Monday, 7 October 2013

Nominal Anchors Of Monetary Policy

Nominal Anchor:
·         Nominal anchors are the variables that keep the price level from growing or falling from a certain level, thus keeping the price stable.
·         Nominal anchor is important because it can limit the time-consistency problem, in which the monetary policy is conducted on day-to-day, discretionary basis which lead to poor long-term output.

Time-Consistency Problem:
·         It arises because economic behavior is influenced by the firms and the people.
·         Policy makers assume that the discretionary policy will not make the firm and people’s behavior to change, so they adopt expansionary policy to boost economy which leads to high inflation in long-run.
·         Moreover, the short term objectives are achieved by extending long term objectives.
Regimes of monetary Targeting:
There are 4 basic regimes of monetary targeting which are discussed one by one below:
Exchange Rate Targeting:
This type enables pegging the currency of targeting country with high vale, low inflation currency of anchoring country.
1.      Keeps inflation under control by tying prices of international goods by fixed exchange rate.
2.      Avoids problem of time consistency. The expansionary policy is used when there is a tendency of domestic currency to appreciate. The tightening monetary policy is applied when there is a tendency of domestic currency to depreciate.
3.      Simplicity and clarity of policy. Easy to e understood by public.
4.      This nominal anchor is more effective in controlling inflation in emerging market countries than industrialized countries.
5.      It encourages integration with the neighboring countries.
6.      Tool to break hyper-inflation.
1.      With exchange rate targeting, the country can no longer pursue its independent policy.
2.      Loses its ability to use MP to respond to domestic shocks.
3.      Shocks of anchoring country are directly transmitted to the targeting country. Such as, Change in interest in anchoring country will change interest rate in targeting country.
4.      Exchange rate targeting leaves the country open for speculative attacks.
5.      It weakens the accountability of the policy makers, particularly in emerging market countries. Exchange rate targeting may eliminate the signal that indicates overly expansion of money in the economy. Developed countries have bond markets which indicate expansion of money due to increase in inflation, hence raising the interest rate and reducing the bond-price in the long run. Central banks of developed countries avoid such situation. Emerging markets do not have bond markets, well organized. So if the economy will expand due to exchange rate targeting, the currency will depreciate.

In order to avoid the problem of accountability and transparency, there are two solutions:
·         Currency board
·         Dollarization
Currency Board:
·         Domestic currency is 100% backed by foreign reserves.
·         Note issuing authority sets a fixed exchange rate.
·         The note issuing authority stands ready to exchange the domestic currency with foreign currency at fixed rate when ever public demands it.
·         Note cannot be printed and interest cannot be adjusted.
·         Currency boards are established in Hog Kong, Estonia, Bulgaria, Lithonia, Bosnia, Argentina etc
1.      Money supply can only be expanded when foreign currency is sold at the central bank.
2.      Central bank being transparent is committed to a fixed exchange rate, hence inflation can be controlled easily.
3.      Quick exchange rate adjustment leads to less speculative attacks.
1.      Lack of independent monetary policy.
2.      Loss of central bank’s ability to print money as a lender of last resort.
3.      Speculative attacks may lead to sharp contraction of money in economy leading to economic damages.
Dollarization is the use of US dollar as a currency. It can be a suitable option for emerging mrket countries.
·         Completely avoids speculation on targeting country.
1.      Loss of independent monetary policy.
2.      Increase in economic shocks from anchoring country.
3.      Inability to create money as lender of last resort.
4.      Country losses it own currency, so it losses the revenue that government receives by issuing currency, i.e. seignorage.
Emerging Market Countries
Industrialized Countries

Argentina, till 2002 used exchange rate targeting and fixed its one peso with one dollar. Inflation got controlled
In 1987, France pegged its currency with German mark. Inflation in France was 3% above Germany in 1996 inflation fell to 2% and later it even got lower than Germany.
Mexico used exchange rate targeting and reduced its inflation from100% in 1988 to below10% in1994.
In 1990, UK pegged its currency with German Mark and inflation reduced from 10% to 3% in 1992.

Italy also had more gain than loss by pegging its currency with German mark.

Speculative attacks in East Asia in 1997 lead to financial crises.
In 1990, Germany reunified and result was massive money supply in economy and inflation. Germany had to adopt tight policy so it increased the interest rate leading to the increase in the interest rate of France and Uk.  All countries who pegged their currency with mark suffered from inflation due to slow output growth and unemployment.
Before, 1997, Thailand had currency crisis because there was no control of public over the policy maker, and there was great political pressure which made MP overly expanded.
France, Sweden, Italy, Uk were speculated, hence the only solution was to depreciate the currency against mark. However, France managed to adjust to the mark and was less attacked by speculators. So it continued to follow the same regime. However, UK adopted inflation targeting. Result was that France faced unemployment and slow growth issues in long-run while UK got saved.
In 1994 Mexico also suffered speculative attacks.

In 2002, speculative attacks in Argentina made its economy fell in financial and economic crises.

Monetary Targeting:
Developed countries do not opt exchange rate targeting because:
·         The country is too large.
·         No currency can be used as nominal anchor for their domestic currency.
Policy makers adopt monetary aggregate targeting to achieve price stability.
Milton Friedman suggested that the chosen monetary aggregate will grow at constant rate. But its not the case. Central bank never adhered strict rules for monetary growth.
1.      Focus on long term considerations and control of inflation.
2.      Transparent policy making.
3.      Clear and easy to be understood by public.
4.      Flexible in practice rather than strict and rigid.
5.      Adjustments are made in policy to cope up with domestic considerations.
6.      Enables central bank to choose inflation goals.
7.      Information about achievement of policy can be obtained with in weeks.
8.      Monetary aggregate targeting generates signals to market and public which helps in fixing inflation problems.
9.      Immediate accountability of the outcomes of the policy.
1.      Policy conflicts with exchange rate goals.
2.      M1, M3 are not reliable indicators of tightness of policy.
3.      If money growth gets too slow it may lead to collapse of stock and land prices, bank crisis, deflation and financial instability.

Canada and UK
·         Adopted Monetary Gradualism
·         Targeted M1 growth to control money supply with in target
·         M1 was abandoned by central bank of Canada
·         UK adopted M3.
·         UK adopted Medium Term Financial Strategies and proposed gradual deceleration of M3 strategies but it had same problems as M1.
·         M3 was suspended and M0 was introduced. M3 was abandoned till 1987.

Later, the central bank of UK and Canada adopted multiple aggregate and did not announce any regular schedule. They used artificial means to bring down the targeted aggregates, hence they missed targeted monetary aggregates and deviation in MP occurred.

Increase in the oil prices was major shock for Japan
Inflation increased above 20%
Started forecasting at beginning of each quarter for M2+CDs and adopted expansionary policy
Second oil price shock. But this time M2+CD growth was reduced.
Better performance of economy due to successful MP
Mid of 1970
Monetary growth slowed down and inflation increased.
After 1987
Deregulation in Japan reduced performance of M2+CD monetary aggregate. Also, Bank Of Japan was concerned about currency appreciation.
Money growth increased which increased speculative attacks on stock and real estate and caused economic bubble.
Tight monetary policy collapsed the economic bubble.
·         Collapse of stock and land prices.
·         Bank crisis.
·         Deflation.
·         Financial instability.

End of 1974-20years
Monetary Aggregate Targeting. Inflation was controlled
Narrow Monetary Aggregate targeting in which the weighted average of bank deposits and currency in circulation was taken which was equal to reserve ratio.
M3 target was adopted. Germany focused on exchange rate and increase in output. Flexible policy was adopted rather than rigid. Gradually covered the long-term inflation.
Medium term growth paths were adopted.
Expansion path
Medium path
M0 was adopted and it enabled in controlling inflation

M1 was targeted
Narrow Monetary Aggregate, M0 was adopted.
Inflation overshoot because of 2 reasons:
ü  Swiss Bank allowed monetary base to grow above 2%.
ü  Change in inter-bank payment method.

Success of Central Banks Of Germany and Switzerland: Monetary aggregate targeting may bring inflation in the long-run, if the monetary substantial targets are missed. However, the central bank of Germany and Switzerland succeeded besides missing monetary targets because the policy was communicated to the public and the markets. There was high transparency in MP and greater central bank’s accountability.
Terminologies related to Monetary Aggregate:

It only includes cash or assets that could quickly be converted into currency. This measure is known as narrow money because it is the smallest measure of the money supply.

A category of the money supply that includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts. This is used as a measurement for economists trying to quantify the amount of money in circulation. 
A category within the money supply that includes M1 in addition to all time-related deposits, savings deposits, and non-institutional money-market funds.
The Money Supply M2+CD released by the Bank of Japan measures all the JPY (Japanese Yen) in circulation, encompassing notes and coins as well as money held in bank accounts. It is considered as an important indicator of inflation, as monetary expansion adds pressure to the exchange rates. An acceleration of the M2 money is considered as positive for the JPY, whereas a decline is as negative.
The category of the money supply that includes M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. This is the broadest measure of money; it is used by economists to estimate the entire supply of money within an economy.It only includes cash or assets that could quickly be converted into currency. 

Inflation Targeting:
This policy is adopted by countries who want to have their independent MP.
Elements of Inflationary MP:
1.      Public announcement of medium-term numerical targets of inflation.
2.      Institutional commitment to price stability as primary long term goal.
3.      Strategy involving more than one variable for decision making.
4.      Transparency is increased by communicating stance to the public.
5.      Increased accountancy of central bank.
1.      Focus on domestic concerns.
2.      Independent policy.
3.      Stability in relationship between money and inflation.
4.      Uses all information and not only one variable to make policy.
5.      Easier to be understood by public.
6.      Increase in accountability of central bank.
7.      Takes support of political dialogue and debates to ensure transparency.
8.      Inflation targeting central banks are in continuous communication with Government.

1.      Delayed Signals:
a)      Inflation is not easily controlled by policy makers.
b)      Inflation outcomes can be observed after a time lag.
c)      Signals are received late by market and public.
2.      Too much rigidity:
a)      Rigid rules are to be followed.
b)      Policy makers have to respond to unforeseen circumstances.
c)      All useful information is to be considered.
d)     Policy depends upon case to case and according to circumstances of the country.
3.      Potential for increased output fluctuation:
a)      When there is high inflation, the policy will be tight and output fluctuation will be greater.
b)      When the inflation target is set, it has to be above 0 because negative target leads to deflation which is another fearful aspect.

4.      Low Growth Economy:
Leads to low growth and employment but once low inflation levels are achieved output and employment become higher than before.

New Zealand
Parliament passed a new reserve bank for country and increased its independence of policy making.
MP was to be made after negotiation between policy makers, prime minister and governor of central bank.
To lower inflation between 3-5%
To lower inflation between 0-2% range.
Result was:
ü  Recession
ü  Increase in unemployment
After 1992
Growth rate increased to 5% and unemployment decreased.

2-4% Range of Inflation
 Unemployment increased to above 10% but later declined substantially
1-3% inflation range
Result was that inflation dropped dramatically

After September 1992 crisis UK adopted inflation targeting
ü  Inflation range 1-4%
ü  Inflation dropped below 2.5% from 9% in 1991
ü  Growth increased and unemployment decreased.

GDP Targeting:
·         As inflation targeting leads to output fluctuations, so GDP targeting was introduced.
·         GDP targeting puts weight on price and output during policy making

Comments on GDP targeting:
1.      Government/Central bank has to announce number of potential GDP growth overtime.
2.      When potential GDP is announced,it is being criticized by public because they consider it low and think that the central bank is anti-growth.
3.      However, if the estimates are set high, it may get embedded in the inds of the public as target and it leads to inflation.
4.      It is difficult to collect the data of intrinsic price and the nominal price of goods in timely manner.
5.      Concept of inflation targeting is easy to be understood by public as compared to GDP targeting, though GDP targeting is more effective in achieving short term objectives than inflation targeting.

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