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Role of a Nominal Anchor. Ties Down Expectations Helps Avoid Time-Consistency Problem (Kydland – Prescott) 1. The problem arises from pursuit of short-term goals by authorities which lead to bad long-term outcomes 2. Nominal anchor limits political pressure for time- in consistency. - PowerPoint PPT Presentation
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Role of a Nominal Role of a Nominal AnchorAnchor
Ties Down Ties Down Expectations Expectations
Helps Avoid Time-Consistency Problem Helps Avoid Time-Consistency Problem (Kydland – Prescott)(Kydland – Prescott)1. The problem arises from pursuit of short-1. The problem arises from pursuit of short-
term goals by authorities which lead to term goals by authorities which lead to bad long-term outcomesbad long-term outcomes
2. Nominal anchor limits political pressure 2. Nominal anchor limits political pressure for time-for time-ininconsistencyconsistency
Exchange-Rate TargetingExchange-Rate TargetingAdvantagesAdvantages
1. Fixes 1. Fixes for internationally traded goods for internationally traded goods
2. Anchors 2. Anchors expectations expectations
3. Automatic rule, avoids time-3. Automatic rule, avoids time-consistencyconsistency
4. Easy to understand: “sound currency” 4. Easy to understand: “sound currency” as rallying cryas rallying cry
5. Helps economic integration5. Helps economic integration
6. Successful in reducing 6. Successful in reducing
France, UK, MexicoFrance, UK, Mexico
Exchange-Rate Exchange-Rate TargetingTargeting
DisadvantagesDisadvantages1. Loss of independent monetary policy1. Loss of independent monetary policy
Problems after German reunification: Problems after German reunification: UK, French monetary policy too tightUK, French monetary policy too tight
2. Open to speculative attacks2. Open to speculative attacksEurope, Sept. 1992; Mexico, 1994; Europe, Sept. 1992; Mexico, 1994; Asia, ’97Asia, ’97
3. Successful speculative attack 3. Successful speculative attack disastrous for emerging market disastrous for emerging market countries countries financial crisis financial crisis
4. Weakened accountability: lose 4. Weakened accountability: lose exchange-rate signalexchange-rate signal
Currency Boards vs. DollarizationCurrency Boards vs. Dollarization
Currency BoardsCurrency Boards1. Domestic currency exchanged at fixed rate 1. Domestic currency exchanged at fixed rate
for foreign currency automaticallyfor foreign currency automatically2. Fixed exchange rate with very strong 2. Fixed exchange rate with very strong
commitment mechanism and no discretioncommitment mechanism and no discretion3. Usual disadvantages of fixed exchange rate3. Usual disadvantages of fixed exchange rate4. Still subject to speculative attack4. Still subject to speculative attack5. Lose ability to have lender of last resort5. Lose ability to have lender of last resort
DollarizationDollarization1. Even stronger commitment mechanism1. Even stronger commitment mechanism2. No possibility of speculative attack2. No possibility of speculative attack3. Usual disadvantages of fixed exchange rtae3. Usual disadvantages of fixed exchange rtae4. Lose seignorage4. Lose seignorage
Monetary TargetingMonetary TargetingCanadaCanada
1. Targets 1. Targets MM1 till 1982, then abandons it1 till 1982, then abandons it2. 1988: declining 2. 1988: declining targets, targets, MM2 as guide2 as guide
United KingdomUnited Kingdom1. Targets 1. Targets MM3 and later 3 and later MM002. Problems of 2. Problems of MM as monetary indicator as monetary indicator
JapanJapan1. Forecasts 1. Forecasts MM2 + 2 + CDCDss2. Innovation and deregulation makes less useful as monetary 2. Innovation and deregulation makes less useful as monetary
indicatorindicator3. High money growth 1987-1989: “bubble economy,” then tight 3. High money growth 1987-1989: “bubble economy,” then tight
money policymoney policyGermany and SwitzerlandGermany and Switzerland
1. Not monetarist rigid rule1. Not monetarist rigid rule2. Targets using 2. Targets using MM0 and 0 and MM3: changes over time3: changes over time3. Allows growth outside target for 2-3 years, but then reverses 3. Allows growth outside target for 2-3 years, but then reverses
overshootsovershoots4. Key elements: flexibility, transparency, and accountability4. Key elements: flexibility, transparency, and accountability
Monetary TargetingMonetary Targeting
AdvantagesAdvantages1. Able to cope with domestic considerations1. Able to cope with domestic considerations
2. Signals are immediate2. Signals are immediate
3. Immediate accountability of central bank3. Immediate accountability of central bank
DisadvantagesDisadvantages1. Big 1. Big ifif: All advantages require reliable : All advantages require reliable
relationship between goal and targeted relationship between goal and targeted monetary aggregatemonetary aggregate
2. In many countries, weak relationship 2. In many countries, weak relationship between goal and M-aggregatebetween goal and M-aggregate
Poor communications device and Poor communications device and accountabilityaccountability
Inflation Targeting: Inflation Targeting: Horns and TrumpetsHorns and Trumpets
Five ElementsFive Elements1. Public announcement of medium-1. Public announcement of medium-
term inflation-targetterm inflation-target
2. Institutional commitment to price 2. Institutional commitment to price stabilitystability
3. Information inclusive strategy3. Information inclusive strategy
4. Increased transparency through 4. Increased transparency through public communicationpublic communication
5. Increased accountability5. Increased accountability
Inflation Inflation TargetinTargeting in New g in New Zealand, Zealand, Canada, Canada, and the and the UKUK
Inflation TargetingInflation Targeting
AdvantagesAdvantages1. Allows focus on domestic considerations1. Allows focus on domestic considerations
2. Not dependent on reliable relationship 2. Not dependent on reliable relationship between M-aggregate and inflationbetween M-aggregate and inflation
3. Readily understood by public3. Readily understood by public
4. Reduce political pressures for time-4. Reduce political pressures for time-inconsistent policyinconsistent policy
5. Focus on transparency and communication5. Focus on transparency and communication
6. Increased accountability of central bank6. Increased accountability of central bank
7. Performance good: 7. Performance good: and and ee , and stays , and stays low in business cycle upturnlow in business cycle upturn
Inflation TargetingInflation TargetingDisadvantagesDisadvantages
1. Delayed signalling1. Delayed signalling2. Too much rigidity2. Too much rigidity3. Potential for increased output 3. Potential for increased output
fluctuationsfluctuations4. Low economic growth4. Low economic growth
Nominal GDP TargetingNominal GDP Targeting1. Close to inflation targeting with 1. Close to inflation targeting with
concern about output fluctuationsconcern about output fluctuations2. Problem of announcing specific 2. Problem of announcing specific
target for real GDP growthtarget for real GDP growth3. Harder for public to understand3. Harder for public to understand
Monetary Policy with an Implicit Monetary Policy with an Implicit Nominal Anchor: Greenspan’s FedNominal Anchor: Greenspan’s FedForward-Looking and Preemptive to Forward-Looking and Preemptive to
Deal With Long LagsDeal With Long Lags
AdvantagesAdvantages1. Focus on domestic considerations1. Focus on domestic considerations
2. Has worked very well in the U.S.2. Has worked very well in the U.S.
3. If It Ain’t Broke Why Fix It?3. If It Ain’t Broke Why Fix It?
DisadvantagesDisadvantages1. Lack of transparency and accountability1. Lack of transparency and accountability
2. Dependence on personalities2. Dependence on personalities
3. Inconsistent with democratic principles3. Inconsistent with democratic principles