Exchange Rate Targeting

12 Key excerpts on "Exchange Rate Targeting"

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  eBook - ePub

  Handbook of Monetary Policy

  • Jack Rabin(Author)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  During the 1980s and 1990s, a number of countries abandoned these more traditional anchors. One reason was that the relationship of monetary aggregates to economic activity broke down in many countries, leaving those central banks that targeted monetary aggregates relying more on discretion and looking at a wide range of information for guidance. With most of these central banks using a very short-term nominal interest rate as the instrument of monetary policy, some analysts became concerned that, without an explicit target, monetary policy could develop an inflationary bias. For example, if policymakers were slow to react to rising inflation expectations, short-run real interest rates would fall, leading to an increasingly accommodative policy at a time when policy might need to be tightened.

  Other countries that used exchange rate targets abandoned them when exchange rates became misaligned. The problem with using exchange rates as targets is that monetary policy must be directed at keeping the exchange rate within its target range, sometimes at the expense of promoting favorable domestic macroeconomic performance. If exchange rate targets are consistent with favorable macroeconomic performance, they can work well as an anchor for policy. When exchange rates become misaligned, however, a central bank may find itself defending the foreign exchange value of its currency at the cost of achieving goals for the domestic economy. When this happens, speculators may attack the currency, leading possibly to a realignment of exchange rate targets or, at the extreme, their demise as a guide to monetary policy. An example of this phenomenon occurred in the United Kingdom during the crisis in Europe’s exchange rate mechanism (ERM) in 1992, when the UK left the ERM and established inflation targets as its anchor for monetary policy.

  Improving Transparency and Accountability

  Another rationale for inflation targets is that they can improve the transparency of monetary policy and the accountability of monetary policymakers. Inflation targets are highly transparent because they convey to the public a precise, readily understood goal for monetary policy. For example, an inflation target under which a central bank commits to “keep increases in the consumer price index between 1 and 3 percent annually from now until the end of the year 2001” gives the public a clear signal of both near-term and longer term plans. A central bank with such a target provides a clearer signal than a bank that simply commits to “achieving price stability in the long run,” without specifying a numerical definition of price stability or a time frame for achieving it. Of course, the more precise a target, the easier it is to tell whether a target is hit or missed. And when targets are missed, policymakers have to explain why. Advocates of inflation targeting argue that explaining target misses increases transparency. Critics contend that inflation targets might give policymakers too strong an incentive to hit the target at the expense of adverse short-run fluctuations in output and employment.3

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  Monetary Policy, Capital Flows and Exchange Rates

  Essays in Memory of Maxwell Fry

  • William Allen, David Dickinson(Authors)
  • 2002(Publication Date)
  • Taylor & Francis

    (Publisher)

  2

  The differences between inflation targeting and Exchange Rate Targeting are greater, both in concept and in practice, than the differences between inflation targeting and monetary targeting. Of course, it is true that Exchange Rate Targeting makes sense only if there is a predictable relationship between the exchange rate and future inflation, just as in the case of monetary targeting. But not every country can pursue an exchange rate target, for obvious reasons. Somewhere there has to be a so-called anchor currency country which sets a standard by using a different monetary policy technique – and in an important sense countries which target their exchange rates against the anchor currency are borrowing that country’s monetary policy technique and its monetary policy credibility. And, while it is possible to depart temporarily from monetary targets if the underlying relationships appear to have changed,3 it is generally not possible to depart temporarily from exchange rate target bands without there being a severe loss of credibility.

  Specification of the Inflation Target

  It is easy to say that the objective of monetary policy is price stability. It is much harder to specify what that means in terms of observable quantities. A number of decisions need to be made in setting an inflation target. They include:

  1. What price index, and at what level should the target be set?
  2. Should there be a target band, and if so, how wide should it be?

  What Price Index, and at what Level should the Target be Set?

  The measurement of inflation is an important subject in its own right, irrespective of the choice of monetary policy technique. The use of inflation targets merely makes its importance more obvious. Although measurement issues may appear to be matters of detail, they nevertheless raise some fundamental questions, two of which are discussed below.

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  After the Washington Consensus

  Restarting Growth and Reform in Latin America

  • Pedro-Pablo Kuczynski, John Williamson, Pedro-Pablo Kuczynski, John Williamson(Authors)
  • 2003(Publication Date)
  • Peterson Institute for International Economics

    (Publisher)

  In the face of these constraints, a small but increasing number of the region’s countries have chosen to combine more flexible exchange rate regimes with inflation targeting. As was mentioned above, a regime involving more flexibility in the management of exchange rates and inflation targeting was chosen to send a credible message of central banks’ commitment to keep inflation low while avoiding speculative attacks on the exchange rate. The choice of in-flation targeting has the advantage of dealing with both the central bank independence problem and the pass-through problem. With respect to the absence of adequate independence of central banks, this feature constitutes an important limitation on the credibility of any announced monetary/exchange rate policy. Inflation targeting helps be-MONETARY POLICY AND EXCHANGE RATES 147 37. Continuous intervention would be inconsistent with a managed floating regime. 38. A number of analysts argue that an important cause of speculative attacks against the exchange rate has been large and sustained misalignments of the real exchange rate (sharp deviations of the real exchange rate relative to its long-run “equilibrium” level). In this re-gard, avoiding such misalignments is viewed as an important role of monetary/exchange rate policy. Supporters of this view argue for some form of announced foreign exchange in-tervention to prevent real exchange rate disequilibria; see Williamson (2000). It would certainly be beneficial for Latin American countries to prevent significant ex-change rate misalignments. However, I believe there are a number of reasons that do not support the implementation in the region of a policy aiming at keeping the real exchange rate at or around its equilibrium level.

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  Monetary Policy in Central Europe

  • Miroslav Beblavý(Author)
  • 2007(Publication Date)
  • Taylor & Francis

    (Publisher)

  Whenever monetary targets were used in Central Europe, they stood alongside Exchange Rate Targeting in the form of a fixed exchange rate. (The only exceptions are short periods in the Czech Republic and Slovakia following the demise of their pegs.) The monetary targets were also important for central banks in their decision-making. While fixed exchange rates provided nominal anchors for outsiders, they provided little guidance for policy-makers themselves on how to set policy instruments to make the exchange rate sustainable or to achieve a targeted level of inflation. In this sense, monetary targets can be seen as a true intermediate target – a variable influencing inflation that the central bank could control. However, this proved to be the case only with high inflation and low capital inflows. Once inflation dipped below 20 per cent and net capital flows became important in comparison with the overall money supply, monetary targeting became a blunt instrument indeed.

  On a similar note, a rapid capital outflow had a substantial dampening effect on monetary growth often without a corresponding effect on inflation, as inflation was more influenced by currency depreciation and increased inflation expectations (as evidenced by the Czech and Slovak experience in 1997 and 1998).

  After the Exchange Rate Targeting was terminated either voluntarily or following a crisis, all four countries gradually shifted towards inflation targeting. In such an environment, setting and announcing monetary targets became much less relevant and the practice was discontinued.

  Inflation targeting – introduction

  Inflation targeting dispenses with a formal intermediate target and attempts to target inflation directly. The boundary between inflation targeting and other monetary policy frameworks (such as money targeting and discretionary policy with an implicit anchor) is highly uncertain and frequently in the eye of the beholder (Mishkin and Savastano 2001).

  After several developed economies – e.g. Canada, New Zealand, United Kingdom, Sweden, Spain, Finland and Australia – adopted inflation targeting in the early to mid-1990s and early evaluations indicated the relative merits of the new framework (Almeida and Goodhart 1998; Brunila and Lahdenpera 1995; and Leiderman and Svensson 1995), it was rapidly instituted by many developing and transitional economies, which either voluntarily or under duress gave up their fixed exchange rate. Brazil, the Czech Republic, Hungary, Israel, Mexico and Poland are among developing or transitional economies that recently switched to inflation targeting (e.g. Bogdanski et al.

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  Inflation Targeting in the World Economy

  • Edwin M. Truman(Author)
  • 2003(Publication Date)
  • Peterson Institute for International Economics

    (Publisher)

  The constrained discretion of the framework helped discipline monetary—and to some extent fiscal—policy while not being so rigid as to bring on either an economic or a financial crisis. The review of the Polish and Brazilian cases, following the British and Swedish cases, reinforces the point that inflation targeting does not ab-solve the authorities from taking into account exchange rate consider-ations, including the possibility that exchange rate performance may be incompatible with the successful operation of an inflation-targeting framework for monetary policy in terms of hitting or coming close to the inflation targets. Against this background, the questions that the exchange rate debate boils down to are discussed next. What types of exchange rate regimes are compatible with inflation targeting? This question can be divided into two issues: first, to what extent should monetary policy be directed at an ex-change rate target or conditioned by exchange rate considerations? Second, to what extent should exchange market operations be undertaken either to achieve an exchange rate target or merely supplement monetary policy? The next two sections consider these two issues. The final section discusses whether a “fear of floating” is likely to undermine, for either rational or irrational reasons, the capacity, in particular by authorities in emerging-market economies, to implement inflation targeting reasonably effectively. Inflation Targeting and Exchange Rate Regimes Some advocates of inflation targeting take the position that the only ex-change rate regime that is fully compatible with an inflation-targeting framework for the conduct of monetary policy is essentially free float-ing. 15 In this view, anything in the direction of the more rigid pole in the spectrum of exchange rate regimes is at best a distraction and at worst confusing to policymakers and economic agents (Blejer and Leone 2000). In this area virtue does not reside in being doctrinaire.

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  Turkeys Economy from different perspectives after 1980

  The past, present and the future

  • Ebru Gül Yilmaz, Neyir Tekeli(Authors)
  • 2020(Publication Date)
  • Peter Lang Group

    (Publisher)

  In line with the pri- mary objective of price stability, the “inflation targeting regime” was adopted in 2002. Accordingly, the Central Bank started to use short-term interest rates as the main policy instrument. 2.4.6.2 Taylor Rule in Inflation Targeting The Taylor Rule was developed by the American economist John Taylor. A rule that requires central banks to change their policy rates in the same direction as the difference between the actual and targeted inflation rates and the actual and potential output level. This rule can be written as follows: r = slurabove r + π + h (π - ˜ π) + g ( y - slurabove y ) (1) This rule indicates that the policy rate (r) should be set equal to the inflation rate (π) plus an equilibrium real interest rate determined by the monetary authority (ȓ) plus a weighted average of two gaps: (1) an inflation gap, current inflation (π) minus a target inflation rate ( ˜ π), and (2) an output gap, the percentage deviation of real GDP (y) from an estimate of its potential full employment level (ŷ). In the formula, (h) is the inflation response coefficient of the Central Bank, which brings the difference between the actual inflation and the target inflation to the nominal discount rate (Mishkin, 2010). Nowadays, central banks have not adopted monetary policy according to the Taylor Rule. However, this rule is used only as a guide. Because, while there is undesired tendencies in the inflation or economic conjuncture, the Taylor Rule systematically allows to be known the attitude of the monetary authority in advance (CBRT, 2018b). 2.4.6.3 Implicit Inflation Targeting Under the National Program set out in May 2001, the main objective of mone- tary policy was to reduce the inflation to single digits in the medium term and to achieve price stability. To this end, the Central Bank has adopted the Implicit Inflation Targeting in monetary policy strategy.

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  The Inflation-Targeting Debate

  • Ben S. Bernanke, Michael Woodford, Ben S. Bernanke, Michael Woodford(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  It could cause a problem of instrument instability and result in excessive variability of real exchange rate,—and thus in an increased degree of uncertainty in the economy and higher variability of output. 36 In addition, it runs the risk of transforming the exchange rate into a nominal anchor that takes prece-dence over the inflation target. For example, as documented in Bernanke et al. (1999), Israel’s intermediate target of an exchange rate around a crawl-ing peg did slow the Bank of Israel’s e ff ort to win support for disinflation and lowering of the inflation targets in the early years of its inflation-targeting regime. In addition, an active focus on the exchange rate may in-duce the wrong policy response when a country is faced with real shocks such as a terms-of-trade shock. Two graphic examples of these problems are illustrated by the experiences of New Zealand and Chile in the late 1990s. The short horizon for the inflation target in New Zealand led the Reserve Bank to focus on the exchange rate as an indicator of the monetary policy stance because of the direct impact of exchange rate movements on infla-tion. By early 1997, the Reserve Bank institutionalized this focus by adopt-ing as its primary indicator of monetary policy a Monetary Conditions In-dex (MCI) similar to that developed by the Bank of Canada. The idea behind the MCI, which is a weighted average of the exchange rate and a short-term interest rate, is that both interest rates and exchange rates on average have o ff setting impacts on inflation. When the exchange rate falls, this usually leads to higher inflation in the future, and so interest rates need to rise to o ff set the upward pressure on inflation. However, the o ff setting e ff ects of interest rates and exchange rates on inflation depend on the na-ture of the shocks to the exchange rates.

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  Latin American Macroeconomic Reforms

  The Second Stage

  • José Antonio González, Vittorio Corbo, Anne O. Krueger, Aaron Tornell, José Antonio González, Vittorio Corbo, Anne O. Krueger, Aaron Tornell(Authors)
  • 2010(Publication Date)
  • University of Chicago Press

    (Publisher)

  A future challenge is to consider substituting a more traditional interest rate instrument for the current quantitative instrument of monetary policy (the borrowed re-serves target, or corto ). Future Challenges Faced by In fl ation-Targeting Countries Let me now turn to the challenges faced by the in fl ation-targeting cen-tral banks in the region. First of all, although Chile, Mexico, and Brazil have had successful experiences to date, the latter two countries still need to bring in fl ation down to the level observed in developed countries, a phe-nomenon that has not been seen in our economies for quite some time. A broad recommendation to help achieve this goal is to have sound public fi nances. Second, due to our history of unsound fi scal policy, high in fl ation, and drastic devaluations accompanied by fi nancial crisis, in fl ation expecta-tions and in fl ation itself are extremely sensitive to exchange rate move-ments. Although the macroeconomic situation has changed, expectations are still heavily in fl uenced by too many years of instability, forcing the monetary-policy reaction function to be very responsive to developments in the foreign exchange market. This necessary response reduces the ad-vantages of the fl exible exchange rate as a shock absorber, while the solid macroeconomic framework forces a change in the way expectations are formed, credibility is built up, and the pass-through is reduced. Once this is accomplished, the exchange rate will play a larger role as a relative price and will stop being a signal of future in fl ation. Therefore, the full bene fi ts of the regime will come into e ff ect. There is a fi nal point that I would like to address. In an open economy, when the central bank raises interest rates in response to an acceleration of aggregate demand, it runs the risk of increasing the current account de fi cit, in turn augmenting the vulnerability of the economy to shifts in in-vestors’ con fi dence.

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  Inflation Targeting in MENA Countries

  An Unfinished Journey

  • Mongi Boughzala, D. Cobham(Authors)
  • 2011(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Industrial country inflation targeters typically do not intervene at all in forex markets, arguing that all they need to do is to take proper account of the consequences of exchange rate movements for inflation. And in the period of (formal and informal) IT the exchange rate prices pass- through seems to have been much lower than in the 1970s and 1980s (see, for example, Taylor, 2000). However, it can be argued that emer- ging market inflation targeters face a different situation (Amato and Gerlach, 2002): the exchange rate for their currencies may be more vola- tile, agents are accustomed to using an exchange rate peg as the basis for their inflation expectations, and domestic banks and firms may have significant foreign exchange liabilities such that exchange rate move- ments can have large adverse effects on their balance sheets. In other Introduction 7 words the 'fear of floating' first identified by Calvo and Reinhart (2002) may not be entirely misplaced. For example, Al-Mashat (2011) presents a New Keynesian model, calibrated for Egypt, within which she exam- ines the effect on inflation and output volatility of varying degrees of responsiveness by the central bank to exchange rate movements. Her results enable her to argue that the optimal policy is towards the com- plete exchange rate flexibility end of the spectrum, but not quite at the end. In practice a number of IT-adopting countries initially maintained an exchange rate peg (often a crawling peg) in parallel to their inflation targets in the early years of IT, but then discarded the peg once they had reached steady state inflation.

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  21st Century Economics: A Reference Handbook

  • Rhona C. Free(Author)
  • 2010(Publication Date)
  • SAGE Publications, Inc

    (Publisher)

  3 7 MONETARY POLICY AND INFLATION TARGETING PAVEL S. KAPINOS Carleton College DAVID WICZER University of Minnesota I nflation targeting (IT) is a framework for the conduct of monetary policy, under which the monetary authority announces a medium- or long-run inflation target and then uses all available information to set its policy instrument, the short-term nominal interest rate, so that this target is met. Short-lived deviations from the inflationary target may be acceptable, especially when there may be a short-run trade-off between meeting the target and another welfare consideration, for example, the output gap—the difference between actual and potential output. Hence, although the central bank commits to meeting a certain inflationary target, in practice, IT takes a less rigid form, with the central bank exercising some discretion over the path of actual inflation toward its tar-get. Recently, dozens of central banks around the world have introduced IT as their operational paradigm. Numerous studies indicate that this policy has been suc-cessful in achieving macroeconomic stability at no long-run cost in terms of lower real activity. Many central banks that have not explicitly subscribed to IT have been shown to follow it implicitly. IT provides a way for the central bank to communicate its intentions to the public in a clear, unequivocal manner, making the conduct of monetary policy more transparent and predictable. Transparency allows the public to hold the central bank accountable for its policy actions. In fact, in some countries, inflation-targeting central banks are subject to intense public scrutiny from the legislative bodies. Predictability of monetary policy allows the cen-tral bank to manage public inflationary expectations and better anchor them around the inflationary target; this allows the central bank to achieve macroeconomic stabil-ity more effectively.

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  The Monetary Transmission Process

  Recent Developments and Lessons for Europe

  • D. Bundesbank(Author)
  • 2001(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  It is important to avoid giving the impression that central banks are reluctant to cut interest rates and quick to raise them. That would be the opposite of the politician's preference for raising interest rates `when necessary' and lowering them `when possible'. Symmetry should be an important part of the approach to setting interest rates. The problem with a target range is that there is a lack of clarity about the objective of monetary policy. Of course one might argue that the central bank would do best by aiming for the centre of the range, and economic agents would know that. The analogy is that, faced with an open goal and with some uncertainty about your ability to kick a football, the best advice is to aim for the point between the middle of the goalposts. Sadly, many footballers of my acquaintance seem to be confused by an open goal, hesitate, and too often miss. A point target has the virtue of concentrating the mind. It is also particularly useful in the context of a policy making committee, to demonstrate that the concept of `hawks' and `doves' on the same committee has no meaning when the committee has a common point in¯ation target. Third, Svensson suggests that the use of the reference value for money by the ECB is misguided. The announcement of a money target might confuse agents rather than `anchor' in¯ationary expectations. I have more sympathy with the idea that money is special. There is still much that we do not fully understand about the transmission mechanism, but it is dif®cult to talk about in¯ation or monetary policy without according a special role for money. And many of the models which play down the role of money and give a prominent place to such concepts as the neutral real interest rate or the equilibrium exchange rate presume more knowledge about the empirical values of these concepts than is available in practice to central banks. So I think there are two reasons for allowing a special role to money.

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  Economic and Financial Developments in Latin America

  • S. Motamen-Samadian(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  Inflation targeting overlooks the structural imbalance in the trade account of the developing economy. Hence, its role in giving the right 120 Inflation Targeting and Exchange Rate Risk direction to inflation expectations is constrained by the same factors that led to the break down of the previous exchange-rate crawling-peg regime. Foreign investors’ expectations of central bank management will eventually have to confront reality; and rising current account and fiscal balances will, in the end, bring about the reversal of short-term capital flows on which short-term price stability was based. Conclusion In emerging economies subject to structural inflation, independent central banks concerned mainly with price stability show a bias towards stabilizing the nominal exchange rate, either openly through a crawling peg, or (more subtly), through inflation targeting, and a discretional monetary policy heavily dependent on international market evaluations of country-risk. Both modalities are bound to fail in the medium term, for at least two reasons. First, because they overlook the structural origin of trade-account imbalances, and rely heavily on interest rate policy, which is ineffective in lowering the income elasticity of imports. Second, because they eventually conduce to fiscal imbalances, due to increased cost of government domestic debt, which is an important indicator of country risk in evaluations made by international investors. The remedies to exchange-rate instability in emerging economies posited during the last decade also disregard asymmetries in the eco- nomic behaviour of economies at different stages of development. It is generally assumed that an exchange-rate crisis arises from lack of credi- bility regarding central bank policies, and that free capital mobility con- tributes to exchange rate instability. On the basis of this diagnosis, two extreme solutions are often recom- mended.

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