Learning Outcome By the end of this chapter you should be able to, ■ Define Monetary targeting
■ Define Inflation targeting
■ Discuss the various choices of policy anchor o Volume of money o Interest rate o Exchange rate
■ ifi u
strate the relationship between exchange rate and monetary
■ Comfre the effects of the monetary policy under a fixed and a flexible exchange rate regime ■ Provide a brief overview of the monetary policy and the role of the State Bank of Pakistan
Formulating the As discussed earlier, the primary goal of monetary policy is to Policy, Choice °f target general price levels while at the same time try to maintain a sustainable level of Mone
tary Policyemployment and aggregate output level. In the
preceding chapter we learned about the Anch°r channels through which monetary policy affects inflation and aggregate output. Here, we
will discuss how monetary policy strategy is formed and implemented.
One important element of a monetary policy strategy is to set economic targets via focusing on different variables. An anchor is a variable that central bank uses to control the ultimate target of monetary policy. 7 More specifically, a monetary poHcy anchor can be exchange rate, money Aupply, rate of inflation or interest rate that the central bank intermediately focuses on m order to achieve the desired general price level in the country.
During the early 1970s, many central banks thought that a change in monetary policy strategies is necessary to control inflation and unemployment more effectively. This led to a more focused approach by the central banks to target inflation and aggregate output level. As a result, central banks around the world experimented, broadly stating, with two alternative strategies: monetary targeting and inflation targeting For a detailed discussion of these two strategies, see Bemanke and Mishkin, "Central Bank Behavior and the Strategy of Monetary Policy: Observations from Six Industrialized Countries”, NBER Macroeconomics Annual, 1992. Before we delve into defining these strategies more comprehensively, it is important to understand that both these strategies target inflation with fomer targeting it indirectly and the latter directly. In addition, given the importance of international trade and finance and their impact on
domestic price level, exchange rate targeting also has a long history. I Monetary Policy Regimes
182
Monetary Targeting
The Central Bank's Monetary Tools
Monetary targeting refers to the setting of a rate of growth of money supply (usually M2) by the central bank for the next year. This targeted growth rate of money supply is the primary target of the central bank and is announced publically. Moreover, the target level of money supply growth, in principal, needs to be consistent with the central bank’ s desired level of inflation. The key element of monetary targeting is to adjust interest rates more freely in order to achieve the desired outcome of money supply growth.
During the 1970s, major central banks adopted monetary targeting as the monetary policy strategy; the first to adopt this being the central bank of Germany, Bundesbank, in 1975.
After Fed (Federal Reserve System; the central banking system of the United States) adopted monetary targeting in late 1970s, it set growth targets for three different monetary aggregates, namely Ml * M2 and M3. Abel and Bernanice (1998) argue that because Fed only had control of the monetary base (high powered money) at its disposal, trying to contro : all three measures of money supply was unrealistic. As a result, Fed missec its monetary growth targets three years in a row (1979-1982). Similarly in the UK, the Bank of England announced its M3 target in 1976. Howev er the targets were not met and the Bank of England also kept revising t he targets on an interim basis, making the monetary policy strategy ambiguous.
Due to financial innovations, financial systems around the world chani r : rapidly during the 1970s and 1980s. New instruments were introduce^^ in the banking sector and regulations changed accordingly. This led » central banks changing money supply rapidly in order to stabilize aggreAas demand. However, abrupt changes in money demand made r predictability vague and thus targeting monetary growth became effective.
Despite the fact that the ultimate goal of monetary targeting
\s 3 m
control inflation, most of the countries found it difficult to adcrrd inflation. For instance in the UK, inflation began to increase in 19”A touched the 20% mark by 1980, playing down the effectiveness of monfiJ targeting.Having said that, not all countries who adopted monetary targeting to achieve their desired targets. Most notably, the central banks of GeAlH and Switzerland were often able to keep money demand more szM/primarily because their monetary growth targeting was more and transparent and they have a relatively tighter regulatory contra
•their financial markets.
Can a Central Bank target interest rates as well?
and Monetary Policy Regimes 183
For a detailed discussion of these two strategies, see Bemanke and Mishkin, "Centra! Bank
Behavior and the Strategy of Monetary Policy: Observations from Six Industrialized
Countries", NBER Macroeconomics Annual, 1992
aggregates (such as M2) or interest rates to achieve the desired goals. These two anchors are mutually exclusive; a central bank can only target either monetary aggregates or interest rates but not both. Suppose for instance that the central bank is targeting interest rates. Due to a change in the public consumption pattern, demand for money changes and this leads to fluctuation in interest rates. To keep interest rates at the targeted level, the central bank has to increase or decrease money supply (e.g. through sale or purchase of government securities in the open market).
Alternatively, if the central bank is aim ing to keep the money supply at a certain level, a similar shock (i.e. change in consumption pattern) will bring about changes in money demand and thereby in interest rates. Here, the central bank cannot address interest rate fluctuations by changing money supply.
Inflation Targeting As stated earlier, inflation targeting refers to the public announcement of inflation targets for the coming year(s). Mishkin (2001) Inflation Targeting by Frederic S. Mishkin, in Howard Vane and Brian Snowdon, Encyclopedia of Macroeconomics (Edward Elgar: Cheltenham U.K., 2002): identifies five key elements of inflation targeting as a monetary policy strategy. These are (1)public announcement of quantitative targets for inflation; (2) dedication to price stability as the main goal of monetary policy; (3) choice and setting of monetary policy instruments using many variables instead of only focusing on monetary aggregates; (4) transparency of monetary policy strategy; and (5) accountability of the central bank for achieving its inflation targets. One important thing to note about inflation targeting is its emphasis on transparency and accountability;
something that was not present (or at least vague) when central banks
were by andlarge practicing monetary targeting. The central bank of New Zealand was the first bank to publically announce a set of inflation targets in 1990 and is the prime example of the success of inflation targeting (see Chart 11.1).
Chart 11.1 : NewZealand CPS inflation (year-on-yearchange) %
In inflation targeting, the central bank directly targets the ultiA
(inflation), instead ofirst setting targets for intermediate goakMoreoverA inflation targeting
gives central banks more mdependence and Aexi in adjusting money supply whenever money demand
A
nges.Anoth
eas A to advantage is that the targets of inflation are much ''
to the general public than monetary targets, since people can understand theArdatively more easUy and thus act
monetary policy relatively more transparent. In addition with the pa g of time the quality of central banks , communication alsoimproved as they shifted from releasing dry and formal reports to
and easy-to-understand reports. Some of the examples a England’s Inflation Report and SBP’s Inflation Monitor. Mishkm (200 ) argues that these
publications have been used by the centra :scommunicate the following to the general public, politicians and fi participants: (1) monetary policy’s goals and UmitaUons; (2) quantitative inflation targets including their
rationale; (3)=s
central banks in fine-tuning their policies.
Another quality of inflation targeting is its flexibility. Inflation A does not require central banks to follow simple and mechanical . to conduct monetary policy, nor does it reqmre centcal
=== solely on one variable. Usually, central banks aroundthe world. inflation via the use of a key Policy Interest Rate to curb excess However, before changing the Policy Rate, a central bank inflation targeting uses all available information. One good such information is SBP ’ s Monetary Policy Information Con A that is released along with a monetary policy statement. This mfo. helps SBP in devising the monetary policy.
Furthermore, the central bank becomes more accountable for as transparency increases, though the level of accounts 1 a - economies. The strongest case of central bank