Under this policy approach the target is to keep "inflation, under a particular definition such as "Consumer Price Index, within a desired range.
The inflation target is achieved through periodic adjustments to the Central Bank "interest rate target. The interest rate used is generally the "overnight rate at which banks lend to each other overnight for cash flow purposes. Depending on the country this particular interest rate might be called the cash rate or something similar.
As the Fisher Effect model explains, the equation linking inflation with interest rates (both foreign and abroad) is the following:
Π = i - r
Where π is the inflation at home, i is the home interest rate set by the central bank, and r is the real world interest rate. Using i as an anchor, central banks can influence π. However, a necessary assumption for this equation to hold, is that the world real interest rate is constant. Central banks can choose to maintain a fixed interest rates at all times, or to keep a constant interest rate until the real world interest rate changes. The duration of this policy varies, because of the simplicity associated with changing the nominal interest rate.
The interest rate target is maintained for a specific duration using open market operations. Typically the duration that the interest rate target is kept constant will vary between months and years. This interest rate target is usually reviewed on a monthly or quarterly basis by a policy committee.
Changes to the interest rate target are made in response to various market indicators in an attempt to forecast economic trends and in so doing keep the market on track towards achieving the defined inflation target. For example, one simple method of inflation targeting called the "Taylor rule adjusts the interest rate in response to changes in the inflation rate and the "output gap. The rule was proposed by "John B. Taylor of "Stanford University.
The inflation targeting approach to monetary policy approach was pioneered in New Zealand. It has been used in "Australia, "Brazil, "Canada, "Chile, "Colombia, the "Czech Republic, "Hungary, "New Zealand, "Norway, "Iceland, "India, "Philippines, "Poland, "Sweden, "South Africa, "Turkey, and the "United Kingdom.
Price level targeting is a monetary policy that is similar to inflation targeting except that CPI growth in one year over or under the long term price level target is offset in subsequent years such that a targeted price-level is reached over time, e.g. five years, giving more certainty about future price increases to consumers. Under inflation targeting what happened in the immediate past years is not taken into account or adjusted for in the current and future years.
Uncertainty in price levels can create uncertainty around "price and "wage setting activity for firms and workers, and undermines any "information that can be gained from "relative prices, as it is more difficult for firms to determine if a change in the "price of a "good or "service is because of "inflation or other factors, such as an increase in the "efficiency of "factors of production, if "inflation is high and "volatile. An increase in "inflation also leads to a decrease in the "demand for money, as it reduces the "incentive to hold money and increases "transaction costs and "shoe leather costs.
In the 1980s, several countries used an approach based on a constant growth in the money supply. This approach was refined to include different classes of money and credit (M0, M1 etc.). In the US this approach to monetary policy was discontinued with the selection of "Alan Greenspan as Fed Chairman.
This approach is also sometimes called "monetarism.
Central banks might choose to set a money supply growth target as a nominal anchor to keep prices stable in the long term. The quantity theory, is a long run model, which links price levels to money supply and demand. Using this equation, we can rearrange to see the following:
Where π is the inflation, μ is the money supply growth rate and g is the real output growth. This equation suggests that controlling the money supply’s growth rate can ultimately lead to price stability in the long run. To use this nominal anchor, a central bank would need to set μ equal to a constant and commit to maintaining this target.
However, the money supply growth rate is considered a weak policy, because there is no way to target real output growth, As a result, a higher output growth rate will result in a too low level of inflation. A low output growth rate will result in inflation that would be higher than the desired level.
While monetary policy typically focuses on a "price signal of one form or another, this approach is focused on monetary quantities. As these quantities could have a role on the economy and business cycles depending on the households' risk aversion level, money is sometimes explicitly added in the central bank's reaction function. Recently, however, central banks are shifting away from policies that focus on money supply targeting, because of the uncertainty that real output growth introduces. Some central banks, like the ECB, are choosing to combine money supply anchor with other targets.
This policy is based on maintaining a "fixed exchange rate with a foreign currency. There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed exchange rate is with the anchor nation.
Under a system of fiat fixed rates, the local government or monetary authority declares a fixed exchange rate but does not actively buy or sell currency to maintain the rate. Instead, the rate is enforced by non-convertibility measures (e.g. "capital controls, import/export licenses, etc.). In this case there is a black market exchange rate where the currency trades at its market/unofficial rate.
Under a system of fixed-convertibility, currency is bought and sold by the central bank or monetary authority on a daily basis to achieve the target exchange rate. This target rate may be a fixed level or a fixed band within which the exchange rate may fluctuate until the monetary authority intervenes to buy or sell as necessary to maintain the exchange rate within the band. (In this case, the fixed exchange rate with a fixed level can be seen as a special case of the fixed exchange rate with bands where the bands are set to zero.)
Under a system of fixed exchange rates maintained by a currency board every unit of local currency must be backed by a unit of foreign currency (correcting for the exchange rate). This ensures that the local monetary base does not inflate without being backed by hard currency and eliminates any worries about a run on the local currency by those wishing to convert the local currency to the hard (anchor) currency.
Under "dollarization, foreign currency (usually the US dollar, hence the term "dollarization") is used freely as the medium of exchange either exclusively or in parallel with local currency. This outcome can come about because the local population has lost all faith in the local currency, or it may also be a policy of the government (usually to rein in inflation and import credible monetary policy).
Theoretically, using Relative PPP, the rate of depreciation must equal the inflation differential.
(E(H/F) )/ (EH/F) =ΠH +ΠF
which implies that:
ΠH = (E(H/F) )/ (EH/F) +ΠF
where the subscript "H" denotes the home country and "F" indicates the foreign country. The anchor variable is the rate of depreciation, (E(H/F) )/ (EH/F) . Therefore, the rate of inflation at home must equal the rate of inflation in the foreign country plus the rate of depreciation of the exchange rate of home’s currency, relative to the other.
With a strict fixed exchange rate or a peg, the rate of depreciation of the exchange rate is set equal to zero, such as in currency unions. In the case of a crawling peg, the rate is set equal to constant. With a limited flexible band, the rate of depreciation is allowed to fluctuate within a given range.
By fixing the rate of depreciation, PPP theory concludes that the home country’s inflation rate must depend on the foreign country. For example, a two percent increase in inflation at home raises the foreign country’s inflation by two percent. Countries may decide to use a fixed exchange rate monetary regime in order to take advantage of price stability and control inflation. In practice, more than half of nation’s monetary regimes use fixed exchange rate anchoring.
These policies often abdicate monetary policy to the foreign monetary authority or government as monetary policy in the pegging nation must align with monetary policy in the anchor nation to maintain the exchange rate. The degree to which local monetary policy becomes dependent on the anchor nation depends on factors such as capital mobility, openness, "credit channels and other economic factors.
Nominal anchors are possible with various exchange rate regimes.
|Type of Nominal Anchor||Compatible Exchange Rate Regimes|
|Exchange Rate Target||Currency Union/Countries without own currency, Pegs/Bands/Crawls, Managed Floating|
|Money Supply Target||Managed Floating, Freely Floating|
|Inflation Target (+ Interest Rate Policy)||Managed Floating, Freely Floating|
Following the collapse of Bretton Woods, nominal anchoring has grown in importance for monetary policy makers and inflation reduction. Particularly, governments sought to use anchoring in order to curtail rapid and high inflation during the 1970s and 1980s. By the 1990s, countries began to explicitly set credible nominal anchors. In addition, many countries chose a mix of more than one target, as well as implicit targets. As a result, global inflation rates have, on average, decreased gradually since the 1970s and central banks have gained credibility and increasing independence.
The Global Financial Crisis of 2008 has sparked controversy over the use and flexibility of inflation nominal anchoring. Many economists argue that inflation targets are currently set too low by many monetary regimes. During the crisis, many inflation anchoring countries reached the lower bound of zero rates, resulting in inflation rates decreasing to almost zero or even deflation.
The anchors discussed in this article suggest that keeping inflation at the desired level is feasible by setting a target interest rate, money supply growth rate, price level, or rate of depreciation. However, these anchors are only valid if a central bank commits to maintaining them. This, in turn, requires that the central bank abandons their monetary policy autonomy in the long run. Should a central bank use one of these anchors to maintain a target inflation rate, they would have to forfeit using other policies. On that note, it is important to mention that using these anchors may prove more complicated for certain exchange rate regimes. Freely floating or managed floating regimes, have more options to affect their inflation, because they enjoy more flexibility than a pegged currency or a country without a currency. The latter regimes would have to implement an exchange rate target to influence their inflation, as none of the other instruments are available to them.
The short-term effects of monetary policy can be influenced by the degree to which announcements of new policy are deemed "credible. In particular, when an anti-inflation policy is announced by a central bank, in the absense of credibility in the eyes of the public "inflationary expectations will not drop, and the short-run effect of the announcement and a subsequent sustained anti-inflation policy is likely to be a combination of somewhat lower inflation and higher unemployment (see "Phillips curve#NAIRU and rational expectations). But if the policy announcement is deemed credible, inflationary expectations will drop commensurately with the announced policy intent, and inflation is likely to come down more quickly and without so much of a cost in terms of unemployment.
Thus there can be an advantage to having the central bank be independent of the political authority, to shield it from the prospect of political pressure to reverse the direction of the policy. But even with a seemingly independent central bank, a central bank whose hands are not tied to the anti-inflation policy might be deemed as not fully credible; in this case there is an advantage to be had by the central bank being in some way bound to follow through on its policy pronouncements, lending it credibility.
Optimal monetary policy in international economics is concerned with the question of how monetary policy should be conducted in interdependent open economies. The "classical view holds that international macroeconomic interdependence is only relevant if it affects domestic output gaps and inflation, and monetary policy prescriptions can abstract from openness without harm. This view rests on two implicit assumptions: a high responsiveness of import prices to the exchange rate, i.e. producer currency pricing (PCP), and frictionless international financial markets supporting the efficiency of flexible price allocation. The violation or distortion of these assumptions found in empirical research is the subject of a substantial part of the international optimal monetary policy literature. The policy trade-offs specific to this international perspective are threefold:
First, research suggests only a weak reflection of exchange rate movements in import prices, lending credibility to the opposed theory of local currency pricing (LCP). The consequence is a departure from the classical view in the form of a trade-off between output gaps and misalignments in international relative prices, shifting monetary policy to CPI inflation control and real exchange rate stabilization.
Second, another specificity of international optimal monetary policy is the issue of strategic interactions and competitive devaluations, which is due to cross-border spillovers in quantities and prices. Therein, the national authorities of different countries face incentives to manipulate the "terms of trade to increase national welfare in the absence of international policy coordination. Even though the gains of international policy coordination might be small, such gains may become very relevant if balanced against incentives for international noncooperation.
Third, open economies face policy trade-offs if asset market distortions prevent global efficient allocation. Even though the real exchange rate absorbs shocks in current and expected fundamentals, its adjustment does not necessarily result in a desirable allocation and may even exacerbate the misallocation of consumption and employment at both the domestic and global level. This is because, relative to the case of complete markets, both the Phillips curve and the loss function include a welfare-relevant measure of cross-country imbalances. Consequently, this results in domestic goals, e.g. "output gaps or inflation, being traded-off against the stabilization of external variables such as the terms of trade or the demand gap. Hence, the optimal monetary policy in this case consists of redressing demand imbalances and/or correcting international relative prices at the cost of some inflation.
Corsetti, Dedola and Leduc (2011) summarize the status quo of research on international monetary policy prescriptions: "Optimal monetary policy thus should target a combination of inward-looking variables such as output gap and inflation, with currency misalignment and cross-country demand misallocation, by leaning against the wind of misaligned exchange rates and international imbalances." This is main factor in country money status.
Developing countries may have problems establishing an effective operating monetary policy. The primary difficulty is that few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting money demand and fiscal pressure to levy the inflation tax by expanding the base rapidly. In general, the central banks in many developing countries have poor records in managing monetary policy. This is often because the monetary authority in developing countries are mostly not independent of the government, so good monetary policy takes a backseat to the political desires of the government or are used to pursue other non-monetary goals. For this and other reasons, developing countries that want to establish credible monetary policy may institute a currency board or adopt "dollarization. This can avoid interference from the government and may lead to the adoption of monetary policy as carried out in the anchor nation. Recent attempts at liberalizing and reform of financial markets (particularly the recapitalization of banks and other financial institutions in Nigeria and elsewhere) are gradually providing the latitude required to implement monetary policy frameworks by the relevant central banks.
Beginning with New Zealand in 1990, central banks began adopting formal, public "inflation targets with the goal of making the outcomes, if not the process, of monetary policy more transparent. In other words, a central bank may have an inflation target of 2% for a given year, and if inflation turns out to be 5%, then the central bank will typically have to submit an explanation. The "Bank of England exemplifies both these trends. It became independent of government through the Bank of England Act 1998 and adopted an inflation target of 2.5% RPI, revised to 2% of CPI in 2003. The "European Central Bank adopted, in 1998, a definition of "price stability within the "Eurozone as inflation of under 2% "HICP. In 2003, this was revised to inflation below, but close to, 2% over the medium term. Since then, the target of 2% has become common for other major central banks, including the "Federal Reserve (since January 2012) and "Bank of Japan (since January 2013).
There continues to be some debate about whether monetary policy can (or should) smooth "business cycles. A central conjecture of "Keynesian economics is that the central bank can stimulate "aggregate demand in the short run, because a significant number of prices in the economy are fixed in the short run and firms will produce as many goods and services as are demanded (in the long run, however, money is neutral, as in the "neoclassical model). However, some economists from the "new classical school contend that central banks cannot affect business cycles.
Conventional macroeconomic models assume that all agents in an economy are fully rational. A "rational agent has clear preferences, models uncertainty via expected values of variables or functions of variables, and always chooses to perform the action with the optimal expected outcome for itself among all feasible actions – they maximize their "utility. Monetary policy analysis and decisions hence traditionally rely on this "New Classical approach.  However, as studied by the field of "behavioral economics that takes into account the concept of "bounded rationality, people often deviate from the way that these neoclassical theories assume. Humans are generally not able to react fully rational to the world around them – they do not make decisions in the rational way commonly envisioned in standard macroeconomic models. People have time limitations, "cognitive biases, care about issues like fairness and equity and follow rules of thumb ("heuristics).
This has implications for the conduct of monetary policy. Monetary policy is the final outcome of a complex interaction between monetary institutions, central banker preferences and policy rules, and hence human decision-making plays an important role. It is more and more recognized that the standard rational approach does not provide an optimal foundation for monetary policy actions. These models fail to address important human anomalies and behavioral drivers that explain monetary policy decisions.
An example of a behavioral bias that characterizes the behavior of central bankers is "loss aversion: for every monetary policy choice, losses loom larger than gains, and both are evaluated with respect to the status quo. One result of loss aversion is that when gains and losses are symmetric or nearly so, risk aversion may set in. Loss aversion can be found in multiple contexts in monetary policy. The "hard fought" battle against the Great Inflation, for instance, might cause a bias against policies that risk greater inflation. Another common finding in behavioral studies is that individuals regularly offer estimates of their own ability, competence, or judgments that far exceed an objective assessment: they are overconfident. Central bank policymakers may fall victim to "overconfidence in managing the macroeconomy in terms of timing, magnitude, and even the qualitative impact of interventions. Overconfidence can result in actions of the central bank that are either "too litte" or "too much". When policymakers believe their actions will have larger effects than objective analysis would indicate, this results in too little intervention. Overconfidence can, for instance, cause problems when relying on interest rates to gauge the stance of monetary policy: low rates might mean that policy is easy, but they could also signal a weak economy.
These are examples of how behavioral phenomena may have a substantial influence on monetary policy. Monetary policy analyses should thus account for the fact that policymakers (or central bankers) are individuals and prone to biases and temptations that can sensibly influence their ultimate choices in the setting of macroeconomic and/or interest rate targets.
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