
instrument, namely short-term interest rate.

The inflation targeting CBs reduce inflation by
raising interest rates because monetary
authorities frequently use short term interest
rates as a weapon against inflation.
19

However, this policy leads to an overvaluation of
the exchange rate because of the capital inflows.

Rising interest rates affect the short term capital
flows, as capital flows into a country, the nominal
exchange rate appreciates.

Exactly under this strategy, low inflation targets
can lead to appreciation of the real exchange
rate. This reduces export competitiveness but
increases imports (Heintz, 2006). In other words,
negative effects occur on net export.
20
 We
know that exchange rate is an
important factor in determining inflation
rate in developing countries, CB can not
be completely free to let the exchange rate
float.
21
What is recommended by the IMF and the
Orthodoxy?

Currently recommended by the IMF and the
orthodoxy:
- A fully opened capital account- no capital
controls or other restrictions on capital mobility,
- A pure floating, market determined exchange
rate-non-intervention in the foreign exchange
market,
-An inflation targeting monetary policy.
22

This combination has an important negative
attribute (Frenkel,2005):

The volatility of capital flows is transmitted
through the volatility of nominal and real
exchange rates and relative prices with adverse
effects on employment and growth.
23
The Cost of Accumulating Reserve

Another important issue is capital account
liberalization and unstable financial flows are
needed to increase reserves as protection.

In the absence of any exchange rate target
officially stated (because a pure floating
exchange rate), the need for holding foreign
reserves at the CBs should have been minimal
(Epstein and Yeldan,2006).
24

Rodrik (2006) stated that developing countries
began to accumulate reserves as a
consequence of financial liberalization and
globalization and the increase in developing
country’s reserves is related to changes not in
real quantities (such as import or output) but in
financial magnitudes.
25

The need for reserve can be explain by the need
for liquidity.

Liquidity, in turn, could be achieved via three
strategies (Rodrik,2006):
- Reducing short-term debt,
- Creating a collateralized credit facility,
- Increasing foreign exchange reserves of the
CBs.
26

However accumulating reserves is also costly.

The costs include:
- The spread between the yield on liquid reserve
assets and the external costs of funds,
- The sterilization policy causing an increase of
interest rates,
- Not using this source on the creation of
employment or education.
27

Dani Rodrik (2006) says that the spread
between the yield on liquid reserve assets and
the external costs of funds represents the social
cost of self-insurance.

In his study he calculated this cost is close to 1
percent of GDP.
28

When CBs attempt to compensate the liquid
effect of accumulating reserve, they sterilizing
them by selling domestic liabilities from their
portfolio may even bid up local interest rates
(Frenkel and Taylor,2006).

So this can cause more capital inflows again and
appreciation of exchange rate.
29
The Argument of Trilemma

The impossible trinity-trilemma says that CBs
can only have two out of three of the following
options: open capital markets, a fixed exchange
rate system and an autonomous monetary
policy.

In an (internationally) financially integrated
economy with high capital flows, monetary policy
is bounded only one instrument-short term
interest rate.
30

It can be concluded that without any capital
control mechanisms or any exchange rate
arrangements, a central bank using only short
term interest rates can not achieve low inflation
rates with a low sacrifice ratio.
31
Low Inflation Rates-For Whom?

Low inflation rates or price stability is for whom?

Inflation targetinglow inflation ratesbut high
sacrifice ratio, loss of CB credibility.

So why the IMF and the Orthodoxy insist on
inflation targeting?
32

Epstein and Power (2003) answer this question:
Focus on fighting inflation and keeping it low and
stable is in the interest of rentier groups in these
countries.

Who is rentier?
 Keynes refers to the rentier as the functionless
investor who generates income via his
ownership of capital.
 Kalecki’s definition: it represents the income
received by owners of financial firms + the return
to holders of financial assets generally.
33

High inflation rates decrease the value of
financial wealth.
 In addition, higher interest rates attract financial
flows searching only high gains.
 Financial liberalization and liberalization of the
capital account created more financial instability,
and thereby, created the need for economic
actors to purchase more financial products and
create more profits for finance (Epstein and
Power ,2003) .
34

Epstein and Power (2003) present that in many
countries, higher real interest rates and lower
inflation increase the rentier shares of income.

In a neo-liberal world, the countries are
conditioned to adopt and maintain contractionary
monetary policies (i.e. inflation targeting) in
order to secure “investor confidence” and
“international credit worthiness” (Epstein and
Yeldan,2006).
 So, CBs are independent from government
deficits but dependent on “investor confidence”.
35
The case of Turkey
36
Central Banking in Turkey

Central Bank of Republic of Turkey (CBRT)
used to act as an agent of development before
the mid 1980s.
 But in the 1990s, like most CBs, CBRT gave its
priority to the macroeconomic stability- a
combination of price stability and financial
stability.
 To achieve the stability objective, CBRT started
to use indirect instruments heavily, such as open
market operations.
37

In 2001, CBRT announced its independence
after a change in its legislation.

In the period of 2001-2006, CBRT adopted
implicit inflation targeting strategy.

In 2006, CBRT announced to adopt explicit
inflation targeting.
38
Table 1:Main Macroeconomic Indicators of Turkey (Sources: CBRT and SIS)
Indicators
2001
2002
2003
2004
2005
2006
CPI inf. (%)
68.5
29.7
18.4
9.32
7.72
9.65
GNP growth (%)
-9.5
7.9
5.9
9.9
7.6
6.0
Real XR (1995=100)
112.5
125.3
136.5
143.5
160.0
160.6
T-Bill rate (%)
82.3
62.7
46.0
24.7
16.3
18.0
Current Account
Balance (million $)
3.390
-1.524
-8.036
-15.604
-22.824
-31.460
Current Account
Balance/GNP(%)
2.4
-0.8
-3.4
-5.2
-6.4
-7.9
Foreign Debt Stock
(million $)
113.593
129.701
144.915
160.789
168.808
206.471
Short Term Foreign
Debt Stock (million $)
16.403
16.424
23.013
31.880
37.103
41.984
FDI (million $)
2.771
830
1.253
2.024
8.726
19.234
CB Reserves
(million $)
19.799
28.071
35.162
37.643
52.432
60.707
Unemployment rate
(%)
8.4
10.3
10.5
10.3
10.3
9.9
39
Assessing the Inflation Targeting
Strategy in Turkey
40
Table 2:Inflation, Growth and Unemployment in Turkey
Years
CPI inflation
(%)
Growth
Rate (%)
Unemployment rate+
discouraged workers
rate (%)
2001
68.5
-9.5
12.3
2002
29.7
7.9
14.0
2003
18.4
5.9
14.0
2004
9.32
9.9
14.6
2005
7.72
7.6
16.1
2006
9.65
6.0
16.6
Sources:CBRT and SIS
41
Inflation, Growth and Unemployment in Turkey
80
70
60
50
CPI
40
Growth
30
Unemployment
20
10
0
-10
2001
2002
2003
2004
2005
2006
-20
Years
42
Volatility of growth and inflation in Turkey
(2001-2006)
Volatility of Growth
: 1.527
Volatility of Inflation (CPI) : 0.9785
43
Table 3:Foreign Direct Investment Inflow by Sectors in Turkey (Million $)
Annual
Sectors
2003
2004
2005
2006
Agriculture
1
4
5
6
Mining
14
75
40
120
Manufacturing
448
214
789
1.395
Services*
196
927
7.699
15.813
Other
86
71
4
112
Total
745
1.291
8.5347
17.446
* An increase particularly in the financial intermediaries sector
Source: T.R. Prime Ministry, State Planning Organization
44
Table 4:Foreign Direct Investment Inflow by Sectors in Turkey (%)
Percentage Share
Sectors
2003
2004
2005
2006
Agriculture
0.1
0.3
0.1
0.0
Mining
1.9
5.8
0.5
0.7
Manufacturing
60.1
16.6
9.2
8.0
Services*
26.3
71.8
90.2
90.6
Other
17.0
7.9
0.4
0.6
Total
100.0
100.0
100.0
100.0
* An increase particularly in the financial intermediaries sector
Source: T.R. Prime Ministry, State Planning Organization
45
Table 5:
Real Exchange Rate, Current Account Balance and Central Bank Reserves in Turkey
Years
Real XR
(1995=100)
Current Account
Balance (Million $)
CB Reserves
(million $)
2001
112.5
3.390
19.799
2002
125.3
-1.524
28.071
2003
136.5
-8.036
35.162
2004
143.5
-15.604
37.643
2005
160.0
-22.824
52.432
2006
160.6
-31.460
60.707
Sources: CBRT and SIS
46
Table 6: Main Components of the Balance Of Payments (Million $)
2005
2006
-22824
-31316
Capital Originating from
Foreign Sources
40381
57747
Capital Originating from
Domestic Sources
-2052
-17581
-17847
-6114
2342
-2736
Net Capital Inflow
40671
37430
Net Capital Transmission
17025
24708
Foreign Debt Inducing
Capital Inflows
24899
36011
Foreign Hot Money
15950
10512
Domestic Hot Money
787
-17325
Net Hot Money Flows
16737
-6813
Current Account
Balance
Change in Reserves *
Net Errors and Omission
* (-) indicates increase
Source: Boratav (2007)
47
Conclusion
48

Central Bank (CB) policies are of great
importance for both developed and developing
countries. In the past, we know that many
developed countries have used some monetary
policy tools to reach development objectives as
an important part of their tasks. Now, most
developing countries want to adopt a ‘new’
monetary policy strategy namely ‘inflation
targeting’ which only focus on the ‘price stability’.
In this strategy, we see that CB operations have
changed from using direct instruments to
‘market-based’ operations like using indirect
instruments.
49

On the other hand, these new CB policies also
raise some problems especially in developing
countries, for example rising current account
deficits, unemployment and unstable growth
rates. These problems are often related to the
financial liberalization-unstable financial flowswhich eliminates capital controls and exchange
rate controls.
50

Hence the central banks of developing countries
must reconsider the era of globalization and its
negative effects on their economies.

They can begin to realize it by accepting that
there must be an alternative approach.

In my opinion, this will be a good starting point
for us.
51
And finally,

Thanks to the IDEAs, Tsinghua University and the
School of Economics, Renmin University for such a
comprehensive organisation
and
 Thanks to you for your patience.
52