Feature: Overview Of Monetary Policy Regime
In theory, when one talks about monetary policy, it comes down to central bank regulating the value of the currency using the interest rates to influence increase or decrease of the money supply. In this vane, there are several different ways in which countries can pursue price stability.
One of such way is simply to administer prices in accordance with a set objective. Ultimately though, government administered prices require, government-administered investment, production, and distribution.
Historically this policy method has been associated with central planning, productive and allocative inefficiency, low levels of income, persistent market disequilibrium as evidenced by long queues for poor quality goods and services.
Therefore, the desire to allocate resources on the basis of the profit incentive and market-determined price signals means that consumer demand and the cost of production calls for the rejection of administered prices. When individual prices are market-determined, the aggregate price level (i.e., the value of money) is determined by the market so as to equate the demand for and supply of money.
To achieve an inflation target, it requires that the supply of money should be consistent with the demand for money at the targeted price level.
The three most common general approaches to determining the supply of money are: (a) to limit its creation by banks by directly controlling the amount of credit they may extend, (b) to limit its creation by banks by controlling the amount of reserves available to them, and (c) to fix the exchange rate of the currency to another currency or unit whose value behaves in the desired way and to allow the supply of money to be determined by demand for it at the value that has been fixed by the exchange rate.
The approach of a fixed exchange rate has considerable advantages but requires that government borrowing be limited to amounts that can be raised from the public. Fixing the value of money exogenously (e.g., to the dollar, Euro, SDR, gold, oil, or a commodity basket) is not only the easiest monetary policy to administer, assuming that the fiscal deficit can be minimized, but it probably provides the quickest way to establish faith in the stability of such money’s value.
As a result, most transition economies adopted a fixed exchange rate during the earliest phase of transition to help provide credibility for the central bank and stability to the economy, but then moved to more flexible exchange rate regimes.
If the rules of a fixed exchange rate are followed, the value of money will be the same as the value of the currency or basket of currencies, goods or assets to which the exchange rate of the currency has been fixed.
Therefore, it is also essential to anchor the domestic currency to a foreign currency. Apart from dollarisation (i.e., no domestically issued currency at all); a currency board is the simplest monetary regime with an externally fixed value to administer and has the highest credibility. A currency board simply buys and/or sells its currency in exchange for the currency or commodity(s) to which its value is fixed.
The rules of a currency board require the monetary authority to hold the asset to which the domestic money’s value is fixed to the full extent of the currency it has issued (i.e., at least 100 percent backing).
The board would accomplish this by issuing its currency only by buying the currency (or other assets) to which its value is fixed. If anyone holding its currency wishes to exchange it for the asset(s) backing it, the board must redeem its currency at the currency’s fixed price.
An alternative market approach to equating the supply of and demand for money is for the central bank to determine the money supply and allow the market to determine its value (i.e., to determine the price level). This approach contrasts with the fixed exchange rate approach in which the value of money is fixed and the market determines its supply, and obviously requires that exchange rates be market-determined.
Controlling the supply of money in an effort to stabilise its value requires a reasonably good estimate of the demand for money.
Price stability is still the ultimate objective of monetary policy with a market determined nominal exchange rate.
As previously stated, a monetary aggregate target is really an intermediate target that is only chosen because the central bank has closer control over the monetary aggregate than inflation. The behaviour of the monetary aggregate, in turn, should have a relatively predictable impact on inflation.
If the link between the monetary aggregate is weak, difficult to measure or unpredictable, an alternative to targeting a monetary aggregate is targeting inflation directly. Inflation targeting eliminates the intermediate target and focuses directly on the ultimate objective for inflation.
While inflation targeting central banks require much the same data as those targeting a monetary aggregate, a more central role is played by relatively simple policy models that forecast inflation given alternative assumptions about the near term (two to three years) behaviour of key macroeconomic variables.
In conclusion, successful inflation targeting requires a very structured process of collecting and analyzing economic and financial data and communicating the stance of policy to the public in light of model assisted forecasts. Regular interaction between the policy makers and the forecast team is critical to ensure total success.
Close working relationship is essential between the central bank and the forecasting team in monetary targeting; but, effective communication is very critical for inflation targeting.
This is because the central bank must forecast expected inflation, and if it is credible, it becomes a key in determining realised inflation. Thus, inflation targeting also requires very transparent communication of the central bank’s policies and why they are expected to result in achieving the inflation target in the medium term.
The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University. Montgomery, Alabama.
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