ASSIGNMENT COVER SHEET

Student number: 1005520M

Programme: MSc in Investment Banking and Finance

Course: Monetary Policy and Role of Central Banks

Essay title/Question number: 2.Compare and contrast the

Date: 21/11/10

Word Count of Essay: 1990 words

In recent times, economic situation all across the globe has changed so dramatically that it has become

more important for a central bank to develop efficient monetary policies which facilitate all its key

important objectives and good economic growth. This has made policymakers to work more hard in

choosing the appropriate nominal anchor for framing the policy in a way that it drives and achieves

price stability in the economy. Nominal anchors can either be price based or quantity based. In my

essay, I have talked about two price based anchors namely, exchange rate and inflation rate, and one

quantity based, nominal GNP. Then another burning issue of debate all over the world majorly after

the sub-prime crisis in USA is to target asset prices which I have discussed with the opinions of

eminent leaders and economists from all around the world.

EXCHANGE RATE TARGETING

Exchange rate targeting can be of two kinds, fixed exchange rates (currency boards, unilateral

dollarization) and fixed-but-adjustable exchange rates (currency basket peg, crawling peg). As the

country does not have a good domestic credibility, it can be obtained from a foreign source by

adopting other country’s monetary policy. Only goal exchange rate target has is to maintain its

domestic currency in accordance to another country. (Batini, et al, 2005)

Advantages:

As in European Economic and Monetary Union, have adopted a new currency (Euro) and given up

their national currency. This helps in achieving lower transaction costs, removes exchange rate

volatility and attains stability which encourages trading and foreign investments. (Batini, et al, 2005)

Khan, 2003, mentions targeting exchange rates is quite easy to implement and gives a transparent and

understandable figure to the policymakers. He states a study by Franken, Schmukler and Serven (2000)

which says that ‘’hard peg is more verifiable by market participants’’, meaning, it becomes easier for

agents to analyse whether the target is achieved ex post. This induces convergence of agent’s
expectations to the policymaker’s long run targets. Thus by implementing exchange rate targeting,

inflation can be stabilised from high levels.

Disadvantages:

Mishkin (2001/02) states that the main disadvantage of fixed exchange rate is the country loses

monetary autonomy, i.e., losing control over its monetary policy as it has to follow interest rates

determined by the anchor country(country to which currency is pegged). Result of this a pegged

country can’t react to the domestic instability if occurred easily and also it is prone to the shocks from

the anchor country. Also if a country tries to stabilise the domestic economy by increasing the interest

rates, it will lead to decrease in consumer spending and high output volatility thus leading to recession

as happened in Latin America. He points if a country tries to depreciate its domestic currency, it can

lead to banking and financial crisis pushing the country’s economy into depression.

Also the real exchange rate can’t be adjusted by changing nominal exchange rate, therefore, domestic

prices needs to be adjusted which turns more difficult because in that case output has to be adjusted

before determining prices. (Batini, et al, 2005)

INFLATION TARGETING

In inflation targeting, central bank estimates and set a target rate for inflation. Then the policymakers

regulate the actual inflation towards getting that targeted inflation through the use of interest rate

changes and other monetary tools. Price stability should be the primary objective of policymakers and

all employment stability; exchange rate should come secondary. (Khan, 2003).

Advantages:

Inflation targeting biggest advantage over exchange rate is that it can pursue independent monetary

policy which in time of domestic crisis can be handled and also prevents from foreign instability. Also

it is far more economical than exchange rate in failures which creates high inflation, reserve loss and

sometimes even depression, whereas inflation target failure only results to temporary high inflation
and slower growth which can be subsidised by increasing interest rates. Inflation targeting do not need

to focus on monetary target and nominal income thus preventing velocity shocks and concentrating on

forecasting inflation and developing a policy to get targeted inflation. (Mishkin et al, 1997). It carries

more credibility, transparency and is easy to understand for policymakers from other targets. It also

helps in evaluating the performance of central banks. It offers more flexibility to curb inflation over

long run. (Batini, et al, 2005)

Disadvantages:

In contrast to exchange rate or nominal GNP, it is harder for policymakers to fix and achieve inflation

target as inflation has uncertain effects on monetary policy. Also estimation of the effects of monetary

policy takes more than two years in industrialised countries to evaluate its achievement of inflation

targeting. Thus far more time consuming than other two. It leads to high output variability along with

control over inflation rate if implemented rigidly. In justification, Mishkin (1997) mentioned that rise

of inflation rate and lower output during negative supply shock will demand tightening of monetary

policy to get the rigidly set target which can further decrease the output.

It can’t work in the countries which do not meet certain set of conditions like “technical capability of

the central bank in implementing inflation targeting, absence of fiscal dominance, financial market

soundness, and an efficient institutional setup to support and motivate the commitment to low

inflation.” (Batini et al, 2005).

NOMINAL GNP

This is a proposed nominal anchor which has not received much attention among business economists

and policymakers. Here, monetary policy instruments such as short term interest rates and bank reserve

will be adjusted to keep Nominal GNP as close as possible to set target. Kahn, 1988 quotes, “nominal

GNP is the product of the price level and the level of real output.” He suggests two fundamental

approaches for a monetary policy based on Nominal GNP. Firstly, policymakers to determine targets
for monetary aggregates would use nominal GNP target initially. Secondly, analysts have proposed to

target nominal GNP on a six month forecast which is consistent with the goals of monetary policy.

Advantages:

As inflation targeting, Nominal GNP also focuses primarily on price stability. But it prevents

policymakers the condition of increasing real output by increasing inflation in short run. With Kahn’s

two approaches, targeted nominal GNP can’t go off track as the forecasting can be done six months

ahead. If six months forecast shows nominal GNP above target then the policy can be tightened or

vice-versa. This is the best advantage to use this anchor over others as it looks forward. Because of this

policy transmission lag, any disturbances in the future if predicted can be easily curbed. Also the first

approach has been implemented by West German Bundesbank; where the bank sets an “unavoidable”

allowance of 0-2% inflation to add to long run growth rate real GNP. Thus this target is announced for

central bank money. (Kahn, 1988).

Disadvantages:

Nominal GNP target is not easily understood and less transparent than inflation targeting. People can

misinterpret control over nominal GNP as control over real output. In recession when there is

unemployment, stimulation of real GNP by policymakers can result in high inflation rate. It can be

mistaken that the estimated target is an actual target which can cause problems for policymakers as

people can criticise them to run economy with slow growth rate. Implementation of nominal GNP

targets is based on forecasting which can be unreliable and comes without any guarantee of future.

People also do not believe in long term policies and are more concerned in short term recoveries. Like

in case of supply shock, say oil, they want to reduce the inflation and output effect immediately

irrespective of the objectives of policymakers. (Kahn, 1988)

It has been the most controversial issue in modern economics that whether central bank should or

should not target asset prices. The issue was not much discussed until the speech of Fed Chairman,

Alan Greenspan in 2002 to the Jackson Hole Symposium that “bubbles can’t be identified and so

central banks can only focus on dealing with their aftermath” On this John H. Makin, (2009) criticised

him by arguing that if central banks ignore the asset prices as they can’t identify a bubble then they are

encouraging for too much risk taking. It indicated risk takers to take more risk and if in case a bubble

developed and bursts then Fed can bail them out. This resulted in the subprime crisis in the USA. He

mentioned that the asset prices can’t be ignored. Central banks need to determine a target for asset

prices as done with inflation targeting by being judgemental.

John Williamson, (2009) strongly supports targeting of asset prices by suggesting two approaches for

targeting two variables. First, target an instrument at a trade off between them. Or second, deploy two

instruments to pursue two variables. He emphasise on the second proposal as it is more feasible. To

calculate the total capital required, host country central bank should determine additional instrument

being a macroeconomic prudential figure for bank capital multiplied by existing micro prudential

figure determined by home country. This capital requirement can be raised in asset price boom and

vice versa to avoid high interest rates in spite of no price pressure and putting pressure on less lending

banks facing high capital requirements. Also Norbert Walter, (2009) from the recent crisis proposes

the need of targeting asset prices by central banks because of two key points. Firstly, central banks

need and they can analyse asset price movements and its implications on financial system. Secondly,

banks need to present their findings to public, market regulators and politicians so that they can assist

in developing instruments which can help in deflate any potential bubble.

practical problems. He states if asset prices move above target, it can lead to deflation. Because banks

won’t focus on consumer price index even if they are stable or declining. Also practical problem is that

there is no efficient index for asset prices and it would be tough to prepare. Other problems arising

would be: a) what all assets to include in index like real estate, gold, stocks, bonds etc, b) If depending

on stock then will it include only national market stocks or selected ones, c) The index will be

weighted by market cap (S&P 500) or not (Dow Jones) or weighted with other factors like revenues

and employment.

David, (2009) also argues that Central banks should not target asset prices as it is not only difficult, it

also does not go with the two main objectives of maximum employment and stable prices. He states

that rise in stock and real estate value increase aggregate demand and output more than economy’s

calibre, resulting in low resource utilisation, threatening for increased wages and price pressures

therefore leaving central bank to tighten the policy. But if asset prices increase do not see any increase

in prices then policy should not be tightened so as to avoid asset price bubble. Citing USA’s high tech

stock price bubble in late 1990s, the bubble did not have any relation with the increase in the price of

goods and services as there was a direct capital market intermediation from investors into the stocks.

Thus evidently it seems more viable not to target asset prices rather than to target them and add more

complexities to the monetary policy.

Though Inflation targeting has been majorly accepted by many industrialised (U.K, Canada) and

developing (Chile, Brazil) countries but still it’s an ongoing discussion to interpret and imply an

efficient anchor which goes with the objectives of the bank and results in sound economic performance

of a country. The policymakers have to use their prudence and country’s economic conditions to

determine appropriate anchor to frame monetary policy. As far as asset price targeting is concerned, it

seems that economists are more rationale being against the notion but the debate is still on whether the

asset prices should be targeted or not.

 Batini, N., K.Kuttner, and D.Laxton (2005), “Does Inflation Targeting Work in Emerging

Markets?” IMF World Economic Outlook Sept 2005.

http://www.imf.org/external/pubs/ft/weo/2005/02/pdf/chapter4.pdf

 David m. Jones, President and CEO, DMJ Advisors, and Executive Professor of Economics, Lutgert

School of Business, Florida Gulf Coast University, Fall 2009, “Should, or can, Central Banks Target

Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

 Frederic S. Mishkin, Winter 2001/2002 “Monetary Policy”, The National Bureau of Economic

Research. http://www.nber.org/reporter/winter02/mishkin.html

 Frederic S. Mishkin and Adam S. Posen, 1997, FRBNY Economic Policy Review / August 1997

“The rationale of inflation targeting” http://www.ny.frb.org/research/epr/97v03n3/9708part1.pdf

 George A. Kahn, November 1988, Senior economist, Federal Reserve Bank of Kansas City,

Economic Review, “Nominal GNP: An anchor for monetary policy”. Pg 19-25

http://www.kansascityfed.org/PUBLICAT/ECONREV/EconRevArchive/1988/4q82kahn.pdf

 John H. Makin, Principal, Caxton Associates, and Visiting Scholar, American Enterprise Institute,

Fall 2009, “Should, or can, Central Banks Target Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

 John Williamson, Senior Fellow, Peterson Institute for International Economics, Fall 2009,

“Should, or can, Central Banks Target Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

 Khan, M. S. (2003) Current Issues in the Design and Conduct of Monetary Policy,

IMF Working Paper # 03/56, http://www.imf.org/external/pubs/ft/wp/2003/wp0356.pdf

Central Banks Target Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

 Norbert Walter, Chief Economist, Deutsche Bank Group, Fall 2009, “Should, or can, Central Banks

Target Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf

 Richard n. Cooper, Maurits C. Boas Professor of International Economics, Harvard University, Fall

2009, “Should, or can, Central Banks Target Asset Prices?” The International Economy.

http://www.international-economy.com/TIE_F09_AssetPriceSymp.pdf