Frederic S. Mishkin Monetary Policy Strategy The Mit Press (2007) [603551]

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Frederic S. Mishkin Monetary Policy Strategy The Mit Press (2007) [603551]

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\h[Z[h_Yi$c_i^a_dMonetary Policy Strategy

Monetary Policy Strategy

Monetary Policy Strategy
Frederic S. Mishkin
The MIT Press
Cambridge, MassachusettsLondon, England

62007 Massachusetts Institute of Technology
All rights reserved. No part of this book may be reproduced in any form by any electronic or mechanical
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Library of Congress Cataloging-in-Publication DataMishkin, Frederic S.
Monetary policy strategy / by Frederic S. Mishkin.
p. cm.
Includes bibliographical references and index.ISBN 978-0-262-13482-8 (hardcover : alk. paper)1. Monetary policy. I. Title.HG230.3M57 2007339.5
03—dc22 2006033821
1 0987654321

To Laura and Matthew

Contents
Preface ix
1 How Did We Get Here? 1
Frederic S. Mishkin
I Fundamental Issues in the Conduct of Monetary Policy 29
Introduction to Part I 31
2 What Should Central Banks Do? 37
Frederic S. Mishkin
3 The Transmission Mechanism and the Role of Asset Prices in Monetary Policy 59
Frederic S. Mishkin
4 The Role of Output Stabilization in the Conduct of Monetary Policy 75
Frederic S. Mishkin
5 Can Central Bank Transparency Go Too Far? 89
Frederic S. Mishkin
6 Is There a Role for Monetary Aggregates in the Conduct of Monetary Policy? 109
Arturo Estrella and Frederic S. Mishkin
7 Rethinking the Role of NAIRU in Monetary Policy: Implications of Model Formulation
and Uncertainty 133
Arturo Estrella and Frederic S. Mishkin
II Monetary Policy Strategy in Advanced Economies 159
Introduction to Part II 161
8 Central Bank Behavior and the Strategy of Monetary Policy: Observations from Six
Industrialized Countries 165
Ben Bernanke and Frederic S. Mishkin

9 Inflation Targeting: A New Framework for Monetary Policy? 207
Ben Bernanke and Frederic S. Mishkin
10 International Experiences with Different Monetary Policy Regimes 227
Frederic S. Mishkin
11 Why the Federal Reserve Should Adopt Inflation Targeting 253
Frederic S. Mishkin
III Monetary Policy Strategy in Emerging Market and Transition Economies 263
Introduction to Part III 265
12 Inflation Targeting in Emerging Market Countries 271
Frederic S. Mishkin
13 Monetary Policy Strategies for Latin America 279
Frederic S. Mishkin and Miguel A. Savastano
14 Monetary Policy Strategies for Emerging Market Countries: Lessons from Latin
America 309
Frederic S. Mishkin and Miguel A. Savastano
15 Inflation Targeting in Transition Economies: Experience and Prospects 345
Jiri Jonas and Frederic S. Mishkin, with comment by Olivier Blanchard
16 A Decade of Inflation Targeting in the World: What Do We Know and What Do We
Need to Know? 405
Frederic S. Mishkin and Klaus Schmidt-Hebbel
17 The Dangers of Exchange-Rate Pegging in Emerging Market Countries 445
Frederic S. Mishkin
18 The Mirage of Exchange-Rate Regimes for Emerging Market Countries 465
Guillermo A. Calvo and Frederic S. Mishkin
IV What Have We Learned? 485
Introduction to Part IV 487
19 Everything You Wanted to Know about Monetary Policy Strategy, but Were Afraid to
Ask 489
Frederic S. Mishkin
Sources 537
Index 539viii Contents

Preface
Although my father fought in Europe in World War II, the central event in his life
was the Great Depression. When I expected (and hoped) that he would regale us
with stories about his war experience, he instead told us about life in the 1930s and
how devastating the collapse in the economy had been to him and his family. This
experience is what set me on the path to becoming an economist. My father’s stories
made me realize how large an impact the state of the economy could have on peo-
ple’s lives, and I wanted to understand how better policies could lead to improvedoutcomes for the aggregate economy.
When I started taking graduate courses at MIT in 1972 (I actually started my PhD
program while still an undergraduate in my senior year at MIT, and then continued
o‰cially in 1973), I was exposed to two wonderful teachers in monetary economics,
Stanley Fischer and Franco Modigliani. Both made me see that monetary policy
played a key role in the health of the macro economy and I was hooked: I knew
that I was going to become a monetary economist. A major intellectual inﬂuence on
my thinking was Milton Friedman and Anna Schwartz’s A Monetary History of the
United States , which Stan encouraged his students to read telling us that if we were
serious about being monetary economists, then we had to read Friedman and
Schwartz before going to bed. Being a dutiful student, I took Stan’s advice and was
enthralled by the book. Friedman and Schwartz made it abundantly clear that bad
monetary policies could lead to disaster. In addition, their use of historical episodes
to demonstrate the importance of monetary policy to the economy led me to value
the use of case studies as a research tool, which features prominently in a lot of the
economics discussed in this book.
Given this intellectual background, my research in academia has focused on issues
that are central to monetary policymaking. However, after I was the director of re-
search and executive vice president of the Federal Reserve Bank of New York from
1994 to 1997, my research took on a more practical bent and I began to write farmore extensively on strategies for the conduct of monetary policy. This book is a col-
lection of my work on this subject, particularly over the past decade.

The book’s introduction outlines the intellectual environment and history of eco-
nomic ideas that inﬂuenced my writings, which should help put each chapter in per-
spective. Each main part of the book—part I, ‘‘Fundamental Issues in the Conduct
of Monetary Policy’’; part II, ‘‘Monetary Policy Strategy in Advanced Economies’’;
part III, ‘‘Monetary Policy Strategy in Emerging Market and Transition Economies’’;
and part IV, ‘‘What Have We Learned?’’—opens with a short introduction that pro-vides a brief summary of each chapter in that part, describing how these came to be
written and how they ﬁt together. The ﬁnal part of the book contains a concluding
chapter that tries to put it all together by summarizing what we have learned about
monetary policy during the past twenty-ﬁve to thirty years.
I have many people to thank for stimulating my thinking on monetary policy
issues over the years. Not only do these include my coauthors on several chapters
in this book, Ben Bernanke, Guillermo Calvo, Arturo Estrella, Jiri Jonas, Miguel
Savastano, and Klaus Schmidt-Hebbel, but also those who commented on presenta-
tions of this material, who are thanked individually in each chapter. I also beneﬁted
from my interactions with Peter Fisher and William McDonough when I was at the
Federal Reserve Bank of New York, as well as with Michael Woodford and LarsSvensson, with whom I have had numerous, extremely productive conversations
over the years about issues in monetary policy strategy. I have learned a lot from all
of them. Note that any views expressed in this book are mine and not those of
Columbia University, the National Bureau of Economic Research, or the individuals
thanked in each chapter.
I also thank my editor at The MIT Press, Elizabeth Murry, who provided much
valuable input on how this book should be structured. And ﬁnally, I want to thank
my wonderful family: my wife, Sally, who makes sure our marriage is never boring,
and my two children, Laura and Matthew, who always make me laugh and helpmake life an adventure.x Preface

1How Did We Get Here?
Frederic S. Mishkin
The past three decades have seen an extraordinary transformation in the conduct of
monetary policy. In the 1970s, inﬂation had risen to very high levels, with most coun-
tries, including the United States, experiencing inﬂation rates in the double digits.
Today, almost all nations in the world are in a low inﬂation environment. Of 223
countries, 193 currently have annual inﬂation rates less than or equal to 10 percent,
while 149 have annual inﬂation rates less than or equal to 5 percent. 1Why and how
has the strategy of the conduct of monetary policy changed such that it has becomeso successful in taming inﬂation?
The answer provided in the following chapters is that monetary authorities and
governments in almost all countries of the world have come to accept the following
ideas: 1) there is no long-run trade-o¤ between output (employment) and inﬂation; 2)
expectations are critical to monetary policy outcomes; 3) inﬂation has high costs; 4)
monetary policy is subject to the time-inconsistency problem; 5) central bank inde-
pendence is needed to produce successful monetary policy; and 6) a strong nominal
anchor is the key to producing good monetary policy outcomes. But this list, which
central bankers now subscribe to, is not where monetary policymakers started. In the1960s, central bankers had a very di¤erent world view, which produced very bad
monetary policy outcomes.
1.1 Central Banking in the 1960s
The 1960s began with a relatively benign inﬂation environment, particularly in the
United States where inﬂation was running at an annual rate of just over 1 percent.
(Inﬂation rates were at higher rates in countries such as Germany, France, Japan,
and the United Kingdom but were still below 4 percent in 1960.) At the Federal Re-
serve and at many other central banks, the focus was on ‘‘money market conditions’’:
on variables such as nominal interest rates, bank borrowings from the central bank,and free reserves (excess reserves minus borrowings). 2In addition, in the wake of the
Great Depression of the 1930s, the economics professions became dominated by

Keynesians, the followers of John Maynard Keynes, who viewed the Depression as
directly resulting from policy inaction when adverse shocks hit the economy. This led
to an era of policy activism in which economists armed with Keynesian macroecono-
metric models argued that they could ﬁne-tune the economy to produce maximum
employment with only slight inﬂationary consequences. This was the intellectual en-
vironment that I was exposed to when I ﬁrst started my study of economics as anundergraduate in 1969.
Particularly inﬂuential at the time was a famous paper published in 1960 by Paul
Samuelson and Robert Solow, both MIT professors, which argued that work by
A. W. Phillips, which became known as the Phillips curve, suggested that there was
a long-run trade-o¤ between unemployment and inﬂation and that this trade-o¤
should be exploited. 3Indeed, Samuelson and Solow even mentioned that a nonper-
fectionist goal of a 3 percent unemployment rate could be attained at what they con-
sidered to be a low inﬂation rate of 4 to 5 percent per year. This thinking, not only by
Samuelson and Solow, but also by the then-dominant Keynesian economists, led to
increased monetary and ﬁscal policy activism to get the economy to full employment.
However, the subsequent economic record was not a happy one: inﬂation acceler-ated, with the inﬂation rate in the United States and other industrialized countries
eventually climbing above 10 percent in the 1970s, leading to what has been dubbed
‘‘The Great Inﬂation,’’ while the unemployment rate deteriorated from the perfor-
mance in the 1950s.
1.1.1 No Long-Run Trade-Off between Output (Employment) and Inflation
The Monetarists, led by Milton Friedman, ﬁrst mounted the counterattack to policyactivism. Milton Friedman, in a series of famous publications in 1963, established
that ﬂuctuations in the growth rate of the money supply were far more capable ofexplaining economic ﬂuctuations and inﬂation than nominal interest rates. 4In Con-
gressional testimony, Karl Brunner and Allan Meltzer criticized the use of ‘‘money
market conditions’’ to guide monetary policy and suggested that targeting monetary
aggregates would produce better policy outcomes. 5In his famous 1968 presidential
address to the American Economic Association, Milton Friedman along with
Edmund Phelps argued that there was no long-run trade-o¤ between unemployment
and inﬂation rate: rather, the economy would gravitate to some natural rate of un-
employment in the long run no matter what the rate of inﬂation was. 6In other
words, the long-run Phillips curve would be vertical, and attempts to lower unem-
ployment below the natural rate would result only in higher inﬂation. The monetarist
counterattack implied that monetary policy should be focused on controlling inﬂa-tion and the best way to do this would be pursuing steady growth in the money
supply.2 Chapter 1

1.2 Central Banking in the 1970s
At ﬁrst, the monetarist counterattack was not successful in getting central banks to
increase their focus on controlling inﬂation and money supply growth. In the early
1970s, estimates of the parameters of the Phillips curve did not yet suggest that in
the long run the Phillips curve was vertical. Economists and policymakers also were
not as fully aware of how important expectations are to monetary policy’s e¤ect on
the economy, a realization that would have led them to accept the Friedman-Phelps
natural rate hypothesis more quickly. Also, estimates of the natural rate of unem-
ployment were far too low, thus suggesting that increases in inﬂation that were
occurring at then-prevalent unemployment rates were the result of special factors
and not overly expansionary monetary policy. 7
1.2.1 The Rational Expectations Revolution
Starting in the early 1970s, in a series of papers Robert Lucas launched the rational
expectations revolution, which demonstrated that the public’s and the markets’
expectations of policy actions have important e¤ects on almost every sector of the
economy. 8The theory of rational expectations made it immediately clear why there
could be no long-run trade-o¤ between unemployment and inﬂation, so that attempt-
ing to lower unemployment below the natural rate would lead only to higher inﬂa-
tion and no improvement in performance in output or employment. Indeed, one
implication of rational expectations in a world of ﬂexible wages and prices was the
policy ine¤ectiveness proposition , which indicated that if monetary policy were antici-
pated, it would have no real e¤ect on output; only unanticipated monetary policy
could have a signiﬁcant impact. An implication of the policy ine¤ectiveness proposi-
tion was that a constant-money-growth-rate rule along the lines suggested by Milton
Friedman would do as well as any other deterministic policy rule with feedback. 9
The only result of all the policy activism advocated by Keynesian economists would
be higher and more variable rates of inﬂation. Although evidence for the policy inef-
fectiveness proposition is weak, 10the rational expectation revolution’s point that
monetary policy’s impact on the economy is substantially inﬂuenced by expectations
about monetary policy has become widely accepted.
1.2.2 Recognition of the High Costs of Inflation and the Benefits of Price Stability
Events on the ground were also leading to a rejection of policy activism. Inﬂation
began a steady rise in the 1960s and then in the aftermath of the 1973 oil price shock,
inﬂation climbed to double-digit levels in many countries. Economists, but also the
public and politicians, began to discuss the high costs of inﬂation. 11A high inﬂation-
ary environment leads to overinvestment in the ﬁnancial sector, which expands toHow Did We Get Here? 3

proﬁtably act as a middleman to help individuals and businesses escape some of the
costs of inﬂation. 12Inﬂation leads to uncertainty about relative prices and the future
price level, making it harder for ﬁrms and individuals to make appropriate decisions,
thereby decreasing economic e‰ciency. 13The interaction of the tax system and inﬂa-
tion also increases distortions that adversely a¤ect economic activity. 14
The recognition of the high costs of inﬂation led to the view that low and stable
inﬂation can increase the level of resources productively employed in the economy,
and might even help increase the rate of economic growth. While time-series studies
of individual countries and cross-national comparisons of growth rates were not in
total agreement, the consensus grew that inﬂation is detrimental to economic growth,
particularly when inﬂation rates are high. 15
1.2.3 The Role of a Nominal Anchor
The groundbreaking developments in economic theory coincided with the growing
recognition among economists, politicians, and the public of the high costs of inﬂa-
tion. It also made clear why a nominal anchor —a nominal variable that monetary
policymakers use to tie down the price level, such as the inﬂation rate, an exchangerate, or the money supply—is such a crucial element in achieving price stability.
Adhering to a nominal anchor that keeps the nominal variable in a narrow range
supports price stability by directly promoting low and stable inﬂation expectations.
With stable inﬂation expectations, markets do much of the work for monetary poli-
cymakers: low and stable inﬂation expectations result in stabilizing price and wage
setting behavior that lowers both the level and volatility of inﬂation. 16
1.2.4 The Advent of Monetary Targeting
The three related ideas that expansionary monetary policy cannot produce higher
output (employment) in the long run, that inﬂation is costly, and that there are
advantages of a strong nominal anchor, all combined to help generate support for
the idea espoused by Monetarists that central banks needed to control the growth
rate of monetary aggregates. This idea led to the adoption of monetary targeting by
a number of industrialized countries in the mid-1970s (see chapter 8).
Monetary targeting involves three elements: 1) the reliance on information con-
veyed by a monetary aggregate to conduct monetary policy, 2) the announcement
of medium-term targets for monetary aggregates, and 3) some accountability mecha-
nism to preclude large, systematic deviations from the monetary targets. The Federal
Reserve started to follow weekly tracking paths for the monetary aggregate measures
M1 and M2, while indicating its preferred behavior for M2. Then in response to acongressional resolution in 1975, the Fed began to announce publicly its targets for
money growth. In late 1973, the United Kingdom began informal targeting of a
broad monetary aggregate, sterling M3, and began formal publication of targets in4 Chapter 1

1976. The Bank of Canada instituted monetary targeting in 1975 under a program of
‘‘monetary gradualism’’ in which M1 growth was to be controlled with a gradually
falling target range. In late 1974, both the Deutsche Bundesbank and the Swiss
National Bank began to announce money stock targets: the Bundesbank chose
to target central bank money, a narrow aggregate that was the sum of currency in
circulation and bank deposits weighted by the 1974 required reserve ratios, and theSwiss National Bank targeted M1. In 1978, the Bank of Japan announced ‘‘fore-
casts’’ of growth rates of M2 (and after 1979, M2 plus certiﬁcate of deposits).
1.3 Central Banking in the late 1970s and the 1980s: The Failure of Monetary Targeting?
Monetary targeting had several potential advantages over previous approaches to the
conduct of monetary policy. Announced ﬁgures for monetary aggregates are typi-
cally reported within a couple of weeks, and so monetary targets can send almost im-
mediate signals to both the public and markets about the stance of monetary policy
and the intentions of the policymakers to keep inﬂation in check. These signals can
help ﬁx inﬂation expectations and produce less inﬂation. Another advantage of mon-etary targets is promoting almost immediate accountability for monetary policy in
order to keep inﬂation low.
These advantages of monetary aggregate targeting depend on one key assumption:
there must be a strong and reliable relationship between the goal variable (inﬂation
or nominal income) and the targeted aggregate. If there are large swings in velocity,
so that the relationship between the monetary aggregate and the goal variable is
weak, as is found in chapter 6, then monetary aggregate targeting will not work.
The weak relationship implies that hitting the target will not produce the desired out-
come on the goal variable and thus the monetary aggregate will no longer provide anadequate signal about the central bank’s policy stance. The breakdown of the rela-
tionship between monetary aggregates and goal variables such as inﬂation and nom-
inal income was common, not only in the United States, but also even in Germany,
which pursued monetary targeting for a much longer period (chapter 6). 17A similar
instability problem in the money–inﬂation relationship has been found in emerging
market countries, such as those in Latin America (chapter 14).
Why did monetary targeting in the United States, Canada, and the United King-
dom during the late 1970s and the 1980s not prove successful in controlling inﬂation?
There are two interpretations. One is that monetary targeting was not pursued seri-
ously, so it never had a chance to succeed (chapters 8 and 10). The Federal Reserve,
Bank of Canada, and particularly the Bank of England engaged in substantial gameplaying in which they targeted multiple aggregates, allowed base drift (the initial
starting point for the monetary target was allowed to shift up and down with realiza-
tions of the monetary aggregate), did not announce targets on a regular schedule,How Did We Get Here? 5

used artiﬁcial means to bring down the growth of a targeted aggregate, often over-
shot their targets without reversing the overshoot later, and often obscured the rea-
sons why deviations from the monetary targets occurred.
The second reason for monetary targeting’s lack of success in the late 1970s was
the increasing instability of the relationship between monetary aggregates and goal
variables such as inﬂation or nominal income, which meant that this strategy wasdoomed to failure. Indeed, monetary targeting was not pursued seriously because
doing so would have been a mistake; the relationship between monetary aggregates
and inﬂation and nominal income was breaking down. Once it became clear by the
early 1980s that the money–income relationship was no longer strong, the United
States, Canada, and the United Kingdom formally abandoned monetary targeting.
Or as Gerald Bouey, a former governor, of the Bank of Canada, put it: ‘‘We didn’t
abandon monetary aggregates, they abandoned us.’’
The problems that an unstable relationship between the money supply and inﬂa-
tion create for monetary targeting is further illustrated by Switzerland’s unhappy
1989–1992 experience described in chapter 8, during which the Swiss National Bank
failed to maintain price stability after it had successfully reduced inﬂation. 18The
substantial overshoot of inﬂation from 1989 to 1992, reaching levels above 5 percent,
was due to two factors. The ﬁrst was that the Swiss franc’s strength from 1985 to 1987
caused the Swiss National Bank to allow the monetary base (now its targeted aggre-
gate) to grow at a rate greater than the 2 percent target in 1987, and then caused it to
raise the monetary base growth target to 3 percent for 1988. The second reason arose
from the introduction of a new interbank payment system, Swiss Interbank Clearing
(SIC), and a wide-ranging revision of the commercial banks’ liquidity requirements
in 1988. The resulting shocks to the exchange rate and the shift in the demand for
the monetary base arising from the above institutional changes created a seriousproblem for its targeted aggregate. As 1988 unfolded, it became clear that the Swiss
National Bank had guessed wrong in predicting the e¤ects of these shocks so that
monetary policy was too easy even though the monetary base target was undershot.
The result was a subsequent rise in inﬂation to above the 5 percent level. As a result
of this experience, the Swiss National Bank moved away from monetary targeting
ﬁrst by not specifying a horizon for its monetary base target announced at the end of
1990 and then in e¤ect moving to a ﬁve-year horizon for the target afterward, until it
abandoned monetary targeting altogether in 1999.
The German experience with monetary targeting was generally successful, and
coupled with the success of the initial Swiss experience, help us understand why mon-
etary policy practice evolved toward inﬂation targeting. As argued by Ju ¨rgen von
Hagen, the Bundesbank’s adoption of monetary targeting in late 1974 arose from
the decision-making and strategic problems that it faced at the time. 19Under the
Bretton Woods regime, the Bundesbank had lost the ability to control monetary pol-6 Chapter 1

icy, and focusing on a monetary aggregate was a way for the Bundesbank to reassert
control over the conduct of monetary policy. German inﬂation was also very high (at
least by German standards), having reached 7 percent in 1974, and yet the economy
was weakening. Adopting a monetary target was a way of resisting political pressure
and signaling to the public that the Bundesbank would keep a check on monetary
expansion. The Bundesbank also was concerned that pursuing price stability andaiming at full employment and high output growth would lead to policy activism
that in turn would lead to inﬂationary monetary policy. Monetary targeting had the
additional advantage of indicating that the Bundesbank was responsible for control-
ling inﬂation in a longer run context, but was not trying to ﬁght temporary bursts of
inﬂation, particularly if these came from nonmonetary sources.
The circumstances inﬂuencing the adoption of monetary targeting in Germany led
to several prominent design features that were key to its success. The ﬁrst is that the
monetary-targeting regimes were not bound by monetarist orthodoxy and were very
far from a Friedman-type monetary targeting rule in which a monetary aggregate
was kept on a constant-growth-rate path and is the primary focus of monetary pol-
icy.20The Bundesbank allowed growth outside its target ranges for periods of two to
three years, and overshoots of its targets were subsequently reversed. Monetary tar-
geting in Germany and in Switzerland was instead primarily a method of communi-
cating the strategy of monetary policy that focused on long-run considerations and
the control of inﬂation.
The calculation of monetary target ranges put great stress on making policy trans-
parent (clear, simple, and understandable) and on regular communication with the
public. First and foremost, a numerical inﬂation goal was prominently featured in
a very public exercise of setting target ranges. The Bundesbank set targets using a
quantity theory equation to back out the monetary-target-growth rate using the nu-merical inﬂation goal, estimated potential output growth, and expected velocity
trends. The use of estimated potential output growth, and not a desired path of
actual output growth, in setting the monetary targets was an important feature
of the strategy because it signaled that the Bundesbank would not be focusing on
short-run output objectives. Second, monetary targeting, far from being a rigid pol-
icy rule, was quite ﬂexible in practice. As we see in chapter 8, the target ranges for
money growth were missed about 50 percent of the time in Germany, often because
the Bundesbank did not completely ignore other objectives including output and ex-
change rates. 21Furthermore, the Bundesbank demonstrated ﬂexibility by allowing
its inﬂation goal to vary over time and to converge with the long-run inﬂation goal
quite gradually.
When the Bundesbank ﬁrst set its monetary targets at the end of 1974, it
announced a medium-term inﬂation goal of 4 percent, well above what it considered
to be an appropriate long-run goal for inﬂation. It clariﬁed that this medium-termHow Did We Get Here? 7

inﬂation goal di¤ered from the long-run goal by labeling it the ‘‘unavoidable rate of
price increase.’’ Its gradualist approach to reducing inﬂation led to a nine-year period
before the medium-term inﬂation goal was considered to be consistent with price sta-
bility. When this convergence occurred at the end of 1984, the medium-term inﬂation
goal was renamed the ‘‘normative rate of price increases’’ and set at 2 percent, con-
tinuing at this level until it was changed to 1.5 or 2 percent in 1997. The Bundesbankalso responded to restrictions in the supply of energy or raw materials, which
increased the price level by raising its medium-term inﬂation goal; speciﬁcally,
it raised the unavoidable rate of price increase from 3.5 percent to 4 percent in the
aftermath of the second oil price shock in 1980.
The monetary-targeting regimes in Germany and Switzerland demonstrated a
strong commitment to communicating the strategy to the general public. The
money-growth targets were continually used as a framework for explaining the mon-
etary policy strategy: the Bundesbank and the Swiss National Bank expended tre-
mendous e¤ort, both in their publications and in frequent speeches by central bank
o‰cials, to communicate to the public what the central bank was trying to achieve.
Indeed, given that both central banks frequently missed their money-growth targetsby signiﬁcant amounts, their monetary-targeting frameworks are best viewed as
a mechanism for transparently communicating how monetary policy was being
directed to achieve inﬂation goals and as a means for increasing the central bank’s
accountability.
Many other countries envied the success of Germany’s monetary policy regime in
producing low inﬂation, which explains why it was chosen as the anchor country for
the Exchange Rate Mechanism. One clear indication of Germany’s success occurred
in the aftermath of German reuniﬁcation in 1990. Despite a temporary surge in inﬂa-
tion stemming from the terms of reuniﬁcation, high wage demands, and the ﬁscalexpansion, the Bundesbank was able to keep these temporary e¤ects from becoming
embedded in the inﬂation process, and by 1995 inﬂation had fallen below the Bun-
desbank’s normative inﬂation goal of 2 percent.
The experience of Germany and Switzerland illustrate that much of the success
of their monetary policy regime’s success stemmed from their active use of the
monetary-targeting strategy to clearly communicate a long-run strategy of inﬂation
control. Both central banks in these two countries used monetary targeting to clearly
state the objectives of monetary policy and to explain that policy actions remained
focused on long-run price stability when targets were missed. The active communica-
tion with the public by the Bundesbank and the Swiss National Bank increased the
transparency and accountability of these central banks. In contrast, the game playingthat was a feature of monetary targeting in the United States, the United Kingdom,
and Canada hindered the communication process so that transparency and account-
ability of the central banks in these countries was not enhanced.8 Chapter 1

The German and Swiss maintained ﬂexibility in their monetary targeting approach
and did not come even close to following a rigid rule. Despite a ﬂexible approach to
monetary targeting that included tolerating target misses and gradual disinﬂation,
Germany and Switzerland demonstrated that ﬂexibility is consistent with successful
inﬂation control. The key to success was seriousness about pursuing the long-run
goal of price stability and actively engaging public support for this task.
Despite the successes of monetary targeting in Switzerland and particularly Ger-
many, monetary targeting does have some serious drawbacks. The weak relationship
between the money supply and nominal income discussed in chapter 6 implies that
hitting a particular monetary target will not produce the desired outcome for a goal
variable such as inﬂation. Furthermore, the monetary aggregate will no longer pro-
vide an adequate signal about the stance of monetary policy. Thus, except under very
unusual circumstances, monetary targeting will not provide a good nominal anchor
and help ﬁx inﬂation expectations. In addition, an unreliable relationship between
monetary aggregates and goal variables makes it more di‰cult for monetary target-
ing to serve as a communications device that increases the transparency of monetary
policy and makes the central bank accountable to the public.
1.4 The Search for a Better Nominal Anchor: The Birth of Inflation Targeting in the 1990s
The rational expectations revolution also led to a big breakthrough in our under-standing of monetary policy strategy and the importance of a nominal anchor with
the recognition of the time-inconsistency problem.
1.4.1 The Time-Inconsistency Problem
Papers by Finn Kydland and Edward Prescott, Guillermo Calvo, and Robert Barro
and David Gordon all dealt with the time-inconsistency problem, in which monetary
policy conducted on a discretionary, day-by-day basis leads to poor long-run out-
comes. 22Optimal monetary policy should not try to exploit the short-run trade-
o¤ between unemployment and inﬂation by pursuing overly expansionary policy
because decisions about wages and prices reﬂect expectations about policy made
by workers and ﬁrms; when they see a central bank pursuing expansionary policy,
workers and ﬁrms will raise their expectations about inﬂation, and push wages and
prices up. The rise in wages and prices will lead to higher inﬂation, but will not result
in higher output on average. Monetary policymakers, however, are tempted to pur-
sue a discretionary monetary policy that is more expansionary than ﬁrms or people
expect because such a policy would boost economic output (or lower unemployment)in the short run. In other words, the monetary policymakers will ﬁnd themselves
unable to consistently follow an optimal plan over time; the optimal plan is time-
inconsistent and so will soon be abandoned.How Did We Get Here? 9

Putting in place a strong nominal anchor can also help prevent the time-
inconsistency problem in monetary policy by providing an expected constraint on
discretionary policy. A strong nominal anchor can help ensure that the central bank
will focus on the long run and resist the temptation or the political pressures to pur-
sue short-run expansionary policies that are inconsistent with the long-run price sta-
bility goal.
1.4.2 Central Bank Independence
One undesirable feature of the time-inconsistency literature ﬁrst addressed by Ben-
nett McCallum and elaborated upon in chapter 2, is that the time-inconsistency
problem by itself does not imply that a central bank will pursue expansionary mone-
tary policy that leads to inﬂation. 23Simply by recognizing the problem that forward-
looking expectations in the wage- and price-setting process creates for a strategy of
pursuing expansionary monetary policy, monetary policymakers can decide to just
notdo it and avoid the time-inconsistency problem altogether. To avoid the time-
inconsistency problem, the central bank will need to make it clear to the public that
it does not have an objective of raising output or employment above what is consis-tent with stable inﬂation and will not try to surprise people with an unexpected, dis-
cretionary, expansionary policy. 24Instead, it will commit to keeping inﬂation under
control.
Although central bankers are fully aware of the time-inconsistency problem, the
problem remains nonetheless because politicians are able to put pressure on central
banks to pursue overly expansionary monetary policy. 25Making central banks inde-
pendent, however, can help insulate them from political pressures to exploit short-
run trade-o¤s between employment and inﬂation. Independence insulates the central
bank from the myopia that is frequently a feature of the political process arisingfrom politicians’ concerns about getting elected in the near future and should thus
lead to better policy outcomes. Evidence supports the conjecture that macroeco-
nomic performance is improved when central banks are more independent. When
central banks in industrialized countries are ranked from least legally independent
to most legally independent, the inﬂation performance is found to be the best for
countries with the most independent central banks. 26
Both economic theory and the better outcomes for countries that have more inde-
pendent central banks have led to a remarkable trend toward increasing central bank
independence. Before the 1990s, very few central banks were highly independent,
most notably the Bundesbank, the Swiss National Bank, and, to a somewhat lesser
extent, the Federal Reserve. Now almost all central banks in advanced countriesand many in emerging market countries have central banks with a level of indepen-
dence on par with or exceeding that of the Federal Reserve. In the 1990s, greater in-10 Chapter 1

dependence was granted to central banks in such diverse countries as Japan, New
Zealand, South Korea, Sweden, the United Kingdom, and those in the Eurozone.
1.4.3 The Birth of Inflation Targeting
Putting in place a strong nominal anchor can help prevent the time-inconsistencyproblem in monetary policy by providing an expected constraint on discretionarypolicy. A strong nominal anchor can help ensure that the central bank will focus on
the long run and resist the temptation or the political pressures to pursue short-run
expansionary policies that are inconsistent with the long-run price stability goal.
However, as we have seen, a monetary target will have trouble serving as a strong
nominal anchor when the relationship between money and inﬂation is unstable. The
disappointments with monetary targeting led to a search for a better nominal anchor
and resulted in the development of inﬂation targeting in the 1990s, which is discussed
in chapters 9 to 16.
Inﬂation targeting evolved from monetary targeting by adopting its most success-
ful elements: an institutional commitment to price stability as the primary long-run
goal of monetary policy and to achieving the inﬂation rate goal; increased transpar-ency through communication with the public about the objectives of monetary policy
and the plans for policy actions to achieve these objectives; and increased account-
ability for the central bank to achieve its inﬂation objectives. Inﬂation targeting,
however, di¤ers from monetary targeting in two key dimensions: 1) rather than an-
nounce a monetary aggregates target, this strategy publicly announces a medium-
term numerical target for inﬂation, and 2) it makes use of an information-inclusive
strategy, with a reduced role for intermediate targets such as money growth.
New Zealand was the ﬁrst country to adopt inﬂation targeting. After bringing in-
ﬂation down from almost 17 percent in 1985 to the vicinity of 5 percent by 1989, theNew Zealand parliament passed a new Reserve Bank of New Zealand Act in 1989
that became e¤ective on February 1, 1990. Besides moving the central bank from
being one of the least independent to one of the most independent among the indus-
trialized countries, the act also committed the Reserve Bank to a sole objective of
price stability. The act stipulated that the minister of ﬁnance and the governor of the
Reserve Bank should negotiate and make public a Policy Targets Agreement that
sets the criteria by which monetary policy performance would be evaluated. These
agreements have speciﬁed numerical target ranges for inﬂation and the dates by
which they were to be reached.
The ﬁrst Policy Targets Agreement, signed by the minister of ﬁnance and the gov-
ernor of the Reserve Bank on March 2, 1990, directed the Reserve Bank to achievean annual inﬂation rate of 3 to 5 percent by the end of 1990 with a gradual reduction
in subsequent years to a 0 to 2 percent range by 1992 (changed to 1993), which wasHow Did We Get Here? 11

kept until the end of 1996 when the range was changed to 0 to 3 percent and then to
1 to 3 percent in 2002.
New Zealand’s action was followed by Canada in February 1991, Israel in January
1992, the United Kingdom in October 1992, Sweden in January 1993, and Finland
in February 1993. (Chile adopted a softer form of inﬂation targeting in January
1991). 27Since its inception, more than twenty countries have adopted inﬂation tar-
geting, and new ones are added to the inﬂation-targeting club every year.
Inﬂation targeting has superseded monetary targeting because of several advan-
tages. First, inﬂation targeting does not rely on a stable money-inﬂation relationship
and so large velocity shocks of the type discussed in chapter 6, which distort this re-
lationship, are largely irrelevant to monetary policy performance. 28Second, the use
of more information, and not primarily one variable, to determine the best settings
for policy, has the potential to produce better policy settings. Third, an inﬂation tar-
get is readily understood by the public because changes in prices are of immediate
and direct concern, while monetary aggregates are farther removed from peoples’ di-
rect experience. Inﬂation targets are therefore better at increasing the transparency of
monetary policy because these make the central bank’s objectives clearer. This doesnot mean that monetary targets could not serve as a useful communication device
and increase accountability to control inﬂation as they did in Germany and Switzer-
land, but once the relationship between monetary aggregates and inﬂation breaks
down, as it has repeatedly (and especially in Switzerland), monetary targets lose a
substantial degree of transparency because the central bank now has to provide com-
plicated discussions of why it is appropriate to deviate from the monetary target.
Fourth, inﬂation targets increase central bank accountability because its performance
can now be measured against a clearly deﬁned target. Monetary targets work less
well in this regard because the unstable money-inﬂation relationship means that thecentral bank will necessarily miss its monetary targets frequently and thus makes it
harder to impose accountability on the central bank. The Bundesbank, for example,
missed its target ranges more than half the time and it was the most successful prac-
titioner of this policy regime. Inﬂation targeting has much better odds of successful
execution.
A key feature of all inﬂation-targeting regimes is the enormous stress put upon
transparency and communication. Inﬂation-targeting central banks have frequent
communications with the government, some mandated by law and some in response
to informal inquiries, and their o‰cials take every opportunity to make public
speeches on their monetary policy strategy. Communication of this type also has
been prominent among central banks that have not adopted inﬂation targeting,including monetary targeters such as the Bundesbank and Switzerland, as well as
nontargeters such as the Federal Reserve. Yet inﬂation-targeting central banks have
taken public outreach a number of steps further: not only have they engaged in12 Chapter 1

extended public information campaigns, even engaging in the distribution of glossy
brochures, but they have engaged in publishing a type of document known by its ge-
neric name Inﬂation Reports after the original document published by the Bank of
England.
The publication of Inﬂation Reports is particularly noteworthy because these docu-
ments depart from the usual, dull-looking, formal central bank reports and incorpo-rate the best elements of college textbook writing (using fancy graphics and boxes) to
better communicate with the public. Inﬂation Reports are far more user-friendly than
previous central bank documents and clearly explain the goals and limitations of
monetary policy, including the rationale for inﬂation targets: the numerical values
of the inﬂation targets and how these were determined; how the inﬂation targets are
to be achieved, given current economic conditions; and the reasons for any devia-
tions from targets. Almost all Inﬂation Reports also provide inﬂation forecasts, while
the majority provide output forecasts, and some provide a projection of the policy
path for interest rates (see table 5.1 in chapter 5). These communication e¤orts have
improved private-sector planning by reducing uncertainty about monetary policy, in-
terest rates, and inﬂation; these reports have promoted public debate of monetarypolicy, in part by educating the public about what a central bank can and cannot
achieve; and these have helped clarify the responsibilities of the central bank and of
politicians in the conduct of monetary policy.
Because an explicit numerical inﬂation target increases the central bank’s account-
ability in controlling inﬂation, inﬂation targeting also helps reduce the likelihood that
a central bank will su¤er from the time-inconsistency problem in which it reneges on
the optimal plan and instead tries to expand output and employment by pursuing
overly expansionary monetary policy. But since time-inconsistency is more likely to
come from political pressures on the central bank to engage in overly expansionarymonetary policy, a key advantage of inﬂation targeting is that it is better able to
focus the political debate on what a central bank can do best in the long-run—
control inﬂation—rather than what it cannot do: raise economic growth and the
number of jobs permanently through expansionary monetary policy. (A remarkable
example of raising the level of public discussion, as recounted in chapter 10, occurred
in Canada in 1996 when a public debate ensued over a speech by the president of the
Canadian Economic Association criticizing the Bank of Canada.) 29Thus, inﬂation
targeting appears to reduce political pressures on the central bank to pursue inﬂa-
tionary monetary policy and thereby reduces the likelihood of time-inconsistent
policymaking.
Although inﬂation targeting has the ability to limit the time-inconsistency problem,
it does not do this by adopting a rigid rule, and thus has much in common with
the ﬂexibility of earlier monetary-targeting regimes. Inﬂation targeting has rule-
like features in that it involves forward-looking behavior that limits policymakersHow Did We Get Here? 13

from systematically engaging in policies with undesirable long-run consequences. But
rather than using a rigid rule, it employs what Ben Bernanke (now chairman of the
Board of Governors of the Federal Reserve) and I dubbed ‘‘constrained discretion’’
in chapter 9. Inﬂation targeting allows for some ﬂexibility but constrains policy-
makers from pursuing overly expansionary (or contractionary) monetary policy.
Inﬂation targeting also does not ignore traditional output stabilization, but instead
puts it into a longer-run context, placing it outside the shorter-run business cycle con-
cerns that characterized monetary policy throughout the 1960s and 1970s. Inﬂation-
targeting regimes allow for the ﬂexibility to deal with supply shocks and have
allowed the target to be reduced gradually to the long-run inﬂation goal when inﬂa-
tion is initially far from this goal (also a feature of monetary targeters such as Ger-
many). As Lars Svensson had shown, a gradual movement of the inﬂation target
toward the long-run, price-stability goal indicates that output ﬂuctuations are a con-
cern (in the objective function) of monetary policy. 30In addition, inﬂation targeters
have emphasized that the ﬂoor of the range should be as binding a commitment as
the ceiling, indicating that they care about output ﬂuctuations as well as inﬂation.
Inﬂation targeting is therefore better described as ‘‘ﬂexible inﬂation targeting.’’
The above discussion suggests that although inﬂation targeting has evolved from
earlier monetary policy strategies, it does represent true progress. But how has inﬂa-
tion targeting fared? Has it actually led to better economic performance?
1.4.4 Has Inflation Targeting Made a Difference?
The simple answer to this question is generally yes, with some qualiﬁcations. 31This
conclusion is derived from the following four results: 32
/C15Inﬂation levels (and volatility), as well as interest rates, have declined after coun-
tries adopted inﬂation targeting.
/C15Output volatility has not worsened, and, if anything, improved after adoption of
inﬂation targeting.
/C15Exchange rate pass-through seems to be attenuated by adoption of inﬂation
targeting. 33
/C15The fall in inﬂation levels and volatility, interest rates, and output volatility
was part of a worldwide trend in the 1990s, and inﬂation targeters have not done
better in terms of these variables or in terms of exchange rate pass-through
than noninﬂation-targeting industrialized countries such as the United States or
Germany. 34
The fact that inﬂation-targeting countries see improvement in inﬂation and output
performance but do not do better than countries like the United States and Germany
also suggests that what is really important to successful monetary policy is the estab-14 Chapter 1

lishment of a strong nominal anchor. 35As is pointed out in chapters 8 and 10, 36
Germany was able to create a strong nominal anchor with its monetary-targeting
procedure. In the United States, the strong nominal anchor has been in the person
of Alan Greenspan (chapter 2). Although inﬂation targeting is one way to establish
a strong nominal anchor, it is not the only way. It is not at all clear that inﬂation
targeting would have improved performance in the United States during the Green-span era, although it well might do so after Greenspan is gone (chapter 11). Further-
more, as is emphasized in chapters 13 and 18, by itself, an inﬂation target is not
capable of establishing a strong nominal anchor if the government pursues irrespon-
sible ﬁscal policy or inadequate prudential supervision of the ﬁnancial system, which
might then be prone to ﬁnancial blow-ups. 37
There is, however, empirical evidence on inﬂation expectations that is more telling
about the possible beneﬁts of inﬂation targeting. Recent research has found the fol-
lowing additional results:
/C15Evidence is not strong that the adoption of inﬂation targeting leads to an immedi-
ate fall in inﬂation expectations. 38
/C15Inﬂation persistence, however, is lower for countries that have adopted inﬂation
targeting than for countries that have not.
/C15Inﬂation expectations appear to be more anchored for inﬂation targeters than non-
targeters: that is, inﬂation expectations react less to shocks to actual inﬂation for tar-
geters than nontargeters, particularly at longer horizons. 39
These results suggest that once inﬂation targeting has been in place for a while, it
does make a di¤erence because it better anchors medium- and longer-term inﬂation
expectations and thus strengthens the nominal anchor. Since, as argued earlier, estab-
lishing a strong nominal anchor is a crucial element in successful monetary policy, 40
the evidence on inﬂation expectations provides a stronger case that inﬂation targeting
has represented real progress.
The beneﬁts of inﬂation targeting have led me to advocate inﬂation targeting for
the Federal Reserve and this topic is taken up in chapter 11.
1.5 An Alternative Nominal Anchor: Exchange-Rate Pegging
Pegging the value of the domestic currency to that of a large, low-inﬂation country is
another potential nominal anchor for monetary policy. This monetary policy regime
has a long history. Exchange-rate pegging has several advantages. It directly contrib-
utes to keeping inﬂation under control by tying the inﬂation rate for internationallytraded goods to that found in the anchor country. It anchors inﬂation expectations to
the inﬂation rate in the anchor country as long as the exchange-rate peg is credible.
With a strong commitment mechanism, it provides an automatic rule for the conductHow Did We Get Here? 15

of monetary policy that mitigates the time-inconsistency problem: it forces a tighten-
ing of monetary policy when there is a tendency for the currency to depreciate, or a
loosening of policy when there is a tendency to appreciate.
Given its advantages, it is not surprising that exchange-rate pegging has been used
to lower inﬂation both in advanced economies (chapter 10) and in emerging market
countries (chapters 13 and 14). There are, however, several serious problems with thisstrategy, as pointed out in these chapters. With capital mobility the targeting country
can no longer pursue its own independent monetary policy and use it to respond to
domestic shocks that are independent of those hitting the anchor country. Further-
more, an exchange-rate peg means that shocks to the anchor country are directly
transmitted to the targeting country, because changes in interest rates in the anchor
country lead to a corresponding change in interest rates in the targeting country.
A second disadvantage of an exchange-rate peg is that it can weaken the account-
ability of policymakers, particularly in emerging market countries. Because exchange-
rate pegging ﬁxes the exchange rate, it eliminates an important signal that can help
limit the time-inconsistency problem by constraining monetary policy from becoming
too expansionary. In industrialized countries, particularly in the United States, thebond market provides an important signal about the stance of monetary policy.
Overly expansionary monetary policy or strong political pressure to engage in overly
expansionary monetary policy produces an inﬂation scare in which inﬂation expec-
tations surge, interest rates rise, and long-term bond prices sharply decline. Because
both central banks and politicians want to avoid this kind of scenario, overly expan-
sionary policy will be less likely.
In many countries, particularly emerging market countries, the long-term bond
market is essentially nonexistent. Under a ﬂoating exchange-rate regime, however, if
monetary policy is too expansionary, the exchange rate will depreciate. In thesecountries the daily ﬂuctuations of the exchange rate can, like the bond market in the
United States, provide an early warning signal that monetary policy is too expan-
sionary. Just as the fear of a visible inﬂation scare in the bond market constrains cen-
tral bankers from pursuing overly expansionary monetary policy and constrains
politicians from putting pressure on the central bank to engage in overly expansion-
ary monetary policy, fear of exchange-rate depreciations can make overly expan-
sionary monetary policy less likely.
The need for signals from the foreign exchange market may be even more acute in
emerging market countries because the balance sheet and actions of their central
banks are not as transparent as they are in industrialized countries. Pegging the ex-
change rate to another currency can make it even harder to ascertain the centralbank’s policy actions. The public is less able to keep watch on the central bank and
the politicians pressuring it, which makes it easier for monetary policy to become too
expansionary.16 Chapter 1

A third, and probably the most severe, problem is that an exchange-rate peg leaves
countries open to speculative attacks on their currencies, and if these attacks are suc-
cessful, the collapse of the domestic currency is usually much larger, more rapid, and
more unanticipated than when a depreciation occurs under a ﬂoating exchange-rate
regime. A pegged regime is especially dangerous for an emerging market economy
because they have so much of their debt denominated in foreign currencies, a phe-nomenon called liability dollarization . Emerging market countries with pegged ex-
change rates are thus especially vulnerable to twin crises, in which the currency
collapse destroys ﬁrms’ and households’ balance sheets, which in turn provokes a ﬁ-
nancial crisis and a sharp economic contraction. Emerging market countries exiting
from pegged exchange-rate regimes are more prone to higher-cost ﬁnancial crises and
large declines in output the longer the exchange-rate peg has been in place. 41
As chapter 17 points out, the dangers of pegged exchange-rate regimes for emerg-
ing market countries are so clear that most of them would be far better o¤ avoiding
exchange-rate pegs as their monetary policy strategy, and instead have a ﬂexible ex-
change rate with inﬂation targeting. However, in emerging market countries whose
political and monetary institutions are particularly weak and who therefore have ahistory of continual bouts of very high inﬂation, ﬁxing the exchange rate relative to
a sound currency may be the only way to break inﬂationary psychology and stabilize
the economy. In addition, a pegged exchange rate may encourage integration of the
domestic economy with its neighbors, which may be an important goal in its own
right. These considerations have led some economists to suggest that there are times
when a strong commitment to a ﬁxed exchange rate (either through a currency board
or through full dollarization in which the country abandons its currency and adopts
a foreign currency like the dollar as its money) might be necessary. 42
However, as argued in chapter 18, the choice of exchange-rate regime, whether a
ﬁxed or ﬂexible one, is likely to be of secondary importance to the development of
good ﬁnancial, ﬁscal, and monetary institutions in producing successful monetary
policy in emerging market countries.
1.6 Where Is Monetary Policy Strategy Heading?
Just as inﬂation targeting evolved from earlier monetary policy strategies, monetary
policy strategy will continue to evolve over time. There are four major issues under
active debate regarding where monetary policy strategy should be headed in the
future.
1.6.1 Inflation versus Price-Level Targeting?
Currently all inﬂation-targeting countries target an inﬂation rate rather than the
price level. The traditional view, forcefully articulated by Stanley Fischer, arguesHow Did We Get Here? 17

that a price-level target might produce more output variability than an inﬂation tar-
get because unanticipated shocks to the price level are not treated as bygones and
must be o¤set. 43Speciﬁcally, a price-level target requires that an overshoot of the
target must be reversed, and this might require quite contractionary monetary policy,
which, with sticky prices, could lead to a sharp downturn in the real economy in the
short run. Indeed, if the overshoot is large enough, returning to the target might re-quire a deﬂation, which could promote ﬁnancial instability and be quite harmful.
On the other hand, in theoretical models with a high degree of forward-looking be-
havior, a price-level target produces less output variance than an inﬂation target. 44
(A price-level target was used successfully in Sweden in the 1930s.) 45Empirical evi-
dence, however, does not clearly support forward-looking expectations formation,
and models with forward-looking behavior have counter-intuitive properties that
seem to be inconsistent with inﬂation dynamics. 46Thus, the jury is still out on
whether the monetary policy regime should move from inﬂation targeting to price-
level targeting. Indeed, in the future central banks might experiment with hybrid pol-
icies that combine features of an inﬂation and a price-level target by announcing a
commitment to some error correction in which target misses will be o¤set to someextent in the future. 47Evaluating these hybrid policies should be a major focus of
future research, but the reasoning here indicates that monetary policy should respond
to persistent undershoots or overshoots of the inﬂation target as is discussed in
chapter 19.
1.6.2 How Far Should Central Bank Transparency Go?
Inﬂation-targeting central banks have also been moving to greater and greater trans-parency over time by publishing their forecasts. The central banks in New Zealand,
Colombia, and, most recently, Norway have been announcing projections of theirpolicy path for future interest rates. Publication of forecasts and policy projections
can help the public and the markets understand central bank actions, thus decreasing
uncertainty and making it easier for the public and markets to assess whether the
central bank is serious about achieving its inﬂation goal.
Lars Svensson argues that not only should central banks announce their projec-
tions of the future policy path, but also announce their objective function (the rela-
tive weights they put on output versus inﬂation ﬂuctuations in their loss function). 48
I, however, argue in chapter 5 that central bank transparency can go too far if it
complicates communication with the public. Announcing a policy path may confuse
the public if it does not su‰ciently convey that the path is conditional on events in
the economy. The public may then see a deviation from this path as a central bankfailure, and the central bank would then be vulnerable to attacks that it is ﬂip-
ﬂopping, which could undermine the support for its independence and focus on price
stability. This objection does not mean that providing information about the future18 Chapter 1

policy path in some form has no value. It does mean that there are nuances as to how
this could be done. Providing information about the future policy path in more gen-
eral terms or in terms of fan charts that emphasize the uncertainty about the future
policy path might achieve most of the beneﬁts of increased disclosure and still make
clear how conditional the policy path is on future events. 49Central banks pursuing
inﬂation targeting are likely to experiment further with di¤erent approaches to pro-viding more information about future policy, and I discuss possible alternatives in
chapter 19.
Central banks should not only care about reducing the volatility of inﬂation, but
should also want to lower output (employment) ﬂuctuations. In chapter 4, I argue
that monetary policy that targets inﬂation, but does it in a ﬂexible manner, is the
best way to produce better outcomes for both output and inﬂation ﬂuctuations. In-
deed, central bankers do care about stabilizing output and employment, as evidenced
by their actions; they are, however, very reluctant to talk about it because they are
worried that it will lead to political pressure for them to pursue overly expansionary
policy that will lead to inﬂation. The reluctance to discuss stabilization goals is what
I refer to in chapter 5 as the ‘‘dirty little secret’’ of central banking. I argue there thatcentral banks do need to be more transparent about the fact that they want to stabi-
lize output and employment ﬂuctuations, but that they should not publish an output
(potential GDP) or unemployment target. As is illustrated by chapter 7, the appro-
priate level of output or unemployment targets is very hard to measure, and shoot-
ing for these targets is likely to lead to poor policy outcomes. How central banks
should communicate their concerns about output ﬂuctuations is discussed further in
chapter 19.
1.6.3 How Should Monetary Policy Authorities Respond to Asset Prices?
A ﬁnal issue confronting central banks is how they should respond to movements in
asset prices and I discuss this issue in chapters 3 and 19. It is generally agreed that
monetary policy should react to asset prices when changes in these prices provide
useful information about future inﬂation and the path of the economy. The tougher
issue is whether central banks should react to asset prices over and above their e¤ects
on future inﬂation. Bubbles in asset prices, when they collapse, can lead to ﬁnancial
instability; as a result some researchers have argued that monetary policy should act
to limit asset price bubbles to preserve ﬁnancial stability. 50To do this successfully,
the monetary authorities would need to know when a bubble exists, yet it is unlikely
that government o‰cials, even central bankers, know better what are appropriate
asset prices than do private markets. 51Ben Bernanke and Mark Gertler ﬁnd that
an inﬂation-targeting approach that does not focus on asset prices over and above
their e¤ect on the economy but does make use of an information-inclusive strategy
in setting policy instruments has the ability to make asset price bubbles less likely,How Did We Get Here? 19

thereby promoting ﬁnancial stability. 52With the recent sharp run-up of housing
prices in many countries and the possibility of bubbles, central banks’ concerns
about asset price movements and what to do about them are unlikely to abate.
1.6.4 How Should the Monetary Policy React to Exchange Rates in an Inflation-Targeting
Regime?
Even if a central bank is targeting inﬂation, ﬂuctuations in the exchange rate, which
of course is another important asset price, are also a major concern to inﬂation-
targeting central banks, particularly in emerging market countries because, as we
have seen, sharp depreciations can trigger a ﬁnancial crisis. 53Inﬂation-targeting cen-
tral banks therefore cannot a¤ord to pursue a policy of benign neglect to exchange
rates, as emphasized in chapter 13. 54They may have to smooth ‘‘excessive’’ ex-
change rate ﬂuctuations, but how they should do this is still an open question. In-
deed, there is a danger that focusing on exchange rate movements might transform
the exchange rate into a nominal anchor that interferes with achieving the inﬂation
rate target. (This indeed happened in Hungary, as pointed out in chapter 15.) 55In
addition, when inﬂation targeters have focused on exchange rate movements, theyhave often made serious errors. 56Dealing with exchange rate ﬂuctuations is one
of the most serious challenges for inﬂation-targeting regimes in emerging market
countries.
1.7 Conclusion
The practice of central banking has made tremendous strides in recent years. We are
currently in a highly desirable environment that few would have predicted ﬁfteen
years ago: not only is inﬂation low, but its variability and the volatility of outputﬂuctuations are also low. This book argues that new thinking about monetary policy
strategy is one of the key reasons for this success. If we learn from experience, per-
haps we can replicate and reﬁne what does work, and not repeat past mistakes.
Notes
1. See Central Intelligence Agency (2006).
2. See Mayer (1998) and Romer and Romer (2002) for a description of economic thinking and monetary
policy practice in the 1960s.
3. Samuelson and Solow (1960) and Phillips (1958).4. Friedman and Schwartz (1963a,b) and Friedman and Meiselman (1963).5. Brunner and Meltzer (1964a,b,c).
6. Phelps (1967) and Friedman (1968).
7. Mayer (1998) and Romer and Romer (2002).20 Chapter 1

8. Lucas (1972, 1973, and 1976). The Lucas (1976) paper was already very inﬂuential in 1973, when it was
ﬁrst presented in 1973 at the ﬁrst Carnegie-Rochester Conference. Note that although Muth (1960, 1961)
introduced the idea of rational expectations more than ten years earlier, his work went largely unnoticeduntil resurrected by Lucas.
9. Sargent and Wallace (1975).10. See Mishkin (1982a,b, 1983).11. For example, see the surveys in Fischer (1993) and Anderson and Gruen (1995).
12. English (1996).
13. Briault (1995).14. Fischer (1994) and Feldstein (1997).15. For example, see the survey in Anderson and Gruen (1995).16. The importance of a strong nominal anchor to successful monetary policy is also a key feature of re-
cent theory on optimal monetary policy, referred to as the new neoclassical synthesis (Woodford, 2003,and Goodfriend and King, 1997).
17. For evidence in the United States, see Stock and Watson (1989), Friedman and Kuttner (1993), and
chapter 6.
18. Also see Rich (1997).19. von Hagen (1999).20. Issing (1996).21. Also see von Hagen (1995), Neumann and von Hagen (1993), Clarinda and Gertler (1997), Mishkin
and Posen (1997), and Bernanke and Mihov (1997).
22. Kydland and Prescott (1977), Calvo (1978), and Barro and Gordon (1983).23. McCallum (1995).24. When a central bank does not pursue an objective of raising output or employment above what is con-
sistent with stable inﬂation, there will be no inﬂation bias (average inﬂation above the optimal long-run
level). In a model with a forward-looking, New Keynesian, Phillips curve, however, there will still be aproblem of stabilization bias (too much focus on reducing output ﬂuctuations relative to inﬂation ﬂuctua-
tions) and a lack of history dependence (response to initial conditions that would produce better outcomes).
See Woodford (2003).
25. For an example of how the time-inconsistency problem can be modeled as resulting from political
pressure, see Mishkin and Westelius (2005).
26. For example, Alesina and Summers (1993), Cukierman (1992), and Fischer (1994), and the recent sur-
veys in Forder (2000), and Cukierman (2006).
27. The dating of adoption of inﬂation targeting is not always clear-cut. The dates used here are from
chapter 16.
28. An unstable relationship between money and inﬂation could make inﬂation targeting more di‰cult be-
cause there is less information in the monetary aggregates to help forecast inﬂation. However, successful
inﬂation targeting is not dependent on having a stable money-inﬂation relationship as long as other infor-
mation enables the monetary authorities to forecast future inﬂation and the impact of the current mone-tary policy stance on the economy.
29. Also see Mishkin and Posen (1997) or Bernanke et al. (1999).30. Svensson (1997).31. This is the conclusion in a recent paper presented to the Executive Board of the IMF. Roger and Stone
(2005).
32. There is also some mildly favorable evidence on the impact of inﬂation targeting on sacriﬁce ratios.
Bernanke et al. (1999) did not ﬁnd that sacriﬁce ratios in industrialized countries fell with adoption of in-ﬂation targeting, while Corbo, Landerretche, and Schmidt-Hebbel (2002) with a larger sample of inﬂationtargeters have concluded that inﬂation targeting did lead to an improvement in sacriﬁce ratios. However,How Did We Get Here? 21

deﬁning sacriﬁce ratios is extremely tricky, so I would put less weight on this evidence. Sabba ´n, Rozada,
and Powell (2003) also ﬁnd that inﬂation targeting leads to nominal exchange rate movements that are
more responsive to real shocks rather than nominal shocks. This might indicate that inﬂation targetingcan help the nominal exchange rate to act as a shock absorber for the real economy.
33. Lower exchange rate pass-through might be seen as a drawback because it weakens this channel of the
monetary policy transmission mechanism. As long as other channels of monetary policy transmission arestill strong, however, the monetary authorities still have the ability to keep inﬂation under control.
34. For evidence supporting the ﬁrst three results, see Bernanke et al. (1999), Corbo, Landerretche,
and Schmidt-Hebbel (2002), Neumann and von Hagen (2002), Hu (2003), Truman (2003), and Ball andSheridan (2005).
35. Ball and Sheridan (2005) is one of the few empirical papers that is critical of inﬂation targeting: it
argues that the apparent success of inﬂation-targeting countries is just a reﬂection of regression towardthe mean; that is, countries that start with higher inﬂation are more likely to ﬁnd that inﬂation will fall
faster than countries that start with an initially low inﬂation rate. Since countries that adopted inﬂation
targeting generally had higher initial inﬂation rates, their larger decline in inﬂation just reﬂects a generaltendency of all countries, both targeters and nontargeters, to achieve better inﬂation and output perfor-mance in the 1990s when inﬂation targeting was adopted. This paper has been criticized on several groundsand its conclusion that inﬂation targeting had nothing to do with improved economic performance isunwarranted; see Hyvonen (2004), Gertler (2005), and Mishkin and Schmidt-Hebbel (2005). However,
Ball and Sheridan’s paper does raise a serious question because inﬂation targeting is an endogenous choice
and ﬁnding that better performance is associated with inﬂation targeting may not imply that inﬂation tar-geting causes this better performance. Mishkin and Schmidt-Hebbel (2005) does attempt to explicitly dealwith potential endogeneity of adoption of inﬂation targeting through use of instrumental variables andcontinues to ﬁnd favorable results on inﬂation targeting performance.
36. Also see Mishkin and Posen (1997), Bernanke et al. (1999), and Neumann and von Hagen (2002).37. Also see Sims (2005).38. For example, Bernanke et al. (1999) and Levin, Natalucci, and Piger (2004) do not ﬁnd that inﬂation
targeting leads to an immediate fall in expected inﬂation, but Johnson (2002, 2003) does ﬁnd some evi-dence that expected inﬂation falls after announcement of inﬂation targets.
39. Levin, Natalucci, and Piger (2004) and Castelnuovo, Nicoletti-Altimari, and Palenzuela (2003).40. The importance of a strong nominal anchor to successful monetary policy is also a key feature of re-
cent theory on optimal monetary policy, referred to as the new neoclassical synthesis (Woodford, 2003,and Goodfriend and King, 1997).
41. Eichengreen and Masson (1998), Eichengreen (1999), and Aizenman and Glick (2005).42. See chapter 13, Calvo and Reinhart (2000), and McKinnon and Schnabl (2004).43. Fischer (1994).44. For example, Clarida, Gali, and Gertler (1999), Dittmar, Gavin, and Kydland (1999), Dittmar and
Gavin (2000), Eggertson and Woodford (2003), Svensson (1999), Svensson and Woodford (2003), Vestin(2000), Woodford (1999, 2003).
45. Berg and Jonung (1999).46. Fuhrer (1997) and Estrella and Fuhrer (1998).47. Research at the Bank of Canada and the Bank of England (Black, Macklem, and Rose, 1998; Battini
and Yates, 2003; and King, 1999) suggests that an inﬂation target with a small amount of error correctioncan substantially reduce the uncertainty about the price level in the long run, but still generate very fewepisodes of deﬂation.
48. Svensson (2002).49. However, announcing a speciﬁc policy path as has recently occurred in the United States when it
announced that it would remove accommodation at a measured pace, and then having seventeen straightFOMC meetings starting in June of 2004 in which it raised the policy rate by twenty-ﬁve basis points eachtime, did not su‰ciently convey the degree of uncertainty about the future path.
50. For example, Cecchetti, Genberg, Lipsky, and Wadhwani (2000), and Borio and Lowe (2002).22 Chapter 1

51. Bernanke and Gertler (2001) point out that Cecchetti et al. (2000) only ﬁnd that asset prices should be
included in the central bank’s policy rule because they assume that the central bank knows with certainty
that the asset price rise is a bubble and knows exactly when the bubble will burst.
52. Bernanke and Gertler (1999, 2001).53. Mishkin (1996, 1999).
54. Also see Mishkin (2000).
55. It also happened in Israel (Bernanke et al. 1999).56. For example, New Zealand and Chile in 1997 and 1998 (Mishkin, 2001).
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versity Press: Princeton.How Did We Get Here? 27

IFundamental Issues in the Conduct of Monetary Policy

Introduction to Part I
I open the book with a series of chapters that examine some of the most basic ques-
tions in the conduct of monetary policy: what should be the institutional setup for
central banks and how should they operate; how far should central bank transpar-
ency go; how does monetary policy a¤ect the economy; and what should the role
be of asset prices, output stabilization, monetary aggregates, and NAIRU (Non-
Accelerating Inﬂation Rate of Unemployment) in the conduct of monetary policy?
The ﬁrst chapter in part I, ‘‘What Should Central Banks Do?,’’ was written for the
Homer Jones Lecture given at the Federal Reserve Bank of St. Louis in 2000. I out-
line what economic theory and experience tells us about how central banks, as insti-
tutions, should best be set up to conduct monetary policy e¤ectively, and then I
apply the resulting lessons to see if there is room for institutional improvement in
the way the Federal Reserve operates. The lecture begins by discussing seven guiding
principles for central banks: 1) price stability provides substantial beneﬁts, 2) ﬁscal
policy should be aligned with monetary policy, 3) time-inconsistency is a serious
problem to avoid, 4) monetary policy should be forward-looking, 5) accountability
is a basic principle of democracy, 6) monetary policy should be concerned with out-put as well as price ﬂuctuations, and 7) the most serious economic downturns are
associated with ﬁnancial instability. These seven principles are then used to derive
seven criteria for how central banks should operate: 1) price stability should be the
overriding, long-run goal of monetary policy, 2) an explicit nominal anchor should
be adopted, 3) a central bank should be goal-dependent, 4) a central bank should be
instrument-independent, 5) a central bank should be accountable, 6) a central bank
should stress transparency and communication, and 7) a central bank should also
have the goal of ﬁnancial stability. This framework is then used to assess how the
institutional features of the Federal Reserve measure up. As a professor, I can’t resist
giving grades and I evaluate the Fed by giving it a grade on each of the seven crite-
ria. The point I want to emphasize is that despite the Fed’s extraordinarily successfulperformance in recent years, we should not be complacent. Changes in the way the

Federal Reserve is set up to conduct its business are needed to help ensure that the
Fed continues to be successful in the future.
When I started studying economics in 1969 there was a raging debate on how im-
portant monetary policy was to the economy. Prior to the mid-1960s, the Keynesian
thinking that dominated the economics profession suggested that monetary policy
does not matter at all to movements in aggregate output and hence to the businesscycle. The view that the money supply was unimportant was primarily based on the
view that monetary policy was easy during the Great Depression in the United States
because interest rates on Treasury securities were at such low levels. Since the only
way that monetary policy a¤ected the economy in the early Keynesian (ISLM)
model was through interest rates, and the model did not distinguish between real
and nominal interest rates, the conclusion was that monetary policy could not ex-
plain the greatest contraction in American history and so could not be important to
economic ﬂuctuations. In addition, early Keynesian evidence did not ﬁnd a strong
link between interest rates and investment, and since this mechanism was viewed as
the primary way monetary policy impacted the economy, the conclusion was that
money didn’t matter. The Monetarists, led by Milton Friedman, led a counterattackagainst the early Keynesian view that money didn’t matter with a series of remark-
able works all published in 1963: Friedman and Schwartz (1963a), A Monetary His-
tory of the United States, 1867–1960 ; Friedman and Schwartz (1963b), ‘‘Money and
Business Cycles’’; and Friedman and Meiselman (1963), ‘‘The Relative Stability of
Monetary Velocity and the Investment Multiplier.’’ This revisionist monetarist re-
search, which challenged the early Keynesian view that money was easy during the
Great Depression and that money doesn’t matter, led to an explosion of research on
the monetary transmission mechanism led by economists such as Franco Modigliani.
When I began graduate work in economics at MIT in 1972, I was greatly inﬂu-
enced by Franco and became intensely interested in the transmission mechanism of
monetary policy because I was convinced that monetary policy was indeed highly im-
portant, but that there had to be important ways that monetary policy a¤ected the
economy that did not operate through the traditional interest rate channels. My in-
terest in the monetary transmission mechanisms led to my PhD thesis, which was
completed in 1976, and to a series of publications early in my career (Mishkin,
1976a,b,c, 1977a,b,c, 1978a,b; and Kearl and Mishkin, 1977), which posited that an
important element of the monetary transmission mechanism operated through asset
price e¤ects on household balance sheets. My early interest in the role of asset prices
in the monetary transmission mechanism naturally led to thinking about what role
asset prices should play in monetary policy and led to the survey written for a con-ference at the Austrian National Bank in 2001 that constitutes chapter 3. This chap-
ter outlines the literature on the transmission mechanisms of monetary policy beyond32 Introduction to Part I

the standard interest rate channel by focusing on how monetary policy a¤ects ﬁrms’
and households’ investment and consumption decisions through asset prices: stock
prices, real estate prices, and exchange rates. Given the role that asset prices play in
transmission mechanisms, central banks often have been tempted to use these as
monetary policy targets. Chapter 3 shows that despite the signiﬁcance of asset prices
in the conduct of monetary policy, targeting asset prices—whether they are exchangerates, real estate, or stock prices—is likely to worsen the performance of monetary
policy. Targeting asset prices worsens economic performance because the response
of monetary policy to asset price ﬂuctuations depends on the nature of shocks to
asset prices and the degree of the shock’s permanence. Furthermore, targeting asset
prices is likely to erode support for central banks’ independence because controlling
these asset prices is beyond central bank capabilities.
As will be emphasized throughout this book, much of the recent success of central
banks has resulted from their increased focus on price stability as the overriding
long-run objective of monetary policy. However, it is clear that central banks should
care not only about promoting low and stable inﬂation, but should also want to pro-
mote maximum sustainable output and employment. Indeed, the goals of both pricestability and maximum sustainable employment, referred to as the dual mandate ,a r e
embedded in central bank legislation in many countries, most prominently in the
United States. Does the dual mandate suggest that central banks should have an em-
ployment or output target? What role does the dual mandate suggest that output sta-
bilization should have in the conduct of monetary policy? Chapter 4, written in 2002,
addresses these questions and provides the following answers. Activist monetary
policy—in which the monetary authorities focus on output ﬂuctuations in the setting
of their policy instrument and in policy statements—is likely to produce worse out-
comes not only for inﬂation but also for output ﬂuctuations. Activist policy of thistype not only will lead to inappropriate monetary policy, but will also complicate
the monetary authority’s communication strategy and can weaken the support for
the independence of the central bank. The analysis in chapter 4 suggests that a ﬂexi-
ble inﬂation-targeting approach to monetary policymaking, which is discussed exten-
sively in parts II and III of this book, enables the central bank to communicate
e¤ectively to the public that it cares about output ﬂuctuations, but makes it less likely
that the central bank will fall into the time-inconsistency trap and try to exploit the
short-run trade-o¤ between output and inﬂation.
In recent years, there has been a major sea change in the way central banks com-
municate with the markets and the public. Now central bank communication is seen
as a central issue in monetary policy strategy. A key issue in chapter 4 is how centralbanks should communicate their concerns about output ﬂuctuations. Chapter 5,
which was written for a conference at the Reserve Bank of Australia in 2004, pursuesIntroduction to Part I 33

the issue of central bank communication strategy in more depth. The trend in central
banking has been to move to ever greater transparency, but should there be a limit?
Can central bank transparency go too far?
Chapter 5 argues that although recent increases in transparency have been very
beneﬁcial and in some ways need to go further, transparency can indeed go too far.
The lens with which I view whether transparency is beneﬁcial is the question, Doesincreased transparency help the central bank do its job—that is, does it enable the
central bank to conduct monetary policy optimally, with an appropriate focus on
long-run objectives? The answer could well be no if the increase in transparency vio-
lates the KISS (Keep It Simple Stupid) principle and thereby makes the central
bank’s communication strategy too complicated. With this perspective, I argue that
there are substantial dangers from a central bank announcing its projections of the
future path of policy rates; I am therefore quite critical of the Federal Reserve’s lan-
guage in its post-FOMC statements from 2003 to 2006, when in e¤ect it announced
exactly what the policy action would be for the next several FOMC meetings. I also
argue that central banks should not announce their objective functions, in disagree-
ment with the view Lars Svensson has strongly advocated, and that central banksshould be wary about publishing too prominently their estimates of current and fu-
ture output gaps (the di¤erence between output and its potential).
On the other hand, there is one area in which central bank transparency, even at
central banks that announce an explicit, numerical, inﬂation target, does not go far
enough: many monetary policymakers are unwilling to honestly discuss that they do
care about output ﬂuctuations, a concern that I refer to as central banking’s ‘‘dirty
little secret.’’ By describing procedures for how the path and horizon of inﬂation tar-
gets would be modiﬁed in the face of large shocks, by emphasizing that monetary
policy will be just as vigilant in preventing inﬂation from falling too low as it is inpreventing it from becoming too high, and by indicating that expansionary policies
will be pursued when output falls very far below potential, central banks can increase
support for their policies and independence.
The ﬁnal two chapters in part I, both written with Arturo Estrella, my colleague at
the Federal Reserve Bank of New York when I was the director of research from
1994 to 1997, are quite a bit more technical than the other chapters in part I and in
the rest of the book. Ever since the monetarist counterrevolution, monetary aggre-
gates often have been seen as having a potentially valuable role in guiding monetary
policy. Experiments with monetary targeting, which are discussed later in chapters 8
and 10, put monetary aggregates at the center of the conduct of monetary policy,
while some central banks give a particularly prominent role to monetary aggregates,most notably the European Central Bank. Other central banks virtually ignore mon-
etary aggregates.34 Introduction to Part I

In chapter 6, written in 1996, Arturo and I examine whether monetary aggregates
contain useful information to guide monetary policy. We look at proposals for use of
these aggregates in monetary policy rules and perform empirical tests on the strength
and stability of the empirical relationships that those rules presuppose. More gener-
ally, we ask what role the aggregates can play if the approach to policy is more eclec-
tic. Our empirical results show that in the United States since 1979, the monetaryaggregates do not provide reliable information on the economy’s future course that
would be helpful in guiding monetary policy. Somewhat surprisingly, our results with
the German monetary aggregate M3 are hardly more favorable. Although these
results do not rule out that monetary aggregates cannot be used in some complicated
way as an information variable, the straightforward use of these aggregates for mon-
etary policy is not supported in countries that have reasonably low inﬂation. Mone-
tary aggregates thus are not usable as part of a strategy in these countries to increase
the transparency of monetary policy to the public and the markets. This is why I am
skeptical of the prominence given to monetary aggregates in the European Central
Bank’s monetary policy strategy.
Another piece of information that has been used widely by central banks to
guide the stance of monetary policy is the gap between realized unemployment
and NAIRU, the nonaccelerating inﬂation rate of unemployment. In simpler words,
NAIRU is the unemployment rate at which inﬂation is expected neither to increase
nor decrease. The NAIRU concept has come under serious attack in recent years,
particularly since 1995 when unemployment fell below 6 percent, which is what
many economists thought was a reasonable value for NAIRU, and yet inﬂation sub-
sequently did not accelerate, but instead actually fell. In chapter 7, which was written
for a conference on monetary policy rules organized by John Taylor in 1996, Arturo
Estrella and I rethink the NAIRU concept to examine whether it might have a usefulrole in monetary policy. We show that trying to drive the unemployment rate toward
NAIRU would lead to poor policy outcomes and, therefore, having any kind of
NAIRU target for monetary policy is inappropriate. On the other hand, NAIRU
can be useful in the conduct of monetary policy if it is deﬁned as a short-run, rather
than a long-run, construct, and we show how this can be done.
References
Friedman, Milton, and David Meiselman. 1963. ‘‘The Relative Stability of Monetary Velocity and the In-
vestment Multiplier.’’ In Stabilization Policies . Commission on Money and Credit, ed. (Upper Saddle
River, N.J.: Prentice Hall): 165–268.
Friedman, Milton, and Anna Jacobson Schwartz. 1963a. A Monetary History of the United States, 1867–
1960. Princeton, N.J.: Princeton University Press.
Friedman, Milton, and Anna Jacobson Schwartz. 1963b. ‘‘Money and Business Cycles.’’ Review of Eco-
nomics and Statistics , vol. 45, Supplement: 32–64.Introduction to Part I 35

Kearl, James R., and Frederic S. Mishkin. 1977. ‘‘Illiquidity, the Demand for Residential Housing, and
Monetary Policy.’’ Journal of Finance 37, no. 5 (December): 1571–1586.
Mishkin, Frederic S. 1976a. ‘‘Illiquidity, Consumer Durable Expenditure, and Monetary Policy.’’ Amer-
ican Economic Review 66, no. 4 (September): 642–654.
Mishkin, Frederic S. 1976b. ‘‘Household Liabilities and the Generalized Stock-Adjustment Model.’’ Re-
view of Economics and Statistics LVIII, no. 4, (November): 481–485.
Mishkin, Frederic S. 1976c. ‘‘Liquidity and the Role of Monetary Policy in Consumer Durable Demand.’’
New England Economic Review (November/December): 31–42.
Mishkin, Frederic S. 1977a. Illiquidity, the Demand for Consumer Durables, and Monetary Policy . Federal
Reserve Bank of Boston, Report 61. 1976 PhD thesis, MIT.
Mishkin, Frederic S. 1977b. ‘‘A Note on Short-Run Asset E¤ects on Household Saving and Consump-
tion.’’ American Economic Review no. 2 (March): 246–248.
Mishkin, Frederic S. 1977c. ‘‘What Depressed the Consumer? The Household Balance-Sheet and the
1973–75 Recession.’’ Brookings Paper on Economic Activity (1): 123–164.
Mishkin, Frederic S. 1978a. ‘‘Monetary Policy and Liquidity: Simulation Results.’’ Economic Inquiry 16,
no. 1 (January): 16–36.
Mishkin, Frederic S. 1978b. ‘‘The Household Balance-Sheet and the Great Depression.’’ Journal of Eco-
nomic History 38 (December): 918–937.36 Introduction to Part I

2What Should Central Banks Do?
Frederic S. Mishkin
2.1 Introduction
In the last twenty years, there has been substantial rethinking about how central
banks should do their job. This rethinking has led to major changes in how centralbanks operate, and we are now in an era in which central banks in many countries
throughout the world have had notable success—keeping inﬂation low, while their
economies experience rapid economic growth. In this chapter, I outline what we
think we have learned about how central banks should be set up to conduct mone-
tary policy and then apply these lessons to see if there is room for institutional im-
provement in the way the Federal Reserve operates.
The chapter begins by discussing seven guiding principles for central banks and
then uses these principles to outline what the role of central banks should be. This
framework is then used to see how the institutional features of the Fed measure up.I will take the view that despite the Fed’s extraordinarily successful performance in
recent years, we should not be complacent. Changes in the way the Fed is set up to
conduct its business may be needed to help ensure that the Fed continues to be as
successful in the future.
2.2 Guiding Principles for Central Banks
Recent theorizing in monetary economics suggests seven basic principles that can
serve as useful guides for central banks to help them achieve successful outcomes in
their conduct of monetary policy. These are:
/C15Price stability provides substantial beneﬁts;
/C15Fiscal policy should be aligned with monetary policy;
/C15Time inconsistency is a serious problem to be avoided;
/C15Monetary policy should be forward looking;

/C15Accountability is a basic principle of democracy;
/C15Monetary policy should be concerned about output as well as price ﬂuctuations;
and
/C15The most serious economic downturns are associated with ﬁnancial instability.
We will look at each of these principles in turn.
2.2.1 Price Stability Provides Substantial Benefits to the Economy
In recent years a growing consensus has emerged that price stability—a low and sta-
ble inﬂation rate—provides substantial beneﬁts to the economy. Price stability pre-
vents overinvestment in the ﬁnancial sector, which in a high-inﬂation environment
expands to proﬁtably act as a middleman to help individuals and businesses escape
some of the costs of inﬂation. 1Price stability lowers the uncertainty about relative
prices and the future price level, making it easier for ﬁrms and individuals to make
appropriate decisions, thereby increasing economic e‰ciency. 2Price stability also
lowers the distortions from the interaction of the tax system and inﬂation. 3
All of these beneﬁts of price stability suggest that low and stable inﬂation can in-
crease the level of resources productively employed in the economy, and might even
help increase the rate of economic growth. While time-series studies of individual
countries and cross-national comparisons of growth rates are not in total agreement,
there is a consensus that inﬂation is detrimental to economic growth, particularly
when inﬂation is at high levels. 4Therefore, both theory and evidence suggest that
monetary policy should focus on promoting price stability.
2.2.2 Align Fiscal Policy with Monetary Policy
One lesson from the ‘‘unpleasant monetarist arithmetic’’ discussed in Sargent and
Wallace (1981) and the recent literature on ﬁscal theories of the price level (Wood-
ford, 1994 and 1995) is that irresponsible ﬁscal policy may make it more di‰cult for
the monetary authorities to pursue price stability. Large government deﬁcits may put
pressure on the monetary authorities to monetize the debt, thereby producing rapid
money growth and inﬂation. Restaining the ﬁscal authorities from engaging in exces-
sive deﬁcit ﬁnancing thus aligns ﬁscal policy with monetary policy and makes it eas-
ier for the monetary authorities to keep inﬂation under control.
2.2.3 Time Inconsistency Is a Serious Problem to Be Avoided
One of the key problems facing monetary policymakers is the time-inconsistencyproblem described by Calvo (1978), Kydland and Prescott (1977), and Barro andGordon (1983). The time-inconsistency problem arises because there are incentives
for a policymaker to try to exploit the short-run tradeo¤ between employment and
inﬂation to pursue short-run employment objectives, even though the result is poor38 Chapter 2

long-run outcomes. Expansionary monetary policy will produce higher growth and
employment in the short-run. Therefore, policymakers will be tempted to pursue
this policy even though it will not produce higher growth and employment in the
long-run because economic agents adjust their wage and price expectations upward
to reﬂect the expansionary policy. Unfortunately, however, expansionary monetary
policy will lead to higher inﬂation in the long-run, with its negative consequencesfor the economy.
McCallum (1995) points out that the time-inconsistency problem by itself does not
imply that a central bank will pursue expansionary monetary policy that leads to
inﬂation. Simply by recognizing the problem that forward-looking expectations in
the wage- and price-setting process promotes a strategy of pursuing expansionary
monetary policy, central banks can decide not to play that game. From my ﬁrst-
hand experience as a central banker, I can testify that central bankers are very aware
of the time-inconsistency problem and are, indeed, extremely averse to falling into a
time-inconsistency trap. However, even if central bankers recognize the problem,
there still will be pressures on the central bank to pursue overly expansionary mone-
tary policy by politicians. Thus, overly expansionary monetary policy and inﬂationmay result, so that the time-inconsistency problem remains. The time-inconsistency
problem is just shifted back one step; its source is not in the central bank, but rather,
resides in the political process.
The time-inconsistency literature points out both why there will be pressures on
central banks to pursue overly expansionary monetary policy and why central banks
whose commitment to price stability is in doubt are more likely to experience higher
inﬂation. In order to prevent high inﬂation and the pursuit of a suboptimal monetary
policy, monetary policy institutions need to be designed in order to avoid the time-
inconsistency trap.
2.2.4 Monetary Policy Should Be Forward Looking
The existence of long lags from monetary policy actions to their intended e¤ects
on output and inﬂation suggests that monetary policy should be forward looking.
If policymakers wait until undesirable outcomes on inﬂation and output ﬂuctua-
tions actually arise, their policy actions are likely to be counterproductive. For exam-
ple, by waiting until inﬂation has already appeared before tightening monetary
policy, the monetary authorities will be too late; inﬂation expectations will already
be embedded into the wage- and price-setting process, creating an inﬂation mo-
mentum that will be hard to contain. Once the inﬂation process has gotten rolling,
the process of stopping it will be slower and costlier. Similarly, by waiting until theeconomy is already in recession, expansionary policy may kick in well after the econ-
omy has recovered, thus promoting unnecessary output ﬂuctuations and possible
inﬂation.What Should Central Banks Do? 39

To avoid these problems, monetary authorities must behave in a forward-looking
fashion and act preemptively. For example, assume that it takes two years for mon-
etary policy to have a signiﬁcant e¤ect on inﬂation. Under these circumstances, even
if inﬂation is quiescent currently (with an unchanged stance of monetary policy) and
policymakers forecast inﬂation to rise in two years time, they must act immediately
to head o¤ the inﬂationary surge.
2.2.5 Policymakers Should Be Accountable
A basic principle of democracy is that the public should have the right to control
the actions of the government: In other and more famous words, ‘‘The government
should be of the people, by the people and for the people.’’ Thus, the public in a de-
mocracy must have the capability to ‘‘throw the bums out’’ or punish incompetent
policymakers through other methods in order to control their actions. If policy-
makers cannot be removed from o‰ce or punished in some other way, this basic
principle of democracy is violated. In a democracy, government policymakers need
to be held accountable to the public.
A second reason why accountability of policymakers is important is that it helps
to promote e‰ciency in government. Making policymakers subject to punishment
makes it more likely that incompetent policymakers will be replaced by competent
ones and creates better incentives for policymakers to do their jobs well. Knowing
that they are subject to punishment when performance is poor, policymakers will
strive to get policy right. If policymakers are able to avoid accountability, then their
incentives to do a good job drop appreciably, making poor policy outcomes more
likely.
2.2.6 Monetary Policy Should Be Concerned with Output as well as Price Fluctuations
Price stability is a means to an end—a healthy economy—and should not be treated
as an end in itself. Thus, central bankers should not be obsessed with inﬂation con-
trol and become what Mervyn King (1997) has characterized as ‘‘inﬂation nutters.’’
Clearly, the public cares about output as well as inﬂation ﬂuctuations, and so the
objectives for a central bank in the context of a long-run strategy should not only
include minimizing inﬂation ﬂuctuations, but should also include minimizing output
ﬂuctuations. Objective functions with these characteristics have now become stan-
dard in the monetary economics literature, which focuses on the conduct of mone-
tary policy (e.g., see the papers in Taylor, 1999).
2.2.7 The Most Serious Economic Downturns Are Associated with Financial Instability
A reading of U.S. monetary history (Friedman and Schwartz, 1963, Bernanke, 1983,
and Mishkin, 1991) indicates that the most serious economic contractions in U.S.
history, including the Great Depression, have all been associated with ﬁnancial insta-40 Chapter 2

bility. Indeed, this literature suggests that ﬁnancial instability is a key reason for the
depth of these economic contractions. The recent ﬁnancial crises and depressions in
Mexico and East Asia also support this view (Mishkin, 1996, 1999a and Corsetti,
Pesenti, and Roubini, 1998). Preventing ﬁnancial instability is, therefore, crucial to
promoting a healthy economy and reducing output ﬂuctuations, an important objec-
tive for central banks, as we have seen above.
2.3 Implications for the Role of a Central Bank
Armed with these seven guiding principles, we can now look at what institutionalfeatures a central bank should have in conducting its operations. We derive the fol-
lowing implications/criteria for the role of a central bank:
/C15Price stability should be the overriding, long-run goal of monetary policy;
/C15An explicit nominal anchor should be adopted;
/C15A central bank should be goal dependent;
/C15A central bank should be instrument independent;
/C15A central bank should be accountable;
/C15A central bank should stress transparency and communication;
/C15A central bank should also have the goal of ﬁnancial stability.
2.3.1 Price Stability Should Be the Overriding, Long-Run Goal of Monetary Policy
Together, the ﬁrst three principles for monetary policy outlined above suggest that
the overriding, long-run goal of monetary policy should be price stability. A goal ofprice stability immediately follows from the beneﬁts of low and stable inﬂation,
which promote higher economic output. Furthermore, an institutional commitment
to price stability is one way to make time-inconsistency of monetary policy less
likely. An institutional commitment to the price stability goal provides a counter to
time-inconsistency because it makes it clear that the central bank must focus on the
long-run and thus resist the temptation to pursue short-run expansionary policies
that are inconsistent with the long-run, price stability goal.
The third principle, that ﬁscal policy should be aligned with monetary policy, pro-
vides another reason why price stability should be the overriding, long-run goal of
monetary policy. As McCallum (1990) has pointed out, ‘‘unpleasant monetarist
arithmetic’’ only arises if the ﬁscal authorities are the ﬁrst mover. In other words, ifthe ﬁscal authorities are the dominant player and can move ﬁrst—thus setting ﬁscal
policy exogenously, knowing that the monetary authorities will be forced to accom-
modate their policies to maintain the long-run government budget constraint—then
ﬁscal policy will determine the inﬂation rate. Indeed, this is the essence of the ﬁscalWhat Should Central Banks Do? 41

theory of the price level. On the other hand, as McCallum (1990) points out, if the
monetary authorities are the dominant player and move ﬁrst, then it will be ﬁscal
policy that will accommodate in order to satisfy the long-run government budget
constraint and monetary policy will determine the inﬂation rate. An institutional
commitment to price stability as the overriding, long-run goal, is just one way to en-
sure that monetary policy moves ﬁrst and dominates, forcing ﬁscal policy to alignwith monetary policy.
The sixth guiding principle, that output ﬂuctuations should also be a concern of
monetary policy, suggests that a fanatic pursuit of price stability could be problem-
atic because policymakers should see not only price ﬂuctuations, but also output
ﬂuctuations as undesirable. This is why the price stability goal should be seen as
overriding in the long-run but not in the short-run. As Lars Svensson (1999) states,
central banks should pursue what he calls ‘‘ﬂexible inﬂation targeting,’’ in which the
speed at which a central bank tries to get to price stability reﬂects their concerns
about output ﬂuctuations. The more heavily a central bank cares about output ﬂuc-
tuations, the more time it should take to return to price stability when it is not al-
ready there. However, because a ‘‘ﬂexible inﬂation targeter’’ always sets a long-termprice stability goal for inﬂation, the fact that a central bank cares about output ﬂuc-
tuations is entirely consistent with price stability as the long-run, overriding goal.
2.3.2 An Explicit Nominal Anchor Should Be Adopted
Although an institutional commitment to price stability helps solve time-inconsistencyand ﬁscal alignment problems, it does not go far enough because price stability is not
a clearly deﬁned concept. Typical deﬁnitions of price stability have many elements
in common with the commonly used legal deﬁnition of pornography in the United
States—you know it when you see it. Thus, constraints on ﬁscal policy and discre-tionary monetary policy to avoid inﬂation might end up being quite weak because
not everyone will agree on what price stability means in practice, providing both
monetary policymakers and politicians a loophole to avoid making tough decisions
to keep inﬂation under control. A solution to this problem, which supports the ﬁrst
three guiding principles, is to adopt an explicit nominal anchor that ties down exactly
what the commitment to price stability means.
There are several forms that an explicit nominal anchor can take. One is a com-
mitment to a ﬁxed exchange rate. For example, in 1991, Argentina established a cur-
rency board that required the central bank to exchange U.S. dollars for new pesos at
a ﬁxed exchange rate of one to one. A second nominal anchor is for the central bank
to have a money-growth target, as was the case in Germany. A third nominal anchoris for there to be an explicit numerical inﬂation goal as in inﬂation-targeting coun-
tries such as New Zealand, Canada, the United Kingdom, Australia, and Brazil,
among others. All these forms of explicit nominal anchors can help reduce the time-42 Chapter 2

inconsistency problem, as the success of countries using them in lowering and con-
trolling inﬂation demonstrates (Mishkin, 1999b). These nominal anchors also help
restrain ﬁscal policy and also are seen as an important beneﬁt of inﬂation targeting
in countries such as New Zealand and Canada (Mishkin and Posen, 1997, and Ber-
nanke, Laubach, Mishkin, and Posen, 1999).
One criticism of adopting an explicit nominal anchor, such as an inﬂation target, is
that it will necessarily result in too little emphasis on reducing output ﬂuctuations,
which is inconsistent with the guiding principle that monetary policy should be con-
cerned with output as well as price ﬂuctuations. However, this view is mistaken. In-
ﬂation targeting, as it has actually been practiced (Mishkin and Posen, 1997, and
Bernanke, Laubach, Mishkin, and Posen, 1999), has been quite ﬂexible and has not
led to larger output ﬂuctuations. Indeed, adoption of an inﬂation target can actually
make it easier for central banks to deal with negative shocks to the aggregate econ-
omy. Because a decline in aggregate demand also leads to lower-than-expected inﬂa-
tion, a central bank is able to respond with a monetary easing, without causing the
public to question its anti-inﬂationary resolve. Furthermore, inﬂation targeting can
make it less likely that deﬂation, a fall in the price level, would occur. There are par-ticularly valid reasons for fearing deﬂation in today’s world, including the possibility
that it might promote ﬁnancial instability and precipitate a severe economic contrac-
tion. Indeed, deﬂation has been associated with deep recessions or even depressions,
as in the 1930s, and the recent deﬂation in Japan has been one factor that has weak-
ened the ﬁnancial system and the economy. Targeting inﬂation rates of above zero,
as all inﬂation targeters have done, makes periods of deﬂation less likely. The evi-
dence on inﬂation expectations from surveys and interest rate levels suggests that
maintaining a target for inﬂation above zero (but not too far above) for an extended
period does not lead to instability in inﬂation expectations or to a decline in the cen-tral bank’s credibility.
2.3.3 Central Banks Should Be Goal Dependent
Although there is a strong rationale for the price stability goal and an explicit nomi-nal anchor, who should make the institutional commitment? Should the central bank
independently announce its commitment to the price stability goal or would it be
better to have this commitment be mandated by the government?
Here the distinction between goal independence and instrument independence
made by Debelle and Fischer (1994) and Fischer (1994) is quite useful. Goal indepen-
dence is the ability of the central bank to set its own goals for monetary policy, while
instrument independence is the ability of the central bank to independently set theinstruments of monetary policy to achieve the goals. The ﬁfth guiding principle, that
the public must be able to exercise control over government actions and that policy-
makers must be accountable, so basic to democracy, strongly suggests that the goalsWhat Should Central Banks Do? 43

of monetary policy should be set by the elected government. In other words, a central
bank should not be goal independent. The corollary of this view is that the institu-
tional commitment to price stability should come from the government in the form
of an explicit, legislated mandate for the central bank to pursue price stability as its
overriding, long-run goal.
Not only is the principle of a legislated mandate and goal dependence of the
central bank consistent with basic principles of democracy, but it has the further ad-
vantage that it is consistent with the second and third guiding principles—it makes
time-inconsistency less likely, while making alignment of ﬁscal policy with monetary
policy more likely. As we discussed above, the source of the time-inconsistency prob-
lem is more likely to be embedded in the political process than it is in the central
bank. Once politicians commit to the price stability goal by passing central bank leg-
islation with a price stability mandate, it becomes harder for them to put pressure on
the central bank to pursue short-run expansionary policies that are inconsistent
with the price stability goal. Furthermore, a government commitment to price stabil-
ity also is a commitment to making monetary policy dominant over ﬁscal policy,
ensuring a better alignment of ﬁscal policy with monetary policy.
An alternative way to solve time-inconsistency problems has been suggested by
Rogo¤ (1985): Grant both goal and instrument independence to a central bank and
then appoint conservative central bankers to run it, who put more weight on control-
ling inﬂation (relative to output) than does the general public. The result will be low
inﬂation, but at the cost of higher output variability than the public desires.
There are two problems with this solution. First, having ‘‘conservative’’ central
bankers impose di¤erent preferences from those of the public on the conduct of mon-
etary policy is inherently undemocratic. Basic democratic principles indicate that the
preferences of policymaking should be aligned with those of the society at large. Sec-ond, in the long run, a central bank cannot operate without the support of the public.
If the central bank is seen to be pursuing goals that are not what the public wants,
support for central bank independence is likely to erode. Thus appointment of ‘‘con-
servative’’ central bankers may not be stable in the long run and will not provide a
permanent solution to the time-inconsistency problem.
The same principles that suggest that the central bank should be goal dependent,
with the commitment to the price stability goal mandated by the government, also
suggest that the commitment to an explicit nominal anchor should be made by the
government. In the case of an exchange-rate target, the government should set the
target, as in Argentina, or in the case of an inﬂation target, the government should
set the numerical inﬂation goal. The fact that the government sets these targets sothat the central bank is goal dependent does not mean that the central bank should
be cut out of the decision-making process. Because the central bank has both prestige44 Chapter 2

and expertise in the conduct of monetary policy, governments will almost always be
better served by setting these targets in consultation with the central bank.
Although it is clear that the government should set the goal for the explicit nomi-
nal anchor in the long-run, it is more controversial whether it should set it in the
short-run or intermediate-run. If a government, for example, set a short-run inﬂation
or exchange rate target that was changed every month or every quarter, this couldeasily lead to time-inconsistency in which short-run objectives would dominate. In
many countries that target inﬂation, the Ministry of Finance, as the represen-
tative of the government, does set an annual inﬂation target; however, as docu-
mented in Bernanke, Laubach, Mishkin, and Posen (1999), the target rarely is
changed once price stability is achieved. Thus, even though (in theory) governments
could manipulate an annual inﬂation target to pursue short-run objectives, the trans-
parency of goal-setting leads to a long-run approach to setting inﬂation targets
even when it is done on an annual basis. The situation for the United States is even
more complicated. Because of our congressional system, the Treasury Secretary
is not the representative of Congress, in contrast to the Minister of Finance who
does represent parliament in a parliamentary system. Instead the Treasury Secretaryrepresents the executive branch. Thus, who represents the American government
in setting a short- or intermediate-term target for monetary policy is not clear-
cut. This problem is not as severe for setting the long-run goal of monetary policy,
which could be done by a congressional commission with representatives from
both the executive and legislative branches, as well as from the public and the cen-
tral bank. However, the di‰culties of delegating the setting of shorter run targets for
monetary policy in a congressional system may require that the central bank keep
this responsibility. 5
2.3.4 Central Banks Should Be Instrument Independent
Although the arguments above suggest that central banks should be goal dependent,
the guiding principles in the previous section provide a strong case that central banks
should be instrument independent. Allowing central banks to control the setting of
monetary policy instruments provides additional insulation from political pressures
to exploit short-run tradeo¤s between employment and inﬂation. Instrument inde-
pendence means that the central bank is better able to avoid the pursuit of time-
inconsistent policies in line with the third guiding principle.
The fourth guiding principle, that monetary policy needs to be forward looking in
order to take account of the long lags in the e¤ect of monetary policy on inﬂation,
provides another rationale for instrument independence. Instrument independenceinsulates the central bank from the myopia that is frequently a feature of the political
process arising from politicians’ concerns about getting elected in the near future.What Should Central Banks Do? 45

Thus, instrument independence makes it more likely that the central bank will be for-
ward looking and adequately allow for the long lags from monetary policy actions to
inﬂation in setting their policy instruments.
Recent evidence seems to support the conjecture that macroeconomic performance
is improved when central banks are more independent. When central banks in indus-
trialized countries are ranked from least legally independent to most legally indepen-dent, the inﬂation performance is found to be the best for countries with the most
independent central banks (see Alesina and Summers, 1993, Cukierman, 1992, and
Fischer, 1994, among others). However, there is some question whether causality
runs from central bank independence to low inﬂation or, rather, whether a third fac-
tor is involved, such as the general public’s preferences for low inﬂation that create
both central bank independence and low inﬂation (Posen, 1995).
The bottom line is that basic principles for monetary policy and democracy sug-
gest that central banks should have instrument but not goal independence. This
degree of independence for central banks is analogous to the relationship between
the U.S. military and the government during the successfully prosecuted Gulf War
in 1991. The military had instrument independence: It had complete control overthe prosecution of the war with little interference from the government (in contrast
to the less successfully waged Vietnam War). On the other hand, the military did
not have goal independence: It was the Commander in Chief, George Bush, who
made the decisions as to what the objectives and goals of the war would be.
2.3.5 Central Banks Should Be Accountable
The ﬁfth guiding principle, that policymakers should be accountable, indicates thatthe central bank should be subject to government and public scrutiny. One way of
ensuring accountability is to make the independence of the central bank subject tolegislative change by allowing the act that created the central bank to be modiﬁed
by legislation at any time. Another way is to mandate periodic reporting require-
ments to the government, for example, as was done in the Humphrey-Hawkins legis-
lation which requires the Chairman of the Federal Reserve to testify to Congress
twice a year.
The need for central banks to be accountable provides an additional reason why
central banks should have an explicit nominal anchor. If there is no explicit nominal
anchor, it is far less clear upon what criterion the central bank should be judged, and
thus it is harder to hold it accountable. On the other hand, with an explicit nominal
anchor, like a target for inﬂation or the exchange rate, the public and the politicians
have a clear-cut benchmark to assess the performance of the central bank. Thus, anexplicit nominal anchor enhances the accountability of the central bank. Indeed, with
an explicit nominal anchor, accountability can be enforced by making the central46 Chapter 2

bank governor subject to dismissal if he or she breaches the goals set by the govern-
ment, as is the case in New Zealand.
2.3.6 Central Banks Should Stress Transparency and Communication
Increased transparency of monetary policymaking is another important way to in-crease central bank accountability in line with the ﬁfth guiding principle. Centralbanks need to communicate clearly their monetary policy strategy in order to explain
their objectives and how they plan to achieve them. Each time they change their pol-
icy instruments, such as the interbank interest rate, they also need to clearly state the
decision and then explain the rationale for it. Transparency can be further increased
by publication of the central bank’s forecast and the minutes of the discussion of
monetary policy.
In addition, central banks need to pursue many outreach vehicles to communicate
with the public. These include the continual making of speeches to all elements of so-
ciety, more openness with the press and media, and the development of brochures
and reports that are accessible to the public. Particularly noteworthy in this regard
are the ‘‘Inﬂation Report’’ type documents initially developed by the Bank of En-gland and now emulated by many other central banks. These documents depart
from the usual dull-looking, formal reports of central banks to take on the best ele-
ments of textbook writing (fancy graphics, use of boxes) in order to better communi-
cate with the public.
Increasing transparency and accountability not only helps to align central banks
with democratic principles, and is thus worthy in its own right, but it also has bene-
ﬁts for the ability of central banks to conduct monetary policy successfully. Trans-
parency reduces the uncertainty about monetary policy, interest rates, and inﬂation,
thus making private-sector planning easier. Transparency and communication alsopromote a better public understanding of what central banks can do—promote price
stability which, as suggested by the ﬁrst guiding principle, has the potential to en-
hance economic growth in the long run—and what central banks cannot do—create
permanent increases in output and employment through expansionary policy. Better
public understanding of what central banks can and cannot do is then likely to help
generate more public support for monetary policy, which is focused on price stabil-
ity becoming the long-run, overriding goal.
Although central bankers ﬁnd their life to be a more comfortable one when they
are not accountable and can avoid intense public scrutiny, increased transparency
and accountability have important beneﬁts for central bankers, helping them to ad-
here to the ﬁrst ﬁve guiding principles outlined in the previous section. Because trans-parency and accountability can increase the public support for the price stability goal
and longer-term thinking on the part of the central bank, they can reduce politicalWhat Should Central Banks Do? 47

pressures on the central bank to pursue inﬂationary monetary policy and, thus, limit
the time-inconsistency problem, while generating more support for forward-looking
policy by the central bank. Also, greater transparency and communication can help
the central bank convince the public that ﬁscal policy needs to be aligned with mon-
etary policy.
In addition, transparency and accountability can increase support for indepen-
dence of the central bank. 6An instructive example is provided by the granting of
instrument independence to the Bank of England in May 1997. Prior to this date,
monetary-policy decisions in the United Kingdom were made by the government
(the Chancellor of the Exchequer) rather than by the Bank of England. When, on
May 6, 1997, the Chancellor of the Exchequer, Gordon Brown, announced the
granting of instrument independence to the Bank of England, giving it the power to
set the overnight interest rate, he made it particularly clear at the press conference
that, in his view, the action had been made possible by the increased transparency
and accountability of policy under the recently adopted inﬂation-targeting regime.
2.3.7 Central Banks Should Also Have a Financial Stability Goal
Because central banks should care about output ﬂuctuations (Principle 6) and the
most serious economic contractions arise when there is ﬁnancial instability (Principle
7), central banks also need to focus on preventing ﬁnancial instability. The primary
way that central banks prevent ﬁnancial instability is by acting as a lender of last re-
sort, that is, by supplying liquidity to the ﬁnancial system to keep a ﬁnancial crisis
from spinning out of control. Because acting as a lender of last resort, in e¤ect, pro-
vides a safety net for ﬁnancial institutions to whom the funds will be channeled, it
creates a moral hazard problem in which these institutions who are potential bor-
rowers have incentives to take on excessive risk, which can make ﬁnancial instabilitymore likely. Thus, central banks need to consider the tradeo¤ between the moral haz-
ard cost of the role as lender of last resort and the beneﬁt of preventing ﬁnancial
crises. Keeping moral hazard from getting out of hand indicates that central banks
should not perform the role of lender of last resort unless it is absolutely necessary;
and, therefore, this role should occur very infrequently.
Because lender-of-last-resort lending should be directed at providing funds to sol-
vent, but illiquid, ﬁnancial institutions and not to insolvent institutions, in order to
reduce incentives to take on too much risk by these institutions, the central bank
needs to have information regarding to whom it might have to extend loans when it
performs this role. One way for the central bank to get this information is for it to
have a supervisory role over these institutions. This is an argument for giving centralbanks a role in prudential supervision (see, e.g., Mishkin, 1992, and Bernanke, 2000).
In addition, a supervisory role for the central bank can help it obtain information
about whether a situation really is likely to lead to a ﬁnancial crisis and, thus,48 Chapter 2

requires a lender-of-last-resort intervention. Without this information, the central
bank may either intervene too frequently or fail to do so when it is really needed,
thus making ﬁnancial instability more likely. It is possible that central banks can ac-
quire the information they need from supervisory agencies which are separate from
the central bank, but some central bank o‰cials doubt this (see Peek, Rosengren,
and Tootell, 2000). Thus, there is an argument for the central bank to have a role inprudential supervision, but it is by no means clear-cut. Furthermore, there are argu-
ments against central bank involvement in prudential supervision because it may
cause a central bank to lose its focus on the price-stability objective.
2.4 A Federal Reserve Scorecard
Now that we have outlined what the role of a central bank should be, we can assess
how the institutional features of the Federal Reserve measure up. We provide an as-
sessment of whether the way the Fed is set up to conduct its operations is consistent
with each of the seven criteria discussed in the previous section.
2.4.1 Price Stability Should Be the Overriding, Long-Run Goal of Monetary Policy
Through their testimony and speeches, high o‰cials in the Federal Reserve System,
and especially Alan Greenspan, have made it quite clear that the overriding, long-run
goal for Fed monetary policy is price stability. However, there is no clear mandate
from the U.S. government that price stability should be a long-run, overriding goal.
The Humphrey-Hawkins Act passed in 1978, with the revealing title, ‘‘Full Employ-
ment and Balanced Growth Act,’’ stipulates that monetary policy should have goals
of full employment and economic growth, as well as price stability. It is true that
the Humphrey-Hawkins Act could be interpreted as allowing for price stability tobe the overriding, long-run goal because, as was indicated previously, price stability
is a means of promoting high economic growth and full employment in the long-run.
However, it is even easier to interpret the legislation as supporting an emphasis on
pursuit of full employment and economic growth in the short-run, which is inconsis-
tent with the pursuit of price stability. The lack of a clear mandate for price stability
can lead to the time-inconsistency problem in which political pressure is put on the
Fed to engage in expansionary policy to pursue short-run goals.
In contrast to the United States, many other countries now have legislation which
mandates price stability as the overriding, long-run goal of monetary policy, and
this is a growing trend. For example, a mandate for price stability as the overriding,
long-run goal for monetary policy was a requirement for entry into the EuropeanMonetary Union, and the Maastricht Treaty gives this mandate to the central bank-
ing system for the European Monetary Union, which is most accurately referred
to as the Eurosystem. 7This trend also has been evident even in emerging marketWhat Should Central Banks Do? 49

countries, where many central banks have had their mandate revised to focus on
price stability.
On the ﬁrst criterion of the need for an institutional commitment to price stability,
as the overriding long-run goal, the United States does not score well.
2.4.2 An Explicit Nominal Anchor Should Be Adopted
Not only has the U.S. government not committed to price stability as the overriding,
long-run goal, but also neither it nor the Fed has adopted an explicit nominal an-
chor. The actions and rhetoric of the Greenspan Fed have made it clear that it will
ﬁght to keep inﬂation from rising from the current level of around 2 percent, and it is
fair to characterize the Fed as having an implicit nominal anchor. Nonetheless, the
Federal Reserve has not come out and articulated an explicit goal for inﬂation and
has, instead, stated its commitment to price stability. This has been loosely deﬁned
by Alan Greenspan as a situation in which changes in the price level are not a major
consideration for businesses and households. At the present time, the public (and
maybe even members of the FOMC) have no idea of whether the Fed’s goal for in-
ﬂation is 1 percent, 2 percent, or possibly higher. I think it is fair to say that rightnow the nominal anchor in the United States is Alan Greenspan. The problem is
that this leaves some ambiguity as to what the Fed’s target is. Even more impor-
tantly, the existence of this implicit nominal anchor depends on personalities. Alan
Greenspan, despite his recent reappointment, will not be around forever. When he
steps down, will the public believe that there is su‰cient commitment to a nominal
anchor to keep inﬂation from appearing again?
On the criterion of having an explicit nominal anchor, the institutional set up of
the Fed also does not score well.
2.4.3 Central Banks Should Be Instrument Independent
The Federal Reserve has been set up to be far more independent than other gov-
ernment agencies in the United States. Members of the Board of Governors are
appointed by the government for 14-year terms, insulating them from political pres-
sure, while Reserve Bank presidents, who also sit on the FOMC, are appointed by
the boards of directors at each Reserve Bank and are not subject to Congressional
review. Even more important is that the Federal Reserve generates substantial prof-
its, on the order of $20 billion per year, most of which it returns to the U.S. Trea-
sury, so that it has its own revenue base and is not dependent on funds from the
government. Indeed, by law the Federal Reserve is exempt from General Account-
ing O‰ce (GAO) audits of deliberations, decisions, or actions on monetary policymatters.
Given its insulation from the political process and its ﬁnancial independence, it
should be no surprise that the Fed has complete control over setting its monetary50 Chapter 2

policy instruments. This has the beneﬁts of enabling the Fed to resist political pres-
sure to engage in time-inconsistent expansionary policy and to be forward-looking in
the setting of its policy instruments.
On the criteria of instrument independence the Fed scores well.
2.4.4 Central Banks Should Be Goal Dependent
We have already seen that independence can go too far. Instrument independence
is desirable but goal independence is problematic. The independence of the Fed—
described above—and the lack of a clear mandate from the government allows the
Fed to make the decisions on what the goals of its policies should be. Thus the Fed
has a high degree of goal independence. In some ways goal independence makes the
Fed’s job easier because it insulates it from political pressure, but it does have a
downside. The substantial goal independence of the Federal Reserve creates a fair
amount of tension in a democratic society because it allows an elite group to set the
goals of monetary policy. Indeed, recent criticism of the Federal Reserve may have
been prompted by the impression that the Federal Reserve, and particularly its
Chairman, has become too powerful.
The goal independence of the Federal Reserve should not be seen as total, how-
ever. Politicians do have the ability to inﬂuence the goals of the Fed because the
Congress can modify the Federal Reserve Act at any time. Also, the Fed has a great
interest in other legislation that a¤ects its operations. A case in point is the recent
Gramm-Bliley-Leach Financial Services Modernization Act, passed in 1999, which
had major implications for whether the Federal Reserve would continue to have
supervisory responsibilities over large banking organizations (which it continued to
keep). Furthermore, Congress can criticize the budget of the Fed for items that are
unrelated to monetary policy or foreign-exchange operations. As an example, in1996 Senators Dorgan and Reid called for Congress to exercise budgetary authority
over the nonmonetary activities of the Federal Reserve because they were concerned
that the Fed was too focused on ﬁghting inﬂation and not enough on reducing
unemployment.
As a comparison, the Eurosystem should be seen in some ways as more goal inde-
pendent than the Federal Reserve System and in other ways less. The Maastricht
Treaty speciﬁes that the overriding, long-run goal of the ECB is price stability, so
that the goal for the Eurosystem is more clearly speciﬁed than it is for the Federal
Reserve System. However, Maastricht did not specify exactly what this price stability
means so the Eurosystem has deﬁned the quantitative goal for monetary policy, an
inﬂation rate between 0 and 2 percent. From this perspective, the Federal ReserveSystem is slightly less goal dependent than the Eurosystem. On the other hand, the
Eurosystem’s statutes cannot be changed by legislation, but only by alterations to
the Maastricht Treaty. From this perspective, the Eurosystem is much less goalWhat Should Central Banks Do? 51

dependent than the Federal Reserve System because its statutes are speciﬁed in a
treaty and thus are far harder to change than statutes that are embedded in legislation.
As the examples above indicate, the Federal Reserve is not goal dependent, but we
should not take this view too far. Thus, on the goal dependence criteria, the Fed’s
score is mixed.
2.4.5 Central Banks Should Be Accountable
Closely related to goal dependence is the accountability of the central bank to meet
its goals. There are formal accountability mechanisms for the Fed. For example, the
Chairman of the Board of Governors has been required to testify twice a year to
Congress about the conduct of monetary policy under the Humphrey-Hawkins legis-
lation. Also, as we have seen, the Fed is subject to punitive actions by the Congress
if it so chooses, either by amending the Federal Reserve Act or through passage of
other legislation that a¤ects the Fed.
On these grounds the Federal Reserve System is more accountable than the Euro-
system. As we have seen, the Eurosystem’s statutes cannot be modiﬁed by legislation
but, rather, requires amendment to a treaty, a far more di‰cult process. Moreover,although the President of the European Central Bank is required to testify once a
year to the European Parliament, this requirement may not guarantee su‰cient over-
sight of the Eurosystem’s policies. Since the European Parliament is currently signiﬁ-
cantly less powerful than the national parliaments of the countries that make up the
Monetary Union, scrutiny by that organization would not inﬂuence the Eurosystem’s
behavior as strongly as would oversight by a more powerful body, such as a consor-
tium of national parliaments or the individual parliaments themselves. It is not clear
to whom the Eurosystem would be accountable.
However, the absence of an explicit nominal anchor means that there is no bench-
mark against which the public or Congress can measure the performance of the Fed-
eral Reserve System. In contrast, the Eurosystem has outlined its price-stability goal
of inﬂation between 0 and 2 percent, so there is a predetermined criterion to judge its
performance. Thus, despite the requirement that the Fed testify to Congress, the ac-
countability of the Fed is not very strong. The Federal Reserve is able to obscure
what its strategy and goals are and has indeed done this in the past. This leaves
open the possibility that there could be a political backlash against a ‘‘high-handed’’
Federal Reserve that could have adverse consequences on its independence and abil-
ity to successfully conduct monetary policy in the future.
On the accountability criteria, the Fed also does not score very well.
2.4.6 Central Banks Should Stress Transparency and Communication
In recent years, the Fed has come a long way on the transparency and communica-
tion front. In the past, the Fed had a reputation for not only being unclear about its
goals and strategy, but for keeping markets in the dark about its setting of policy52 Chapter 2

instruments. This has changed dramatically in recent years. Starting in 1994, the Fed
began to announce its policy actions after every FOMC meeting. It then moved in
1999 to announcing the bias in the direction of future moves in the federal funds
rate, which caused some confusion, and so replaced this announcement at the begin-
ning of this year with one that indicates the balance of risks for the future—whether
toward higher inﬂation or toward a weaker economy. Fed o‰cials also have beenmore active in articulating the strategy of monetary policy, its need to be preemptive,
and the importance of the pursuit of price stability.
Despite improved transparency and communication, the lack of explicit goals has
meant that Fed transparency is still much less than at many other central banks. In
contrast to central banks that have adopted inﬂation targeting, the Fed produces
nothing like an ‘‘Inﬂation Report’’ in which it clearly lays out in plain English the
strategy for monetary policy and how well the central bank has been doing. One con-
sequence of the weakness of Fed transparency and communication is that the public
debate on monetary policy in the United States still has a tendency to focus on short-
run considerations, as reﬂected in politicians’ focus on ‘‘jobs, jobs, jobs’’ when dis-
cussing monetary policy. This focus on short-run considerations is substantially lessin countries where central banks use communication vehicles such as ‘‘Inﬂation
Reports’’ to refocus the public debate on longer-run considerations such as price
stability.
It is interesting to contrast the way public debate is conducted with what has
occurred in Canada, which has adopted an inﬂation-targeting regime with high
transparency and accountability. In 1996, the president of the Canadian Economic
Association made a speech criticizing the Bank of Canada for pursuing monetary
policy that (he claimed) was too contractionary. His speech sparked o¤ a widespread
public debate. Instead of degenerating into calls for the immediate expansion ofmonetary policy with little reference to the long-run consequences of such a policy
change, the debate was channeled into a substantive discussion over what should be
the appropriate target for inﬂation, with both the Bank and its critics obliged to
make explicit their assumptions and estimates of the costs and beneﬁts of di¤erent
levels of inﬂation. Indeed, the debate and the Bank of Canada’s record and respon-
siveness led to increased support for the Bank of Canada, with the result that criti-
cism of the Bank and its conduct of monetary policy was not a major issue in the
1997 elections as it had been during the 1993 elections.
On the transparency and communication criteria, the Fed’s score is mixed, al-
though it has been improving over time.
2.4.7 Central Banks Should Also Have a Financial Stability Goal
Here the Fed’s performance has been very strong. The Greenspan Fed has made it
very clear that it will act decisively to prevent ﬁnancial crises and has done so not
only with words but with actions. The Fed’s actions immediately after the OctoberWhat Should Central Banks Do? 53

19, 1987, stock market crash are a textbook case of how a lender-of-last-resort role
can be performed brilliantly. 8The Fed’s action was immediate, with Greenspan
announcing right before the market opened on October 20 of the Federal Reserve
System’s ‘‘readiness to serve as a source of liquidity to support the economic and
ﬁnancial system,’’ which operated to decrease uncertainty in the marketplace.
Reserves were injected into the system, but once the crisis was over, they were with-drawn. Not only was a crisis averted so that the business cycle expansion continued,
but also the inﬂationary consequences of this exercise of the lender-of-last-resort role
were small. The 75 basis point decrease in the federal funds rate in the Fall of 1998
immediately after the Russian ﬁnancial crisis and the near-failure of Long-Term
Capital Management, which roiled U.S. capital markets, also illustrated the Fed’s
commitment to act decisively to prevent ﬁnancial instability. The aftermath was an
economy that continued to expand, with inﬂation staying at the 2 percent level.
On the criteria of the commitment to the ﬁnancial stability goal, the Fed’s score is
excellent.
2.5 Conclusion: What Should the Fed Do?
Our scorecard for the Fed indicates that although the institutional set up of the Fedscores well on some criteria, there is room for improvement in others. But, is there a
need for the Fed as an institution to change? The Fed’s performance in recent years
has been extraordinary. It has been able to bring down inﬂation in the United States
to the 2 percent level, which can reasonably be characterized as being consistent with
price stability, while the economy has been experiencing the longest business cycle
expansion in U.S. history, with very high rates of economic growth. As my son likes
to say, ‘‘It don’t get no better than this.’’ The natural question then arises: If it ain’tbroke, why ﬁx it?
However, our Fed scorecard suggests that we do need to consider institutional
improvements in the way the central bank operates. The absence of an institutional
commitment to price stability, along with weak Fed transparency, which stems from
the absence of an explicit nominal anchor, leaves the Fed open to political pressure
to pursue short-run objectives (i.e., job creation). This might lead to time-inconsistent
expansionary policy and would produce inﬂation. In the past, after a successful pe-
riod of low inﬂation, the Federal Reserve has ‘‘fallen o¤ the wagon’’ and reverted
to inﬂationary monetary policy—the 1970s are one example—and, without an ex-
plicit nominal anchor, this could certainly happen again in the future.
Indeed, the most serious problem with the Fed’s institutional framework and the
way it currently operates is the strong dependence on the preferences, skills, and
trustworthiness of the individuals in charge of the central bank. Yes, the Fed under
Alan Greenspan has been doing a great job, and so the Fed’s prestige and credibility54 Chapter 2

with the public have risen accordingly. But the Fed’s leadership will eventually
change, and there is no guarantee that the new leadership will be committed to
the same approach. Nor is there any guarantee that the relatively good working rela-
tionship that now exists between the Fed and the executive branch will continue. In a
di¤erent economic or political environment—and considering the possibility for a
backlash against the Fed’s lack of accountability—the Fed might face far strongerattacks on its independence and increased pressure to engage in over-expansionary
policies, further raising the possibility that inﬂation will shoot up again.
So what should the Fed do? The answer is that the Fed should continue in the
direction that it has already begun to increase its transparency and accountability.
First, it should advocate a change in its mandate to put price stability as the overrid-
ing, long-run goal of monetary policy. Second, it should advocate that the price-
stability goal should be made explicit, with a numerical long-run inﬂation goal.
Government involvement in setting this explicit goal would be highly desirable, mak-
ing the Fed goal independent, which should help retain public support for the Fed’s
instrument independence. Third, the Fed should produce an ‘‘Inﬂation Report’’ type
of document that clearly explains its strategy for monetary policy and how well it hasbeen doing in achieving its announced inﬂation goal.
The outcome of these changes is that the Fed would be moving to an inﬂation-
targeting regime of the type described in our book, which has been recently published
by the Princeton University Press (Bernanke, Laubach, Mishkin, and Posen, 1999).
Clearly, the U.S. Congress and executive branch need to play an important role in
encouraging the Fed to move toward inﬂation targeting. A detailed outline of a pro-
posal for how this might be done can be found in our book. I leave you to read it on
your own. Otherwise, you will be subjected to another full lecture.
Notes
This chapter was prepared for the Homer Jones Lecture, Federal Reserve Bank of St. Louis, March 30,
2000. I thank Dan Thornton, Bill Poole, Lars Svensson, and the participants in the Macro Lunch at Co-lumbia University for their helpful comments. Any views expressed in this chapter are those of the author
only and not those of Columbia University or the National Bureau of Economic Research.
1. E.g., see English (1996).
2. E.g., see Briault (1995).3. E.g., see Fischer (1994) and Feldstein (1997).4. See the survey in Andersen and Gruen (1995).5. For further discussion of who should set an inﬂation target in the United States, see Bernanke, Lau-
bach, Mishkin, and Posen (1999).
6. Blinder (1998) also makes a strong case for increased transparency and accountability of central banks.7. The Eurosystem currently is made up of the eleven national central banks of the countries that have
joined EMU, with the European Central Bank (ECB) at the center having a role similar to that of theBoard of Governors in the Federal Reserve System.
8. Indeed, this example appears in my textbook (Mishkin, 1998).What Should Central Banks Do? 55

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ence Series on Public Policy (December 1995), pp. 1–46.What Should Central Banks Do? 57

3The Transmission Mechanism and the Role of Asset Prices in
Monetary Policy
Frederic S. Mishkin
Although the instrument set by monetary policymakers is typically an interest rate,
monetary policy a¤ects the economy through other asset prices besides those on
debt instruments. Thus, movements in these other asset prices are likely to play an
important role in how monetary policy is conducted. But what is the appropriate
role for them to play? This chapter answers this question by ﬁrst surveying the mon-
etary transmission mechanism through these other asset prices and then discussing
their role in the conduct of monetary policy.
3.1 Asset Prices in the Monetary Transmission Mechanism
In the literature on the monetary transmission mechanism, there are three categoriesof asset prices besides those on debt instruments that are viewed as providing impor-
tant channels through which monetary policy a¤ects the economy: 1) stock market
prices, 2) real estate prices, and 3) exchange rates.
3.1.1 Stock Market Prices
Fluctuations of the stock market, which are inﬂuenced by monetary policy, have
important impacts on the aggregate economy. Transmission mechanisms involving
the stock market are of three types: 1) stock market e¤ects on investment, 2) ﬁrm
balance-sheet e¤ects, 3) household liquidity e¤ects and 4) household wealth e¤ects.
Stock Market Effects on Investment Tobin’s q-theory (Tobin, 1969) provides an
important mechanism for how movements in stock prices can a¤ect the economy.
Tobin’s q is deﬁned as the market value of ﬁrms divided by the replacement cost of
capital. If q is high, the market price of ﬁrms is high relative to the replacement cost
of capital, and new plant and equipment capital is cheap relative to the market
value of ﬁrms. Companies can then issue stock and get a high price for it relative tothe cost of the facilities and equipment they are buying. Investment spending will rise

because ﬁrms can now buy a lot of new investment goods with only a small issue of
stock.
The crux of the Tobin q-model is that a link exists between stock prices and invest-
ment spending. But how might monetary policy a¤ect stock prices? Expansionary
monetary policy which lowers interest rates makes bonds less attractive relative to
stocks and results in increased demand for stocks that bids up their price. Combiningthis with the fact that higher stock prices will lead to higher investment spending,
leads to the following transmission mechanism of monetary policy which can be
described by the following schematic:
M")P
s")q") I") Y"ð 3:1Ț
where M "indicates expansionary monetary policy, leading to a rise in stock prices
ðPs"Ț, which raises q ðq"Ț, which raises investment ðI"Ț, thereby leading to an in-
crease in aggregate demand and a rise in output ðY"Ț.
Another way of getting to this same mechanism is by recognizing that ﬁrms not
only ﬁnance investment through bonds but also by issuing equities (common stock).
When stock prices rise, it now becomes cheaper for ﬁrms to ﬁnance their investment
because each share that is issued produces more funds. Thus a rise in stock pricesleads to increased investment spending. Therefore, an alternative description of this
mechanism is that expansionary monetary policy ðM"Țwhich raises stock prices
ðP
s"Țlowers the cost of capital ðc#Țand so causes investment and output to rise
ðI";Y"Ț.1In other words:
M")Ps")c#) I")Y"ð 3:10Ț
Firm Balance-Sheet Effects The presence of asymmetric information problems in
credit markets provides another transmission mechanism for monetary policy that
operates through stock prices. This mechanism is often referred to as the ‘‘credit
view,’’ and it works through the e¤ect of stock prices on ﬁrms’s balance sheets so it
is also referred to as the balance-sheet channel. 2
The lower the net worth of business ﬁrms, the more severe is the adverse selection
and moral hazard problems in lending to these ﬁrms. Lower net worth means that
there is e¤ectively less collateral for the loans made to a ﬁrm and so potential losses
from adverse selection are higher. A decline in net worth, which increases the severity
of the adverse selection problem, thus leads to decreased lending to ﬁnance invest-
ment spending. The lower net worth of business ﬁrms also increases the moral hazard
problem because it means that owners of ﬁrms have a lower equity stake, giving
them greater incentives to engage in risky investment projects. Since taking on riskier
investment projects makes it more likely that lenders will not be paid back, a de-crease in net worth leads to a decrease in lending and hence in investment spending.60 Chapter 3

Monetary policy can a¤ect ﬁrms’ balance sheets and aggregate spending through
the following mechanism. Expansionary monetary policy ðM"Ț, which causes a rise
in stock prices ðPs"Țalong lines described earlier, raises the new worth of ﬁrms
ðNW "Ț, which reduces adverse selection and moral hazard problems, and so leads
to higher lending ðL"Ț. Higher lending then leads to higher investment spending
ðI"Țand aggregate spending ðY"Ț. This leads to the following schematic for this
balance-sheet channel of monetary transmission.
M") Ps") NW ") L") I")Y"ð 3:2Ț
Household Liquidity Effects Another way of looking at balance-sheet channels of
monetary transmission is to look at household balance sheets, particularly liquidity
e¤ects on consumer durable and housing expenditures. 3In the liquidity e¤ects view,
balance sheet e¤ects work through their impact on consumer’s desire to spend rather
than on lender’s desire to lend. Because of asymmetric information about their qual-
ity, consumer durables and housing are very illiquid assets. If, as a result of a bad
income shock, consumers needed to sell their consumer durables or housing to raise
money, they would expect a big loss because they could not get the full value of theseassets in a distress sale. In contrast, if consumers held ﬁnancial assets (such as money
in the bank, stocks, or bonds), they could easily sell them quickly for their full mar-
ket value and raise the cash. Hence if consumers expect a higher likelihood of ﬁnding
themselves in ﬁnancial distress, they would rather be holding fewer illiquid consumer
durable or housing assets and more liquid ﬁnancial assets.
A consumer’s balance sheet should be an important inﬂuence on his or her esti-
mate of the likelihood of su¤ering ﬁnancial distress. Speciﬁcally, when consumers
have a large amount of ﬁnancial assets relative to their debts, their estimate of the
probability of ﬁnancial distress is low, and they will be more willing to purchase con-sumer durables or housing. When stock prices rise, the value of ﬁnancial assets rises
as well; consumer durable expenditure will also rise because consumers have a more
secure ﬁnancial position and a lower estimate of the likelihood of su¤ering ﬁnancial
distress. This leads to another transmission mechanism for monetary policy, operat-
ing through the link between money and stock prices:
M") P
s") Financial Assets ")
Likelihood of Financial Distress #) Cd";H")Y"ð 3:3Ț
where C d"indicates a rise in consumer durable expenditure and H "a rise in resi-
dential housing spending.
Household Wealth Effects Another balance-sheet channel operating through the con-
sumer involves household wealth e¤ects. Modigliani’s life cycle model states thatThe Transmission Mechanism and the Role of Asset Prices 61

consumption is determined by the lifetime resources of consumers. An important
component of consumers’ lifetime resources is their ﬁnancial wealth, a major compo-
nent of which is common stocks. Thus expansionary monetary policy which raises
stock prices, raises the value of household wealth, thereby increasing the lifetime
resources of consumers, which causes consumption to rise. This produces the follow-
ing transmission mechanism:
M")Ps")W") C") Y"ð 3:4Ț
where W "and C "indicate household wealth and consumption rises. Research has
found this transmission mechanism to be quite strong in the United States, but the
size of the wealth e¤ect is still controversial. 4
3.1.2 Real Estate Prices
Another set of asset prices that play an important role in the monetary transmission
mechanism are real estate prices. Real estate prices can a¤ect aggregate demand
through three routes: 1) direct e¤ects on housing expenditure, 2) household wealth,
and 3) bank balance sheets.
Direct Effects on Housing Expenditure Monetary expansion ðM"Ț, which lowers inter-
est rates, lowers the cost of ﬁnancing housing and so increases their price ðPh"Ț.
With a higher price of housing relative to its construction cost, construction ﬁrms
ﬁnd it more proﬁtable to build housing, and thus housing expenditure will rise ðH"Ț
and so aggregate demand will rise ðY"Ț.5This transmission mechanism is then
described by the following schematic.
M")Ph") H")Y"ð 3:5Ț
Household Wealth Effects Housing prices are an important component of household
wealth, which as we have seen, a¤ects consumption spending. Hence, expansionary
monetary policy ðM"Ț, which raises housing prices ðPh"Ț, also raises household
wealth ðW"Ț, which raises consumption spending ðC"Țand aggregate demand
ðY"Ț: i.e.,
M")Ph") W") C") Y"ð 3:6Ț
Bank Balance Sheets The credit view of the monetary transmission mechanism sug-
gests that banks play a special role in the ﬁnancial system because they are especially
well suited to solve asymmetric information problems in credit markets. Certain
borrowers will then not have access to the credit markets unless they borrow from
banks. 6Banks engage in a substantial amount of real estate lending, in which the
value of the real estate acts as collateral. If real estate prices rise as a result of mone-62 Chapter 3

tary expansion, then banks’ loan losses will decrease, which increases their bank cap-
ital. Higher bank capital then allows banks to engage in more lending, and because
banks are special, with many customers dependent on them, investment and aggre-
gate demand will rise. The bank balance-sheet channel thus can be described as
follows:
M") Pr") NW b")L") I") Y"ð 3:7Ț
where expansionary monetary policy ðM"Ț, which raises real estate prices ðPr"Ț,
raises bank capital ðNW b"Țand causes bank lending to rise ðL"Ț, thereby causing
investment and output to rise (I "and Y ").
When the opposite happens and real estate prices fall, this transmission mechanism
has often been described as a ‘‘capital crunch’’ and was operational in the United
States in the early 1990s (Bernanke and Lown, 1991) and has been an important
source of stagnation in Japan in recent years.
3.1.3 Exchange Rates
There are two primary mechanisms that operate through exchange rates: 1) exchangerate e¤ects on net exports and 2) exchange rate e¤ects on balance sheets.
Exchange Rate Effects on Net Exports With the growing internationalization of econo-
mies throughout the world and the advent of ﬂexible exchange rates, more attention
has been paid to how monetary policy a¤ects exchange rates, which in turn a¤ect net
exports and aggregate output. Clearly this channel does not operate if a country has
a ﬁxed exchange rate, and the more open an economy is, the stronger is this channel.
Expansionary monetary policy a¤ects exchange rates because when it leads to a
fall in domestic interest rates, deposits denominated in domestic currency become
less attractive relative to deposits denominated in foreign currencies. As a result, the
value of domestic deposits relative to other currency deposits falls, and the exchange
rate depreciates (denoted by E #).7The lower value of the domestic currency makes
domestic goods cheaper than foreign goods, thereby causing a rise in net exports
ðNX"Țand hence in aggregate spending ðY"Ț. The schematic for the monetary
transmission mechanism that operates through the exchange rate is:
M") E#) NX") Y"ð 3:8Ț
Exchange Rate Effects on Balance Sheets Fluctuations in exchange rates also can
have important e¤ects on aggregate demand by a¤ecting the balance sheets of both
ﬁnancial and nonﬁnancial ﬁrms when a substantial amount of domestic debt is
denominated in foreign currency, which is the case for most emerging market coun-tries. In these countries, monetary expansion often can have a negative impact onThe Transmission Mechanism and the Role of Asset Prices 63

aggregate demand if it leads to a depreciation of the exchange rate through the fol-
lowing mechanism.
With debt contracts denominated in foreign currency, expansionary monetary
policy ðM"Țwhich leads to a depreciation or devaluation of the domestic currency
ðE#Țresults in the debt burden of domestic nonﬁnancial ﬁrms to increase. Since
assets are typically denominated in domestic currency and so do not increase invalue, there is a resulting decline in net worth ðNW #Ț. This deterioration in balance
sheets then increases adverse selection and moral hazard problems, which as dis-
cussed above, leads to a decline in lending ðL#Ț, a decline in investment ðI#Țand
hence in economic activity ðY#Ț. The schematic for this transmission mechanism is
as follows:
M")E#) NW #) L#) I#)Y#ð 3:9Ț
This mechanism was very important in the recent ﬁnancial crises in Mexico and East
Asia. 8For example, this mechanism was particularly strong in Indonesia, the worst
hit of all the crisis countries, which saw the value of its currency decline by over 75
percent, thus increasing the rupiah value of foreign-denominated debt by a factor of
four. Even a healthy ﬁrm is likely to be driven into insolvency by such a shock if ithad a signiﬁcant amount of foreign-denominated debt, and then no one will lend to it
even if it has productive investment opportunities.
A second mechanism through which an exchange rate depreciation can lead to a
decline in aggregate demand in emerging markets operates through deterioration of
bank balance sheets. For example, in Mexico and the East Asian countries, banks
and many other ﬁnancial institutions had many liabilities denominated in foreign
currency, which increased sharply in value when a depreciation occurred. On the
other hand, the problems of ﬁrms and households meant that they were unable to
pay o¤ their debt, also resulting in loan losses on the asset side of ﬁnancial institu-
tions’ balance sheets. The result was that banks’ and other ﬁnancial institutions’ bal-
ance sheets were squeezed from both the assets and liabilities side. Moreover, manyof these institutions’ foreign-currency denominated debt was very short term, so that
the sharp increase in the value of this debt led to liquidity problems because this debt
needed to be paid back quickly. The result of the further deterioration in banks’ and
other ﬁnancial institutions’ balance sheets and their weakened capital base is that
they cut back lending. In the case of Indonesia, these forces were severe enough to
cause a banking panic in which numerous banks were forced to go out of business.
The e¤ect of depreciations on bank balance sheets implies that expansionary mon-
etary policy ðM"Țmay actually be contractionary in emerging market countries by
causing bank balance sheets to deteriorate ðNW
b#Ț, and bank lending to fall ðL#Ț,
which then causes investment and aggregate output to fall (I #and Y #): i.e.,64 Chapter 3

M") E#) NW b#) L#) I#) Y#ð 3:10Ț
It is important to note that the possible contractionary e¤ects from expansionary
monetary policy operating through exchange rate e¤ects on balance sheets only op-
erate if the economy has a substantial amount of debt denominated in foreign cur-
rency. These mechanisms are thus rarely important in industrialized countries whose
debt is typically denominated in domestic currency, but they can be very importantin emerging market countries whose debt structure may be entirely di¤erent, with
much of the debt denominated in foreign currency.
3.2 The Role of Asset Prices in Monetary Policy
The survey in the previous section suggests that monetary policy works not just
through its direct e¤ects on interest rates, but also through its e¤ects on other asset
prices. Since other asset prices are an important element of the monetary transmis-
sion mechanism, how can monetary policymakers incorporate movements of these
asset prices into their decisions about the conduct of monetary policy?
In looking at the role of asset prices in monetary policy, it is worth separating the
discussion into how central banks might respond to exchange rates and how they
might respond to ﬂuctuations in stock market and real estate prices.
3.2.1 Exchange Rates
The asset price that typically receives the most attention in discussions of monetarypolicy is the exchange rate. Central banks clearly care about the value of the domes-
tic currency for several reasons. Changes in the exchange rate can have a major im-
pact on inﬂation, particularly in small, open economies. For example, depreciations
lead to a rise in inﬂation as a result of the pass-through from higher import pricesand greater demand for net exports, as discussed in the previous section. In addition,
the public and politicians pay attention to the exchange rate and this puts pressure on
the central bank to alter monetary policy. An appreciation of the domestic currency
can make domestic businesses uncompetitive, while a depreciation is often seen as a
failure of the central bank, as has recently been the case for the European Central
Bank, which has been blamed, I think unfairly, for the euro’s decline.
Emerging market countries, quite correctly, have an even greater concern about
exchange rate movements. Not only can a real appreciation make domestic indus-
tries less competitive, but it can lead to large current account deﬁcits which might
make the country more vulnerable to currency crisis if capital inﬂows turn to out-
ﬂows. Depreciations in emerging market countries are particularly dangerous becausethey can be contractionary, as described in the previous section, and can trigger a ﬁ-
nancial crisis along the lines suggested in Mishkin (1996, 1999a).The Transmission Mechanism and the Role of Asset Prices 65

Concern about exchange rate ﬂuctuations might lead countries to choose to peg
their exchange rates to that of another country. In other work, I have discussed the
pros and cons of pegging exchange rates as a monetary policy strategy and I will not
discuss this issue further. 9However, if a country decides that it wants to have its own
independent monetary policy, then with open capital markets it has to allow the ex-
change rate to ﬂuctuate. However, the fact that exchange rate ﬂuctuations are a ma-jor concern in so many countries raises the danger that monetary policy may put too
much focus on limiting exchange rate movements. This indeed was a problem for Is-
rael in the early stages of its inﬂation targeting regime. As part of this regime, Israel
had an intermediate target of an exchange rate band around a crawling peg, whose
rate of crawl was set in a forward-looking manner by deriving it from the inﬂation
target for the coming year. Even though the Bank of Israel downplayed the exchange
rate target relative to the inﬂation target over time, it did slow the Bank’s e¤ort to
win support for disinﬂation and lowering of the inﬂation targets (e.g., see Bernanke,
Laubach, Mishkin and Posen, 1999).
The second problem from a focus on limiting exchange rate ﬂuctuations is that it
can induce the wrong policy response when a country is faced with real shocks suchas a terms of trade shock. Two graphic examples occurred in New Zealand and Chile
in the late 1990s.
Because of the direct impact of exchange rates on inﬂation, the Reserve Bank of
New Zealand tended to focus on the exchange rate as an indicator of the monetary
policy stance. By early 1997, the Reserve Bank institutionalized this focus by adopt-
ing as its primary indicator of monetary policy a Monetary Conditions Index (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¤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¤set the upward pressure on inﬂation. However, the
o¤setting e¤ects of interest rates and exchange rates on inﬂation depend on the na-
ture of the shocks to the exchange rates. If the exchange rate depreciation comes
from portfolio considerations, then it does lead to higher inﬂation and the optimal
response is an interest rate rise. However, if the reason for the exchange rate depreci-
ation is a real shock such as a negative terms of trade shock which decreases the de-
mand for a country’s exports, then the situation is entirely di¤erent. The negative
terms of trade shock reduces aggregate demand and is thus likely to be deﬂationary.
The correct interest rate response is then a decline in interest rates, not a rise as the
MCI suggests.
With the negative terms of trade shock in 1997, the adoption of the MCI in 1997
led to exactly the wrong monetary policy response to the East Asian crisis. With de-
preciation setting in after the crisis began in July 1997 after the devaluation of the66 Chapter 3

Thai baht, the MCI began a sharp decline, indicating that the Reserve Bank needed
to raise interest rates, which it did by over 200 basis points. The result was very tight
monetary policy, with the overnight cash rate exceeding 9% by June of 1998. Because
the depreciation was due to a substantial, negative terms of trade shock which
decreased aggregate demand, the tightening of monetary policy, not surprisingly,
led to a severe recession and an undershoot of the inﬂation target range with actualdeﬂation occurring in 1999. 10The Reserve Bank of New Zealand did eventually re-
alize its mistake and reversed course, sharply lowering interest rates beginning in July
1998 after the economy had entered a recession, but by then it was too late. It also
recognized the problems with using an MCI as an indicator of monetary policy and
abandoned it in 1999. Now the Reserve Bank operates monetary policy in a more
conventional way, using the overnight cash rate as its policy instrument, with far
less emphasis on the exchange rate in its monetary policy decisions.
Chile, which also adopted inﬂation targeting in the early 1990s, also included a
focus on limiting exchange rate ﬂuctuations by having an exchange rate band with a
crawling peg which was (loosely) tied to lagged domestic inﬂation. 11This focus on
the exchange rate induced a serious policy mistake in 1998 because the central bankwas afraid it might lose credibility in the face of the ﬁnancial turmoil if it allowed the
exchange rate to depreciate after what had taken place in ﬁnancial markets after the
East Asian crisis and the Russian meltdown. Thus instead of easing monetary policy
in the face of the negative terms of trade shock, the central bank raised interest rates
sharply and even narrowed its exchange rate band. In hindsight, these decisions ap-
pear to have been a mistake: the inﬂation target was undershot and the economy
entered a recession for the ﬁrst time in the 1990s. With this outcome, the central
bank came under strong criticism for the ﬁrst time since it had adopted its inﬂation
targeting regime in 1990, weakening support for the independence of the centralbank and its inﬂation targeting regime. During 1999, the central bank did reverse
course, easing monetary policy by lowering interest rates and allowing the peso to
decline.
The contrast of the experience of New Zealand and Chile during this period with
that of Australia, another small open economy with an inﬂation targeting regime, is
striking. Prior to adoption of their inﬂation targeting regime in 1994, the Reserve
Bank of Australia had adopted a policy of allowing the exchange rate to ﬂuctuate
without interference, particularly if the source of the exchange rate change was a
real shock, like a terms of trade shock. Thus when faced with the devaluation in
Thailand in July 1997, the Reserve Bank recognized that it would face a substantial
negative terms of trade shock because of the large component of its foreign tradeconducted with the Asian region and thus decided that it would not ﬁght the depre-
ciation of the Australian dollar that would inevitably result. 12Thus in contrast to
New Zealand, it immediately lowered the overnight cash rate by 50 basis points toThe Transmission Mechanism and the Role of Asset Prices 67

5% and kept it near this level until the end of 1998, when it was lowered again by
another 25 basis points.
Indeed, the adoption of the inﬂation targeting regime probably helped the Reserve
Bank of Australia to be even more aggressive in its easing in response to the East
Asian crisis and helps explain why their response was so rapid. The Reserve Bank
was able to make clear that easing was exactly what inﬂation targeting called for inorder to prevent an undershooting of the target, so that the easing was unlikely to
have an adverse e¤ect on inﬂation expectations. The outcome of the Reserve Bank’s
policy actions was extremely favorable. In contrast to New Zealand and Chile, real
output growth remained strong throughout this period. Furthermore, there were no
negative consequences for inﬂation despite the substantial depreciation of the Austra-
lian dollar against the U.S. dollar by close to 20%: inﬂation remained under control,
actually falling during this period to end up slightly under the target range of 2 to
3%.
The analysis above and the recent experiences of countries like New Zealand,
Chile and Australia strongly suggest that central banks’ concerns about the exchange
rate is not a reason for them to stop keeping their eyes on the inﬂation ball.
Is a focus on achieving the inﬂation goal inconsistent with central banks paying
some attention to the exchange rate? Of course not. As we have seen in the previous
section, an important transmission mechanism for monetary policy is the exchange
rate and its level has important e¤ects on inﬂation and aggregate demand depending
on the nature of the shocks, particularly in small, open economies. Therefore, central
banks will closely monitor exchange rate developments and factor them into its deci-
sions on setting monetary policy instruments. A depreciation of the exchange rate
due to portfolio shocks like terms of trade shocks requires a tightening of monetary
policy in order to keep inﬂation from rising. On the other hand, a depreciation whenthere is a negative terms of trade shock requires a di¤erent response, an easing of
monetary policy as Australia did in 1997.
Does the avoidance of a target for the exchange rate imply a policy of benign
neglect of exchange rates? This issue is particularly relevant for emerging market
countries as is emphasized in Mishkin (2000) and Mishkin and Savastano (2001).
For the reasons discussed earlier, emerging market countries with a lot of foreign-
denominated debt may not be able to a¤ord sharp depreciations of their currencies,
which can destroy balance sheets and trigger a sharp fall in aggregate demand.
Central banks in these countries may thus have to smooth ‘‘excessive’’ exchange
rate ﬂuctuations, while making it clear to the public that they will not preclude the
exchange rate from reaching its market-determined level over longer horizons.The stated rationale for exchange rate smoothing is similar to that of interest-rate
smoothing, which is practiced by most central banks, even those engaged in inﬂation
targeting: the policy is not aimed at resisting market-determined movements in an68 Chapter 3

asset price, but at mitigating potentially destabilizing e¤ects of abrupt changes in
that price.
3.2.2 Stock and Real Estate Prices
With the bursting of the stock market and real estate bubble in Japan at the begin-ning of the 1990s and the recent stock market boom (and partial reversal) in theUnited States, there has been a growing debate about how the monetary authorities
might best react to stock market and real estate ﬂuctuations. 13This section will
argue that the reaction to these asset prices raises similar issues to the reaction to
exchange rate ﬂuctuations. Improved economic performance will result if the policy
response depends on the nature of the shocks, while the central bank is not perceived
as having a target for any asset price, whether it is an exchange rate, or stock market
or real estate prices.
The discussion of the monetary transmission mechanism in the previous section
indicates that real estate and stock price movement do have an important impact on
aggregate demand and thus must be followed closely to evaluate the stance of mone-
tary policy. Indeed, with a standard loss function in which the central bank mini-mizes a weighted average of squared deviations of inﬂation from its target level and
output from potential output, optimal monetary policy will react to changes in real
estate and stock market prices. However, depending on the nature of the shock to
these prices, and depending on whether the shock is considered to be temporary or
permanent, the optimal response of monetary policy would di¤er. Thus, just as tar-
gets for exchange rates would be problematic, so too would targets for real estate and
stock prices.
But this still begs the question of whether monetary authorities can improve their
performance by trying to prick asset price bubbles, because subsequent collapses ofthese asset prices might be highly damaging to the economy, as they were in Japan
in the 1990s. Cecchetti, Genburg, Lipsky and Wadhwani (1999), for example, argue
that central banks should at times target asset prices in order to stop bubbles from
getting too far out of hand. However, there are serious ﬂaws in their argument. First
is that it is very hard for monetary authorities to identify that a bubble has actually
developed. To assume that they can is to assume that the monetary authorities have
better information and predictive ability than the private sector. If the central bank
has no informational advantage, and if it knows that a bubble has developed that
will eventually crash, then the market knows this too and then the bubble would un-
ravel and thus would be unlikely to develop. Without an informational advantage,
the central bank is as likely to mispredict the presence of a bubble as the private mar-ket and thus will frequently be mistaken, thus frequently pursuing the wrong mone-
tary policy. Cecchetti, Genburg, Lipski and Wadhwani (1999) ﬁnd favorable results
in their simulations when the central bank conducts policy to prick an asset priceThe Transmission Mechanism and the Role of Asset Prices 69

bubble because they assume that the central bank knows the bubble is in progress.
This assumption is highly dubious because it is hard to believe that the central bank
has this kind of informational advantage over private markets. Indeed, the view that
government o‰cials know better than the markets has been proved wrong over and
over again.
A second problem with the central bank targeting stock prices is that it is likely to
make the central bank look foolish. The linkage between monetary policy and stock
prices, although an important part of the transmission mechanism, is still neverthe-
less a weak one. Most ﬂuctuations in stock prices occur for reasons unrelated to
monetary policy, either reﬂecting real fundamentals or animal spirits. The loose link
between monetary policy and stock prices therefore means that the ability of the cen-
tral bank to control stock prices is very limited. Thus, if the central bank indicates
that it wants stock prices to change in a particular direction, it is likely to ﬁnd that
stock prices may move in the opposite direction, thus making the central bank look
inept. Recall that when Alan Greenspan made his speech in 1997 suggesting that the
stock market might be exhibiting ‘‘irrational exuberance,’’ the Dow Jones average
was around 6,500. This didn’t stop the market from rising, with the Dow subse-quently climbing to above 11,000.
An additional problem with targeting asset prices is that it may weaken support
for a central bank because it looks like it is trying to control too many elements of
the economy. Part of the recent successes of central banks throughout the world has
been that they have narrowed their focus and have more actively communicated
what they can and cannot do. Speciﬁcally, central banks have argued that they are
less capable of managing short-run business cycle ﬂuctuation and should therefore
focus more on price stability as their primary goal. A key element of the success of
the Bundesbank’s monetary targeting regime was that it did not focus on short-runoutput ﬂuctuation in setting its monetary policy instruments. 14This communication
strategy for the Bundesbank has been very successful, as pointed out in Bernanke,
Laubach, Mishkin and Posen (1999), and has been adopted as a key element in inﬂa-
tion targeting, a monetary regime that has been gaining in popularity in recent years.
By narrowing their focus, central banks in recent years have been able to increase
public support for their independence. 15Extending their focus to asset prices has
the potential to weaken public support for central banks and may even cause the
public to worry that the central bank is too powerful, having undue inﬂuence over
all aspects of the economy.
3.3 Conclusions
The discussion in this chapter shows that other asset prices, and not just interestrates, are important elements of the monetary transmission mechanism. This pro-70 Chapter 3

vides a rationale for why monetary authorities pay a lot of attention to these other
asset prices in the conduct of monetary policy. However, this chapter has also argued
that targeting other asset prices, whether they are exchange rates, real estate or stock
market prices, is likely to worsen the performance of monetary policy. This is be-
cause the response of monetary policy to asset price ﬂuctuations depends on the
nature of the shocks to asset prices and the degree of permanence of the shocks.Furthermore, targeting asset prices is likely to erode support for the independence
of central banks because control of these asset prices is beyond central banks’
capabilities.
Notes
Prepared for the Oesterrische Nationalbank conference on ‘‘The Monetary Transmission Mechanism,’’
November 9, 2001. The views expressed herein are those of the authors and not necessarily those of theNational Bureau of Economic Research.
1. See Bosworth (1975) and Hayashi (1982) for a demonstration that this alternative description of the link
between stock prices and investment is equivalent to the Tobin’s q-approach.
2. For surveys on the credit view, see Bernanke and Gertler (1995), Cecchetti (1995), Hubbard (1995,
2001) and Bernake, Gertler and Gilchrist (1999).
3. See Mishkin (1976, 1977).4. See Modigliani (1971) and Lettau, Ludvigson and Steindel (2002).5. This model of housing expenditure is really a variant of Tobin’s q-theory in which q for housing invest-
ment is the price of housing relative to its replacement cost. For a recent empirical analysis of a model ofthis type, see McCarthy and Peach (2002).
6. See Kashyap and Stein (1994) and Gertler and Gilchrist (1994).7. In the literature, a depreciation of the currency is typically denoted as e ", but I have used the notation
E#because I think it is more intuitive.
8. For example, see Mishkin (1996, 1999a).9. See Mishkin (1999b) and Mishkin and Savastano (2001).10. The terms of trade shock, however, was not the only negative shock the New Zealand economy faced
during that period. Its farm sector experienced a severe drought which also hurt the economy. Thus, a mis-take in monetary policy was not the only source of the recession. Bad luck played a role too. See Drew andOrr (1999) and Brash (2000).
11. See Landerretche, Morande ´and Schmidt-Hebbel (1999), and Mishkin and Savastano (2001).
12. See MacFarlane (1999) and Stevens (1999).13. For example, see Cecchetti, Genburg, Lipsky and Wadwani (1999) and Bernanke and Gertler (1999).14. See Bernanke, Laubach, Mishkin and Posen (1999).15. See Mishkin (1999b) and Bernanke, Laubach, Mishkin and Posen (1999).
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4The Role of Output Stabilization in the Conduct of Monetary Policy
Frederic S. Mishkin
4.1 Introduction
In recent years, central banks have increased their focus on price stability, so much
so that price stability could be characterized as the central bank mantra. However,the public, politicians and central banks also care about the business cycle. What
role does this suggest output stabilization should have in the conduct of monetary
policy?
Because standard formulations of the objectives of monetary policy indicate that
monetary policy aim at minimizing inﬂation and output ﬂuctuations, the seemingly
obvious answer is that monetary policy which is optimal focuses on output as well
as inﬂation ﬂuctuations. Indeed, the famous Taylor rule suggests exactly this, indicat-
ing that the monetary policy authorities should set their interest-rate instrument so
that it reacts to deviations of output from its potential as well as to deviations of in-ﬂation from its target. However, this chapter will argue that this answer is unlikely to
be the correct one.
The chapter makes the following arguments:
1. Too great a focus on output ﬂuctuations may produce undesirable outcomes:
greater ﬂuctuations of output and inﬂation around their targets.
2. On the other hand, monetary policy that targets inﬂation is likely to produce
better outcomes for both output and inﬂation ﬂuctuations.
3. In addition, language which stresses output goals can make a central bank’s
communication strategy less e¤ective and can, thereby, weaken monetary policy
credibility.
4. A communication strategy that, instead, focuses on the control of inﬂation, is
likely to make it easier for the monetary policy authorities to focus on the long run,
thereby enhancing monetary policy credibility.
The fact that, in practice, it may be extremely di‰cult to obtain accurate measures of
the output gap, the di¤erence of actual from potential output, provides one rationale

for the ﬁrst two arguments. However, the ﬁrst two and the remaining arguments are
valid even if accurate measures of the output gap could be obtained. This analysis
then leads to the following conclusion: despite monetary policy makers’ concerns
about the business cycle, they will be far more successful in reducing output and in-
ﬂation ﬂuctuations if they focus less directly on output stabilization and more on
inﬂation stabilization. However, the fact that monetary policy makers downplay theimportance of output in their operating procedure does not mean that they are un-
concerned about output ﬂuctuations, and there are ways for them to communicate
this e¤ectively.
4.2 Output Fluctuations and the Setting of Monetary Policy Instruments in a Simple
Canonical Model
To clarify the discussion of the role of output ﬂuctuations in the setting of monetary
policy instruments, I will make use of a simple, canonical model outlined in Svensson
(1997). Despite this model’s simplicity, it does capture the basic framework that is
often used in monetary policy analysis. Furthermore, more complicated models andthose with more forward-looking behaviour such as the dynamic new Keynesian
model in Clarida et al. (1999) yield similar conclusions to those outlined here. 1The
canonical model comprises an aggregate supply curve in which the change in inﬂa-
tion is a¤ected by the output gap with a 1-period (1-year) lag:
p
t¼pt/C01țgyt/C01țet ð4:1Ț
and an aggregate demand curve in which the output gap is a function of the past out-
put gap to reﬂect persistence and to the real interest rate, again with a 1-period
(1-year) lag:
yt¼ryt/C01/C0fðii/C01/C0pt/C01Țțht ð4:2Ț
where pt¼pt/C0pt/C01is the inﬂation rate at time t(with ptthe log of the price level),
ytis the output gap (the log of the actual to potential output), itis the nominal inter-
est rate, and etand htare i.i.d. (independent and identically distributed) aggregate
supply and demand shocks, respectively.
Optimal monetary policy involves setting the interest rate for each period to mini-
mize the intertemporal loss function:
EtXy
t¼tdt/C0tLt ð4:3Ț
where d<1 is the authorities’ discount rate and where the period-by-period loss
function is76 Chapter 4

Lt¼ðpt/C0p?Ț2
2țly2
t
2ð4:4Ț
The optimal setting of the interest rate is then a ‘‘Taylor rule,’’
it¼ptțb1ðpt/C0p?Țțb2yt ð4:5Ț
in which the interest rate responds to both the inﬂation gap, pt/C0p?, and the output
gap, yt.
This simple model illustrates several important points. First, this model indicates
that monetary policy should focus on output ﬂuctuations for two reasons. Even if
l¼0 so that the monetary authority does not care about output ﬂuctuations and so
can be characterized as an ‘‘inﬂation nutter’’ (King 1996), the b2coe‰cient on the
output gap in the Taylor rule will still be positive. This is because the output gapenters the aggregate supply curve in (4.1) and, therefore, helps to forecast future
inﬂation. Thus, optimal monetary policy, even if the focus is solely on hitting an in-
ﬂation target and not at all on output ﬂuctuations, still reacts to the state of the busi-
ness cycle, as reﬂected in the output gap y
t. Another reason for monetary policy
focusing on output ﬂuctuations arises when minimizing output ﬂuctuations is impor-
tant to the monetary authority so that l>0. Then, the b2coe‰cient will be even
larger. Indeed, case studies of the behaviour of monetary authorities who pursue in-
ﬂation targeting described in Bernanke et al. (1999) do suggest that they care about
output ﬂuctuations which, of course, makes sense because the general public surely
cares about the trade-o¤ between output and inﬂation ﬂuctuations.
Instead of characterizing optimal monetary policy with what Svensson (1999) has
called an ‘‘instrument rule’’ like the Taylor rule in (4.5) above, optimal monetary
policy can be described by a ‘‘target rule’’ in which the setting of forecasted variables
relative to a target is speciﬁed. In the case of l¼0 in the simple model here, Svens-
son (1997) has shown that setting the optimal setting of the interest rate according
to (4.5) is equivalent to setting the interest rate so that the following target rule is
followed:
Etptț2¼p?ð4:6Ț
In other words, the monetary policy instrument is set so as to attain the inﬂation tar-
get over the policy horizon, which, in this model, is two periods (years) ahead. Ifl>0, so that monetary policy makers are also concerned abut output ﬂuctuations,
then the interest rate instrument is also set according to (4.5), which is equivalent to
following a target rule in which the approach to the inﬂation target is more gradual,
i.e.,
E
tptț2/C0p?¼cðEtptț1/C0p?Țð 4:7ȚThe Role of Output Stabilization 77

Svensson (1997) calls this type of policy reaction ‘‘ﬂexible inﬂation targeting,’’ and
the evidence discussed in Bernanke et al. (1999) suggests that it is a realistic approx-
imation of what inﬂation-targeting countries do in practice.
In the simple model outlined here, the instrument rule in (4.5) is equivalent to the
target rules in (4.6) if l¼0, or in (7) if l>0. Output ﬂuctuations inﬂuence the set-
ting of the monetary policy instrument for either of two reasons. First, output ﬂuctu-ations matter because they a¤ect the forecast of future inﬂation, even if policy
makers do not care about minimizing output ﬂuctuations in their objectives ðl¼0Ț.
Indeed, in this canonical model, the only way that policy makers can control inﬂa-
tion is by manipulating the output gap. Second, output ﬂuctuations a¤ect the setting
of the monetary policy instrument because policy makers do care about minimizing
output ﬂuctuations ðl>0Ț, and so it is optimal to approach the inﬂation target more
slowly. Hence either the instrument rule or the target rule leads to the obvious con-
clusion that monetary policy should be ‘‘activist,’’ i.e., it should respond actively to
deviations of output from its potential.
4.3 Criticisms of the Canonical Model and Its Elements
Although the canonical model produces important insights, it can be criticized on thegrounds that the world is not as simple as it suggests. If other variables a¤ect the ag-
gregate demand or supply equations, then the Taylor rule in (4.5) will no longer be
optimal, while the target rules in (4.6) or (4.7) will. This is a key reason why Svensson
and others take the position that target rules have inherent advantages over instru-
ment rules. As argued by Bernanke et al. (1999) and Mishkin (1999), target rules
also have important advantages in communicating with the public, an issue we will
return to in section 4.4.
The world is also complicated by the fact that it may be quite di‰cult to measure
the output gap, y
t. There are two reasons why measuring the output gap is so di‰-
cult. The ﬁrst is that it is hard to measure potential output and the second is that it is
not at all clear what is the proper theoretical concept of the output gap.
4.3.1 Measuring Potential Output Is Hard to Do
One measurement problem occurs because monetary policy authorities have to esti-mate the output gap with real-time data, i.e., data that is available at the time they
set the policy instrument. GDP data is frequently revised substantially and this is one
reason why output gaps are mismeasured in real time. Even more important: it is
notoriously hard to know what potential GDP actually is without hindsight. For ex-ample, it was not until the 1980s that policy makers recognized that potential GDP
growth had slowed markedly after 1973. Orphanides (2001) shows that the errors in78 Chapter 4

measures of output gaps have been very large in the postwar period, while Orpha-
nides (1998) shows that the use of real-time data might lead to such inaccurate esti-
mates that active monetary policy which reacts strongly to output ﬂuctuations
actually increases economic instability. Indeed, Orphanides (2002) argues that the
reason for the Federal Reserve’s poor performance during the 1970s was notthat it
was unconcerned with inﬂation, but rather that it was too activist, i.e., it had a largeweight on output gaps in its Taylor-rule reaction function. Orphanides’ work thus
indicates that even though monetary policy that is set optimally should react actively
to the output gap if it were correctly estimated, too large a focus on the output ﬂuc-
tuations actually leads to worse economic outcomes.
4.3.2 What Is the Proper Concept of the Output Gap?
A second measurement problem occurs because conceptually the ytthat belongs
in the aggregate supply curve in (4.1) is not at all clear and may be quite di¤erent
from conventionally measured output gaps. Clarida et al. (1999) point out that new
Keynesian aggregate supply curves should have ytspeciﬁed as a marginal cost mea-
sure rather than an output gap and they ﬁnd that the marginal cost measure has sub-stantially di¤erent movements and timing than the conventionally measured output
gap. McCallum and Nelson (2000) and McCallum (2001) argue that conventionally
measured output gaps which estimate the gap as deviations from a trend di¤er sub-
stantially from more theoretically grounded measures based on the output level that
would prevail in the absence of nominal price stickiness. They ﬁnd that monetary
policy rules that react to conventional output gap measures produce excessive vola-
tility of output and inﬂation.
Empirical evidence also questions the usefulness of relying on the output gap to
forecast inﬂation (Atkenson and Ohanian 2001). Estrella and Mishkin (1999) alsoﬁnd that Taylor rules which are based on conventional output gaps do not take suf-
ﬁcient account of other factors a¤ecting the inﬂation process and would have led to
monetary policy which was far too tight in the last half of the 1990s. Conventional
views of the output gap suggested that the Federal Reserve should have tightened
monetary policy considerably in the late 1990s as the unemployment rate fell well be-
low 6%, the level below which most economists at the time thought would lead to
accelerating inﬂation. Alan Greenspan, the chairman of the Federal Reserve, resisted
this view because his reading of the data did not suggest inﬂationary pressures in the
economy. The result was that the Federal Reserve kept interest rates low, thus help-
ing to promote the longest business cycle expansion in US history, along with a de-
cline in inﬂation to levels that are consistent with price stability.
One way of characterizing the success of the Greenspan Federal Reserve in the
1990s is that it operated more from the perspective of the target rule in (4.7) ratherThe Role of Output Stabilization 79

than from the instrument rule in (4.5). The Greenspan Federal Reserve recognized
that standard measures of potential output gap were possibly inaccurate and that
measures of the output gap were probably overestimated. The Federal Reserve was
thus more cautious in relying on output gap models and, instead, concentrated on
developments on the inﬂation front in its conduct of policy. As a result, it was unwill-
ing to reign in a rapidly growing economy if it was not leading to a rise in inﬂation.In other words, instead of focusing on output gaps, the Federal Reserve kept its fo-
cus on the inﬂation ball, and this was a key factor in its success in the late 1990s.
4.4 Communicating the Policy Process
The analysis above suggests that, because output gaps are hard to measure, too great
a focus on output ﬂuctuations in the setting of monetary policy instruments is un-
desirable because it is likely to lead to greater inﬂation and output variability. Focus-
ing on output ﬂuctuations can be undesirable for another reason: it can make the
communication process of the monetary authorities less e¤ective, which can also
lead to worse economic outcomes. Indeed, even if output gaps could be measured ac-curately, it still might be undesirable for the monetary authorities to focus on output
ﬂuctuations in setting monetary policy because of the harm it would do to the com-
munication process. The argument for a de-emphasis on the discussion of output sta-
bilization in communicating monetary policy rests on the beneﬁts it provides in terms
of a focus on the long run, enhancing monetary policy credibility and simplifying
communication and transparency. This does not mean that central banks will not in-
dicate to the public that they care about output ﬂuctuations, but they can do so in
the context of outlining how they will pursue inﬂation stabilization.
4.4.1 Long-Run Focus
The optimizing framework in section 4.3 assumes that the monetary authorities are
able to avoid the time-inconsistency problem and can commit either to target rules
or to instrument rules. This framework does involve the monetary authorities taking
account of both output and inﬂation ﬂuctuations in their objective function, but rules
out exploitation of short-run trade-o¤s between output growth and inﬂation, which
is the crux of the time-inconsistency problem. As emphasized in Mishkin (1999,
2000), the source of the time-inconsistency problem is rarely inside the central bank
because central bankers understand that trying to exploit short-run trade-o¤s will
only produce worse long-run outcomes. However, the time-inconsistency problem is
highly relevant to the conduct of central banking because politicians have incentivesto pursue short-run interests and put political pressure on central banks to exploit the
short-run trade-o¤ between output and inﬂation, thereby resulting in overly expan-
sionary monetary policy.80 Chapter 4

Thus an important issue is how can monetary authorities minimize the time-
inconsistency problem? A successful communication strategy is a key part of the
answer. To avoid political pressures to pursue short-run trade-o¤s, central banks
need to focus the debate on what a central bank can do in the long run—control
inﬂation—rather than what it cannot do on a sustainable basis—raise economic
growth through expansionary monetary policy. A focus on output ﬂuctuations in dis-cussing the conduct of monetary policy is likely to make it harder to achieve this ob-
jective. When monetary authorities explain their monetary policy actions by referring
to the need to moderate swings in output growth, the political debate about mone-
tary policy is likely to focus on short-run issues, such as whether the central bank is
doing enough to create jobs and lower unemployment, or whether its policies are
anti-growth. Indeed, in the past, the political debate has frequently taken on these
features in the USA.
To focus the political debate on longer-run issues, central banks have used several
communication strategies. The Bundesbank before the creation of the EMU (when it
had its own independent monetary policy) couched the discussion of monetary policy
in terms of monetary aggregate targets, and it was considered to be one of the mostsuccessful central banks in the world. A key feature of the German monetary target-
ing regime was that the calculation of the monetary target ranges was a very public
exercise that focused on long-run issues (Bernanke and Mishkin 1992; Laubach
and Posen 1997; Mishkin and Posen 1997). First, a numerical inﬂation goal was
prominently featured in the setting of the target ranges. Then, with estimates of po-
tential output growth and velocity trends, a quantity-equation framework was used
to back out target growth rates for the monetary aggregates. An important feature
of this calculation was that potential GDP trends were used rather than actual
GDP, thus reﬂecting the Bundesbank’s articulated position that it should focus onlong-run considerations, particularly price stability, rather than on short-run output
ﬂuctuations.
Central banks in countries that have adopted inﬂation targeting also put a lot of
e¤ort into focusing the public on long-run goals of monetary policy, as documented
by Bernanke et al. (1999). Instead of articulating monetary policy in terms of an in-
strument rule and potential reactions to output ﬂuctuations, monetary policy is dis-
cussed in the context of a target rule like (4.7) in which achievement of the inﬂation
goal is emphasized. Particularly noteworthy in this regard are the publication of In-
ﬂation Reports . These documents explain to the general public the long-run goals and
limitations of monetary policy, the rationale for inﬂation targets and how monetary
policy has to be forward looking to achieve these targets. They and other communi-cations of the central bank, including speeches, testimony to the legislature and even
glossy brochures, have been able to shift the debate on monetary policy away from a
focus on short-run job creation to longer-run considerations.The Role of Output Stabilization 81

A remarkable episode in Canada in the aftermath of a speech in 1996 by the pres-
ident of the Canadian Economic Association, Fortin (1996), discussed in Mishkin
(1999) and Bernanke et al. (1999), illustrates how successful such a strategy can be
in shifting the public debate away from a short-run focus. The speech criticized the
Bank of Canada for pursuing overly contractionary monetary policy and it sparked
o¤ a widespread public debate. What was remarkable was that the communicationstrategy embodied in the inﬂation-targeting regime was able to channel the debate
into a substantive discussion over what should be the appropriate target of inﬂation,
with the Bank defending its 1–3% target range, while Fortin ended up advocating
a 2–4% range. This debate, which involved discussion of the costs and beneﬁts of
di¤erent levels of inﬂation, thus became focused on the long-run goals of monetary
policy, which is exactly where such a debate should be focused for the time-
inconsistency problem to be avoided.
4.4.2 Credibility
A second problem with discussing monetary policy in terms of its reaction to outputﬂuctuations is that it can have undesirable consequences for central bank credibility.A focus on output ﬂuctuations may lead economic agents to believe that the mone-
tary authorities will try to eliminate any decline in output below potential. As a re-
sult, it is more likely that workers and ﬁrms will raise wages and prices because they
know that the monetary authorities are likely to accommodate these rises by pursu-
ing expansionary policy to prevent unemployment from developing. The result is that
a self-fulﬁlling equilibrium can occur in which wages and prices rise, then monetary
policy accommodates this rise, and this leads to further rises in wages and prices, and
so on, thus leading to a new equilibrium with higher inﬂation without a reduction in
output ﬂuctuations. Chari et al. (1998) have described this bad equilibrium as an ‘‘ex-pectation trap.’’ 2Discussing monetary policy objectives in terms of output ﬂuctua-
tions can thus lead to a loss of inﬂation-ﬁghting credibility for the central bank,
with the result that the inﬂation-output ﬂuctuations trade-o¤ worsens.
4.4.3 Simplifying Communication and Transparency
A third problem with monetary authorities discussing output ﬂuctuations in the con-duct of monetary policy is that it complicates their communication strategy. The
KISS (keep it simple stupid) principle suggests that monetary policy should be articu-
lated in as simple a way as possible. The beauty of inﬂation target regimes is that, by
focusing on one objective—inﬂation—communication is fairly straightforward. On
the other hand, when there are two objectives, the public is likely to become con-fused. Discussion of output as well as inﬂation objectives is thus likely to obscure
the transparency of monetary policy and make it less likely that the public will sup-82 Chapter 4

port a monetary policy that focuses on long-run considerations, which is so necessary
to successful monetary policy performance. 3
4.4.4 How Can Central Banks Communicate that They Care about Output Fluctuations?
The conclusion from the above analysis is that too much focus on output ﬂuctuations
in discussions of monetary policy is likely to worsen economic performance. We havealready seen, though, that central banks do care about output ﬂuctuations in their
objective function, which was described in (4.3) and (4.4). How can monetary
authorities convince the public that they are not ‘‘inﬂation nutters,’’ which may be
very important to retaining support for the central bank and its policies? The answer
is that the central bank can discuss the setting of its policy instruments in terms of
the target rule in (4.7). It would do this by indicating that it will not try to hit its
inﬂation target over too short a horizon because this would result in unacceptably
high output losses. Indeed, inﬂation-targeting central banks have been moving in ex-
actly this direction: for example, the Reserve Bank of New Zealand has modiﬁed its
inﬂation-targeting regime to lengthen the horizon over which it tries to achieve its
inﬂation target (Sherwin 1999; Drew and Orr 1999; Reserve Bank of New Zealand2000).
Monetary authorities can further the public’s understanding that they care about
reducing output ﬂuctuations in the long run by emphasizing that monetary policy
needs to be just as vigilant in preventing inﬂation from falling too low as it is from
preventing it from being too high. Indeed, an explicit inﬂation target may help the
monetary authorities to stabilize the economy because they can be more aggressive
in easing monetary policy in the face of negative demand shocks to the economy
without being concerned that this will cause a blowout in inﬂation expectations.
However, to keep the communication strategy clear, the explanation of a monetarypolicy easing in the face of negative demand shocks needs to indicate that it is con-
sistent with the preservation of price stability.
4.5 Implications for the Federal Reserve
Although the Federal Reserve has not adopted inﬂation targeting and has no explic-
itly announced inﬂation goal, it nonetheless has emphasized the price stability goal
for monetary policy. Indeed, a fair characterization of the Federal Reserve, under
Alan Greenspan, is that it has been acting in accordance with the optimizing frame-
work described in section 4.1 and that it has not put too much emphasis on output
ﬂuctuations in the conduct of monetary policy. Starting in February 1994, the Green-span Federal Reserve began raising the federal funds rate, its policy instrument, so as
to pre-emptively head o¤ a rise in inﬂation. These actions were completely consistentThe Role of Output Stabilization 83

with the inﬂation target rule that the central bank set the interest rate instrument to
keep inﬂation near its target several years down the road. Then, as was mentioned
earlier, in the late 1990s, the Federal Reserve refrained from raising interest rates
even when output appeared to be rising above potential output because it was focus-
ing on inﬂation control and yet it was unclear that inﬂation pressures were building
up. This is exactly what following an inﬂation target rule would have prescribed forFederal Reserve behaviour.
It is also not clear that the Federal Reserve has any less inﬂation-ﬁghting credibil-
ity than other central banks that have adopted inﬂation targeting. Thus, we seem to
be in a situation of ‘‘if it ain’t broke, why ﬁx it?’’ However, one concern that I have
raised elsewhere (Mishkin 2000) is that the Federal Reserve’s credibility is very much
based on individual personalities. Alan Greenspan is a highly e¤ective nominal an-
chor in the USA currently but, unfortunately, he will not be around forever. In addi-
tion, the Greenspan Federal Reserve has been operating in a particularly favourable
political environment in recent years. There has been tremendous cooperation be-
tween the US Treasury and the Federal Reserve, while both President Bush and Clin-
ton have refrained from criticizing the Federal Reserve, in contrast to some earlierpresidents. Furthermore, government ﬁscal policy has been favourable for monetary
policy making (at least until recently), with budget surpluses or small deﬁcits.
When Greenspan steps down from the chairmanship of the Federal Reserve and if
the political environment for monetary policy deteriorates, the credibility of the
Federal Reserve and its ability to pursue its price stability goal might be severely
compromised.
The argument above suggests that developing an institutional basis for the way the
Greenspan Federal Reserve has been conducting monetary policy would help to pro-
mote better outcomes for inﬂation and output ﬂuctuations in the future. This is in-deed the rationale for the Federal Reserve to move in the direction of more explicit
inﬂation targeting. However, it also raises concerns about the Federal Reserve’s cur-
rent communication strategy, speciﬁcally in the way it announces its policy stance at
the conclusion of every FOMC meeting. Currently, with the announcement of the
federal funds rate target, the Federal Reserve provides the so-called ‘‘bias’’ or ‘‘bal-
ance of risks’’ statement in which it states that the balance of risks are balanced, or
are ‘‘mainly toward conditions that may generate inﬂation pressures in the foresee-
able future,’’ or are ‘‘mainly toward conditions that may generate economic weak-
ness in the foreseeable future.’’ When there is a long period of time in which the
statements have a balance of risks toward economic weakness in the economy, it
may encourage the public to believe that the Federal Reserve has shifted to a short-run focus on preventing economic downturns.
Since its FOMC meeting in January 2001, when the Federal Reserve indicated that
the balance of risks was toward economic weakness, most of its statements have con-84 Chapter 4

tinued to indicate that the risks are to economic weakness. Indeed, for nearly two
years (as of this writing), none of the Federal Reserve’s statements have indicated
that there are concerns about inﬂationary pressures. The absence in the balance of
risk statements of concerns about inﬂation have the potential to weaken the Federal
Reserve’s credibility as an inﬂation ﬁghter in the future and it might lead to less con-
cern in political circles about inﬂation control. This could lead in the future toincreased political pressure on the Federal Reserve to pursue short-term rather than
long-term policies. Neither of these problems might be severe while Alan Greenspan
remains at the Federal Reserve, but when he departs, they could lead to a worsening
of the trade-o¤ between output and inﬂation ﬂuctuations, thereby worsening eco-
nomic performance.
One solution to the above problem might be to eliminate the balance-of-risks state-
ment, but this statement does have value in enhancing the transparency of Federal
Reserve policy making. In addition, it also allows members of the FOMC to reach
consensus when there is some disagreement about whether to change the federal
funds rate: possible dissenters may be willing to vote with the majority if the FOMC
adopts a balance-of-risks statement which suggests a future change in interest rates inthe direction that they would like to see. Another solution is to modify the balance-
of-risks statement to put more focus on the price stability goal of the Federal Re-
serve. For example, the balance-of-risks when the risk is of higher inﬂation in the
future could still remain as ‘‘mainly toward conditions that may generate inﬂation
pressures in the foreseeable future.’’ However, if the risk is to weakness in the econ-
omy, the statement could be modiﬁed to be ‘‘mainly toward conditions that may gen-
erate economic weakness and deﬂationary pressures in the foreseeable future.’’ This
is quite a small change in the communication strategy of the Federal Reserve but,
when it is ready to reverse course and raise interest rates to head o¤ future inﬂation,having the balance-of-risks statement always focus on inﬂationary pressures might
enhance Federal Reserve credibility and political support for inﬂation control.
4.6 Conclusions
An important issue for monetary policy makers is how activist they should be, i.e., to
what extent should they focus on output ﬂuctuations in the conduct of monetary pol-
icy? The debate on this question is an old one, and the answer that Milton Friedman
(1968) gave many years ago was that activisim would worsen monetary policy per-
formance. Developments in the monetary economics ﬁeld in recent years lead to the
same answer. This paper argues that an activist monetary policy is likely to worsenthe trade-o¤ between output and inﬂation ﬂuctuations, because it will lead to sub-
optimal monetary policy, but also because it complicates monetary authorities’ com-
munication strategy and can weaken the credibility of central banks. The bottom lineThe Role of Output Stabilization 85

is that for the monetary authorities to be successful in minimizing output and inﬂa-
tion ﬂuctuations, they must never take their eye of the inﬂation ball. This is why con-
tinual repeating of the central bank mantra of price stability will not only be good
for the soul, but for the economy as well.
Notes
I thank two anonymous referees for their helpful comments. Any views expressed in this chapter are those
of the author only and not those of Columbia University or the National Bureau of Economic Research.
1. The model in Clarida et al. (1999) modiﬁes (4.1) and (4.2) as follows:
pt¼bEtpt/C01țgyt/C01țet ð4:10Ț
yt¼Etytț1/C0fðit/C0Etptț1Țțht ð4:20Ț
Given the same loss function in (4.3) and (4.4), optimal policy still results in the Taylor rule in (4.5) be-
cause inﬂation and the output gap are su‰cient statistics for the model, i.e., no other variables enter theaggregate supply and demand functions. Note, however, that the coe‰cients in the Taylor rule equation
will di¤er depending on the degree of forward-looking behaviour.
2. I made a similar argument in the ﬁrst and later editions of my textbook, Mishkin (1986), but it was not
until Chari et al. (1998) that the argument was formalized.
3. A similar argument has been made by many critics, myself included, against the two-pillar strategy of
the European central bank: that it is confusing to the public.
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5Can Central Bank Transparency Go Too Far?
Frederic S. Mishkin
5.1 What Are the Issues?
Since the beginning of the 1990s we have seen a revolution in the way central banks
communicate with the markets and the public. In the old days, central banks weregenerally very secretive institutions. Not only did they not clarify what their objec-
tives and strategies were, but they even kept the markets guessing about what the
actual settings of policy instruments were. Central banks were perfectly happy to cul-
tivate a mystique as wise but mysterious institutions, prompting popular books about
central banks to have titles like The Secrets of the Temple (Greider 1987).
The rationale for the secretive behaviour of central banks was that, as one former
Fed o‰cial put it bluntly, ‘‘secrecy is designed to shield the Fed from political over-
sight.’’ 1Although central bank secrecy reﬂects the natural desire of a bureaucracy
to maximise power and prestige by avoiding accountability, the theory of time-inconsistency of optimal policies articulated by Kydland and Prescott (1977) and
Calvo (1978) suggests that there might be a rationale for central bank secrecy be-
cause, as this same Fed o‰cial stated, ‘‘most politicians have a shorter time horizon
than is optimal for monetary policy.’’ In order to avoid the pressures from politicians
on central banks to pursue overly expansionary monetary policy to exploit the short-
run trade-o¤ between employment and inﬂation, central banks might want to ob-
scure their actions and avoid the time-inconsistency problem by focusing on the long
run and ‘‘just doing it’’ as McCallum (1995) has proposed. 2Another way to deal
with the time-inconsistency problem is to appoint conservative central bankers, as
suggested by Rogo¤ (1985), who put more weight on controlling inﬂation relative to
output than does the general public and thus will resist inﬂationary policies. How-ever, for this to work, conservative central bankers need to be independent of the po-
litical process, which is facilitated by central bank secrecy.
There are several problems with this secrecy approach to dealing with the time-
inconsistency problem. First, having secretive central banks is inherently undemo-
cratic. Although it makes sense to insulate central banks from short-run pressures to

pursue overly expansionary monetary policy, basic democratic principles require that
the central bank be accountable for its actions: this requires that the public under-
stands what the central bank is doing. In addition, democratic principles indicate
that the preferences of policy-makers need to be aligned with those of the society at
large. Furthermore, in the long run a central bank cannot operate without the sup-
port of the public. A secretive central bank may heighten suspicions that it is not act-ing in the public interest and so can eventually lead to curbs on its independence.
With the advent of inﬂation targeting in the early 1990s, central banks have been
taking a di¤erent route to solving the time-inconsistency problem. They now recog-
nise that transparency and improved communication with the public and the markets
is the key to having a successful monetary policy. Inﬂation targeting has promoted a
huge increase in transparency about inﬂation objectives and stresses regular commu-
nication with the public. 3Inﬂation-targeting central banks now have frequent, peri-
odic communications with the government, and central bank o‰cials take every
opportunity to make public speeches on their monetary policy strategy. These chan-
nels are also commonly now used by central banks that have not adopted inﬂation
targeting, such as the Federal Reserve, but inﬂation-targeting central banks havetaken public outreach a step further: not only have they engaged in extended public
information campaigns, even engaging in the distribution of glossy brochures as
in New Zealand, but they have engaged in the publication of inﬂation report-type
documents. Inﬂation reports are far more user-friendly than previous central bank
documents and explain the goals and limitations of monetary policy, including the
rationale for inﬂation targets, the numerical values of the inﬂation targets and how
they were determined, how the inﬂation targets are to be achieved, given current eco-
nomic conditions, and reasons for any deviations from targets.
This emphasis on transparency and communication has produced several beneﬁts
for central banks. By explicitly announcing their objectives on the inﬂation front,
central banks have been able to increase their credibility and anchor inﬂation expec-
tations (Levin, Natalucci and Piger 2004). Not only has this helped them achieve low
and stable inﬂation, but output volatility has, if anything, fallen. The strengthening
of the nominal anchor apparently helps move the economy toward the e‰cient fron-
tier of the trade-o¤ between inﬂation and output gap variability, generating better
performance on both the inﬂation and output fronts. 4
Transparency and communication, especially when it has demonstrated the success
in achieving a pre-announced and well-deﬁned inﬂation target, has also helped build
public support for a central bank’s independence and for its policies. As documented
in Mishkin and Posen (1997) and Bernanke et al. (1999), the increased transparencyof its inﬂation-targeting regime led to increased support for the Bank of Canada’s
policies, while it led to the granting of operational independence to the Bank of
England in May 1997. Indeed, when announcing the decision, Gordon Brown, the90 Chapter 5

Chancellor of the Exchequer, indicated that a key factor behind granting the Bank of
England greater independence was that the increased transparency of the inﬂation-
targeting regime enhanced political oversight. An important beneﬁt of the transpar-
ency of an inﬂation-targeting regime, therefore, is that it makes it more palatable to
have an independent central bank which focuses on long-run objectives, but which is
consistent with a democratic society because it is accountable.
Although inﬂation targeting has increased transparency with substantial beneﬁts,
transparency is far from complete. As seen in table 5.1, although almost all
inﬂation-targeting central banks publish their inﬂation forecasts in their Inﬂation
Reports (the Bank of Israel and Central Bank of the Republic of Turkey being the
only exceptions), 5a larger number do not publish output forecasts (the central banks
of Australia, the Philippines, Poland, Romania, South Africa, South Korea and Tur-
key). 6Furthermore, except for the Reserve Bank of New Zealand and most recently
the central bank of Colombia, inﬂation-targeting central banks do not formally an-
nounce their forecasts of the future path for the interest-rate policy instrument. 7No
central bank describes their objective function for monetary policy, while almost all
central banks are reluctant to discuss publicly their concerns about output ﬂuctua-tions. This raises the question of whether central banks should increase transparency
much further. Some monetary economists, with the most prominent example being
Lars Svensson (2002), suggest that the answer is yes. Indeed, he advocates not only
publication of output and inﬂation forecasts, but also announcement of projections
of the future policy path and the central bank objective function. But can transpar-
ency go too far?
To answer this question, we need to keep the following basic question in mind:
Does increased transparency help the central bank to do its job—that is, enable it to
conduct monetary policy optimally with an appropriate focus on long-run objectives?The answer might well be no, particularly if the increase in transparency violates
the KISS (Keep It Simple Stupid) principle. This chapter uses this basic question
as the lens through which it evaluates how far transparency should go. In the next
three sections I look at the following three questions: (i) Should the central bank
publish its forecasts, including projections of the future path of policy rates? (ii)
Should the central bank announce its objective function? (iii) How should the central
bank talk about output ﬂuctuations? The ﬁnal section contains some concluding
remarks.
5.2 Should the Central Bank Publish Its Forecasts, Including Projections of the Future Path
of Policy Rates?
Inﬂation-targeting theory, as illustrated in the simple model of Svensson (1997),
shows that inﬂation forecasts are central to the conduct of monetary policy. HisCan Central Bank Transparency Go Too Far? 91

Table 5.1
Do Inﬂation-Targeting Central Banks Publish Their Forecasts?
Central bankPolicy rate
projections?Inﬂation
forecasts?Output growth
forecasts?Output gap
forecasts?
Australia No Yes No a No
Brazil No†Yes Yes No
Canada No Yes Yes No‡
Chile No Yes Yes NoColombia Yes Yes Yes Yes
Czech Republic No
†Yes Yes Yes
Hungary No†Yes Yes Yes
Iceland No†Yes Yes Yes
Israel No No No NoMexico No Yes Yes NoNew Zealand Yes Yes Yes YesNorway No
†Yes Yes Yes
Peru No Yes Yes No
Philippines No Yes No No
Poland No†Yesb No No
Romania No Yes No NoSlovakia c No Yes Yes No
South Africa No Yes No NoSouth Korea No Yes Yes d No
Sweden No Yes Yes No
‡
Switzerland No Yes Yes No
Thailand No Yes Yes No
Turkey e No No No No
UK No†Yes Yes No
Notes:†Indicates central banks which publish the market expectations of future policy rates even though
there is no o‰cial policy-rate forecast. The central banks of Hungary, Iceland and Poland publish macro
forecasts based on a constant policy-rate path, the Czech Republic and Norway based on market expect-
ations of the policy-rate path, and Brazil and the UK based on both a constant policy-rate path and mar-ket expectations of the policy-rate path.
‡The central banks of Canada and Sweden publish estimates of the current output gap.
aThe Reserve Bank of Australia does not publish output growth forecasts in the Statement on Monetary
Policy . However, GDP forecasts are given twice a year in the Governor’s Opening Statement to the House
of Representatives Standing Committee on Economics, Finance and Public Administration.
bThe National Bank of Poland publishes extensive survey-based inﬂation expectations by market partici-
pants, but refrains from making an exact inﬂation forecast of its own. Instead, a commentary on the like-lihood of fulﬁlling the inﬂation target is included in the Inﬂation Report .
cThe National Bank of Slovakia does not refer to itself as an inﬂation targeter. However, the ECB deﬁnes
it as an ‘‘implicit inﬂation targeter.’’ (Source: ‘‘The acceding countries’ strategies towards ERM II and theadoption of the euro: an analytical review,’’ ECB Occasional Paper No 10, February 2004)
dThe Bank of Korea does not publish output growth forecasts in the Inﬂation Report . However, GDP fore-
casts for the year ahead are given twice a year in their publication Economic Prospects .
eThe Central Bank of the Republic of Turkey does not call its framework ‘‘inﬂation targeting’’ but rather
‘‘implicit inﬂation targeting.’’ However, it follows an end-of-year inﬂation target, which is negotiated bythe government and the IMF.Sources: Central bank websites as of August 2004.92 Chapter 5

model comprises an aggregate supply curve in which the change in inﬂation is af-
fected by the output gap with a one-period (one year) lag:
pt¼pt/C01țgyt/C01țet ð5:1Ț
and an aggregate demand curve in which the output gap is a function of the past out-
put gap to reﬂect persistence, and of the real interest rate, again with a one-period
(one year) lag:
yt¼ryt/C01/C0jðit/C01/C0pt/C01Țțht ð5:2Ț
where pt¼pt/C0pt/C01is the inﬂation rate at time t(with ptthe log of the price level),
ytis the output gap (the log of the ratio of actual to potential output), itis the nom-
inal interest rate, and etand htare independently and identically distributed aggre-
gate supply and demand shocks, respectively.
Optimal monetary policy involves setting the interest rate each period to minimise
the intertemporal loss function:
EtXy
t¼tdt/C0tLt ð5:3Ț
where d<1 is the authorities’ discount rate and where the period-by-period loss
function is:
Lt¼ðpt/C0p/C3Ț2=2țly2
t=2 ð5:4Ț
given the inﬂation target p/C3. In the case of l¼0, where the central bank only cares
about inﬂation ﬂuctuations, Svensson (1997) has shown that the optimal setting of
the interest rate is one in which the following target rule is followed:
Etptț2¼p/C3ð5:5Ț
In other words, the monetary policy instrument is set so as to attain the inﬂation tar-
get over the horizon at which policy changes take e¤ect, which in this model is two
periods (years) ahead. If l>0, so that monetary policy-makers are also concerned
about output ﬂuctuations, then the interest rate instrument is set according to a tar-
get rule in which the approach to the inﬂation target is more gradual, that is: 8
Etptț2/C0p/C3¼cðEtptț1/C0p/C3Țð 5:6Ț
Svensson (1997) calls this type of policy reaction ‘‘ﬂexible inﬂation targeting,’’ and
the evidence discussed in Bernanke et al. (1999) suggests that it is a more realistic ap-
proximation of what inﬂation-targeting countries do in practice.
Equations (5.5) and (5.6) illustrate that central bank decisions about monetary
policy necessarily focus on the inﬂation forecast, and so inﬂation targeting is moreCan Central Bank Transparency Go Too Far? 93

precisely described as being ‘‘inﬂation forecast targeting.’’ Clearly, if inﬂation fore-
casts are the key to the conduct of monetary policy in an inﬂation-targeting regime,
then full transparency requires that the inﬂation forecasts of the central bank
be revealed to the public. Because inﬂation forecasts are generated with forecasts
of other variables, especially output, full transparency also requires that forecasts of
these variables are published. 9There are a number of advantages from publication
of forecasts. First, publication of forecasts can help the public and the markets un-
derstand central bank actions, thus making it easier for them to assess whether the
central bank is serious about achieving its inﬂation goal. Second, publication of fore-
casts enables the public to evaluate the quality of central bank forecasts which will
enhance central bank credibility if these forecasts are viewed as constructed using
best practice. Third, publication of forecasts increases the incentives for the central
bank to produce good forecasts because a poor forecasting record would be
embarrassing.
The three advantages above together point to the more general advantage from
publication of forecasts, that it increases central bank accountability. Because of the
long lags in the e¤ects of monetary policy, which in the simple Svensson model is twoperiods (years), inﬂation outcomes are revealed only after a substantial lag. Thus
without additional information, the inﬂation target by itself does not provide an im-
mediate signal to both the public and the markets as to whether the current stance of
monetary policy is appropriate. Because, as Equations (5.5) and (5.6) illustrate, opti-
mal monetary policy involves ‘‘inﬂation forecast targeting,’’ publication of forecasts
provides immediate information that helps the public to assess whether the central
bank is taking the appropriate steps to meet its objectives. If the public and the mar-
kets think that the central bank’s forecasts are not honest, or that the current policy
stance is inconsistent with the inﬂation forecast, or that the inﬂation forecast di¤erstoo markedly from the stated target, they can immediately voice their criticisms of
the central bank. Increased accountability of the central bank is then the result.
However, despite the obvious advantages of publishing forecasts, there are some
thorny problems. The ﬁrst is the tricky issue: What path of the policy interest rate
should the forecast be conditioned on? There are three choices: (i) a constant interest
rate path; (ii) market forecasts of future policy rates; or (iii) a central bank projection
of the policy interest rate path. A constant interest path would almost surely never be
optimal because future projected changes in interest rates will be necessary to keep
inﬂation on the appropriate target path. 10The second choice is also problematic be-
cause, as Bernanke and Woodford (1997) have shown, there is a circularity problem
if the central bank sets its policy rate on the basis of market forecasts. The markets’forecasts are just guesses of what the central bank will be doing, so if the central
bank just does what the market expects, there is nothing that pins down the system
and inﬂation outcomes will be indeterminate. Theory therefore tells us that the only94 Chapter 5

appropriate and logically consistent choice is the third one, the central bank projec-
tion of the policy path. Clearly, an inﬂation forecast is meaningless without specify-
ing what policy it is conditioned on, and this is why Svensson (2002) argues that
in publishing its forecasts the central bank also needs to announce its projection of
the policy-rate path used in producing its forecast, which will almost surely be time-
varying.
Although Svensson’s argument for announcing the projection of the policy path is
theoretically sound, announcing the policy path is highly problematic. One objection
to a central bank announcing its policy projection, raised by Charles Goodhart
(2001), a former member of the Monetary Policy Committee of the Bank of England,
is that it would complicate the decision-making process of the committee that makes
monetary policy decisions. The current procedure of most central banks is to make
decisions only about the current setting of the policy rate. Goodhart argues that ‘‘a
great advantage of restricting the choice of what to do now, this month, is that it
makes the decision relatively simple, even stark.’’ 11If a policy projection with time-
varying rates is announced, this clearly requires that the monetary policy committee
come to an agreement on this policy path. Svensson (2002) argues that this could bedone by a ‘‘simple’’ voting procedure, but this procedure is far from simple and I
agree with Goodhart that this is unlikely to work. Forcing committee members to
make a decision about the future path of rates and not just the rate today may com-
plicate matters so much that the decision-making process could be impaired. Al-
though committee members might have some idea of a future direction for policy
rates, they are likely to have trouble thinking about a precise policy-rate path rather
than just the setting of the rate today. Furthermore, getting committee members to
agree on a future path of the policy rate might be very di‰cult and could end up be-
ing very contentious. 12
I had a glimpse of the problems with projections of the policy-rate path when I sat
in on Federal Open Market Committee (FOMC) meetings while I was the director
of research at the Federal Reserve Bank of New York from 1994 to 1997. Upon my
arrival at the Fed, the Green Book forecasts (prepared by the Board sta¤ ) were
conditioned on a non-constant interest rate path. Several of the FOMC members
objected to this procedure and this was probably for two reasons. First, having a
sta¤ projection of future interest rates might lead to some prejudgement of the com-
mittee’s decision. Second, it is far easier to make a decision just on the rate today and
not have to discuss the path for future policy rates at the same time. The objections
eventually won the day: the procedure for generating the Green Book forecasts was
changed so that they are now conditioned on a constant policy-rate path, at least inthe short term. Thus, I side with Goodhart. Announcing a projection for the policy-
rate path which would require agreement on this path by the committee deciding on
monetary policy would be counterproductive.Can Central Bank Transparency Go Too Far? 95

The second problem with announcing a projection of the policy-rate path is that it
might complicate communication with the public. Although economists understand
that any policy path projected by the central bank is inherently conditional because
changes in the state of the economy will require a change in the policy path, the pub-
lic is far less likely to understand this. When new information comes in and the cen-
tral bank changes the policy rate from its projected path, the public may see this as areneging on its announced policy or an indication that the central bank’s previous
policy settings were a mistake. Thus even when the central bank is conducting its pol-
icy in an optimal manner, deviations from its projected policy path may be viewed as
a central bank failure and could hurt the central bank’s credibility. In addition, the
deviations of the policy rate from its projected path might be seen as ﬂip ﬂops on
the part of the central bank. As we often see in political campaigns, when a candi-
date changes his position, even if it reﬂects changes in circumstances and thus reﬂects
sound judgement, the candidate is vulnerable to attacks by his or her opponents that
he or she does not have leadership qualities. Wouldn’t central banks be subject to the
same criticism when changing circumstances would force them to change the policy
rate from its previously projected path? The result might be a weakening of supportfor the central bank and its independence.
The recent Federal Reserve experience with the language of their post-FOMC
statement illustrates the problem of the public not understanding that projected pol-
icy paths are conditional on the evolution of the data. In order to underscore its
commitment to preventing a deﬂationary spiral from getting underway in the United
States, the FOMC announced in August 2003 that it would maintain policy accom-
modation for a ‘‘considerable period.’’ As Eggertsson and Woodford (2003) have
shown, a commitment to keeping the policy rate unusually low beyond the time
when the economy begins to recover is an important policy tool to deal with deﬂa-tionary shocks. However, as is clear from Eggertsson and Woodford (2003), the
length of the ‘‘considerable period’’ is dependent on the actual evolution of the econ-
omy. The public may not fully understand this and so if the economy comes back far
stronger than is anticipated, monetary policy may need to be tightened even when
there has been a commitment to easy monetary policy for a ‘‘considerable period.’’
We would then have the problems described above where the central bank’s cred-
ibility might be tarnished. Thus the commitment to a policy path, even when it is
needed, is not without its problems. As is indicated in Ito and Mishkin (2004), I still
believe that deﬂationary environments, like the one we see in Japan, are su‰ciently
damaging that a commitment to the zero interest rate for an extended period is
needed to reﬂate the economy. However, the cost of a commitment to a projectedpolicy-rate path is trickier when the deﬂation risks are not as serious. This problem
has been recognised by o‰cials at the Fed, and explains why they have been seeking
an exit strategy from their commitment to a policy-rate path by ﬁrst changing the96 Chapter 5

language, in January 2004, to say that the FOMC can be ‘‘patient’’ in removing pol-
icy accommodation and then, in May 2004, to say that policy accommodation can
be removed at a pace that is likely to be ‘‘measured.’’
The bottom line is that except in exceptional deﬂationary circumstances like the
one Japan has experienced, announcement of a policy-rate path does not have much
to recommend it. It is likely to complicate policy discussion within central bankswhich might impair the quality of monetary policy decisions, and it also may lead
to a loss of credibility of the central bank and a weakening of the support for central
bank policies. Thus announcement of its projection of the policy-rate path may make
it harder for the central bank to conduct monetary policy optimally with an appro-
priate focus on long-run objectives.
The problem with announcing the projection of the future policy path creates a
problem for publishing forecasts. Clearly, in order for a forecast to be evaluated,
the central bank must reveal the policy path on which it is conditioned. But if it
does not make sense for central banks to announce their projection of a time-
varying, policy-rate path, then the forecasts that they publish cannot be based on
such a projection. The alternative is for the central bank to publish forecasts thatare either conditioned on the policy rate remaining unchanged or on market expect-
ations of future policy rates. Indeed this is what almost all central banks that publish
forecasts do. Only the central banks of New Zealand and Colombia publish their
forecasts based on a projected policy-rate path which they intend to set in the
future. 13
If publishing forecasts based on a projected policy-rate path may do more harm
than good, and yet this is the only logically consistent approach for producing these
forecasts, then is publishing forecasts based on a constant policy rate or on market
expectations of the policy rate truly transparent? After all, the central bank knowsthat neither of these interest rate paths is what it plans to do and the public and mar-
kets know this as well. 14Publishing these logically inconsistent forecasts might even
be viewed as non-transparent and so could potentially damage the central bank’s
credibility. 15The case for publishing forecasts is thus no longer clear cut: there are
costs and beneﬁts. However, for central banks that have lower credibility, particu-
larly those in emerging market economies, there may be a greater need for them to
publish forecasts in order to provide more information to the public, even if the fore-
casts are not based on the central bank’s projection of future policy rates.
5.3 Should the Central Bank Reveal Its Objective Function?
In order for the public and the markets to fully understand what a central bankis doing they need to understand the central bank’s objectives. As argued in the
introduction, the announcement of an explicit, numerical objective for inﬂation isCan Central Bank Transparency Go Too Far? 97

an important step in the right direction and has clear-cut beneﬁts. However, central
banks are not ‘‘inﬂation nutters’’ (King 1997): they do care about output ﬂuctuations
as well as inﬂation ﬂuctuations, and so lis greater than 0 in the central bank objec-
tive function in Equation (5.4). Thus announcing an inﬂation target is not enough:
full transparency requires that the central bank reveal its objective function (Svens-
son 2002).
Again, we need to ask the question whether revealing its objective function will
help the central bank to do its job. I will argue that the answer is no because pushing
transparency further in this direction violates the KISS (Keep It Simple Stupid) prin-
ciple and is likely to hinder the communication process.
The ﬁrst problem with announcing an objective function is that it might be quite
hard for members of a monetary policy committee to specify an objective function.
Having watched how members of a monetary policy committee operate, I can attest
that members of monetary policy boards don’t think in terms of objective functions
and would have a very hard time in describing what theirs is. Indeed, I would suggest
that most monetary economists, even brilliant ones, would have trouble specifying
what their lwould be. A counter to this argument is that the lcould be backed out
by revealed preference. Monetary policy committee members could be confronted
with hypothetical choices about acceptable paths of inﬂation and output gaps and
then their choices would reveal their ls. Although committee members would be
able to do this when confronted with a real world situation, and this is e¤ectively
what was done in Brazil in early 2003, I think they would ﬁnd this di‰cult to do
when the choices are hypothetical—I know I would.
A second problem, raised by Goodhart (2001), is that it would be di‰cult for a
committee to agree on its objective function. As mentioned above, committee mem-
bers might have trouble deﬁning their own objective function, but because the com-position of the committee changes frequently and existing members may change their
views on objectives depending on circumstances, they would also have to revisit the
decision on the committee’s objective function frequently. Deciding on the com-
mittee’s objective function would thus substantially increase the complexity of the
decision process and might also be quite contentious. This violation of the KISS
principle would then have the potential to weaken the quality of monetary policy
decisions.
A third problem is that it is far from clear who should decide on the objective
function. If the members of the monetary policy board do so, isn’t this a violation
of the democratic principle that the objectives of bureaucracies should be set by the
political process? An alternative would be for the government to do so. But if wethink that it would be hard enough for a monetary policy committee to do this, it
would clearly be even more di‰cult for politicians to decide on the objective
function.98 Chapter 5

Even if it were easy for the monetary policy committee or the government to come
to a decision on the objective function, would it be easy to communicate it to the
public? If economists and members of a monetary policy committee have trouble
quantifying their objective function, is it likely that the public would understand
what the central bank was talking about when it announced its objective function?
Announcement of the objective function would only be likely to complicate the com-munication process with the public and is another violation of the KISS principle.
The announcement of the central bank’s objective function can add a further com-
plication to the communication process that might have even more severe conse-
quences for the ability of the central bank to do its job well. The KISS principle
argues for articulation of monetary policy in as simple a way as possible. The beauty
of inﬂation-target regimes is that by focusing on one objective—inﬂation—commu-
nication is fairly straightforward. On the other hand, with the announcement of the
objective function, the central bank will be announcing that it has two objectives,
minimising both output and inﬂation ﬂuctuations. Discussion of output as well as in-
ﬂation objectives can confuse the public and make it more likely that the public will
see the mission of the central bank as elimination of short-run output ﬂuctuations,thus worsening the time-inconsistency problem.
One outcome is that it may make it more likely that workers and ﬁrms will raise
wages and prices because they know that the monetary authorities are likely to ac-
commodate these rises by pursuing expansionary policy to prevent output gaps from
developing. The result is that a self-fulﬁlling equilibrium can occur in which wages
and prices rise, then monetary policy accommodates this rise, and this leads to fur-
ther rises in wages and prices, and so on, thus leading to a new equilibrium with
higher inﬂation but without a reduction in output ﬂuctuations. Chari, Christiano
and Eichenbaum (1998) have described this bad equilibrium as an ‘‘expectationtrap.’’ Discussing monetary policy objectives in terms of output ﬂuctuations can
thus lead to a loss of inﬂation-ﬁghting credibility for the central bank, with the result
that the trade-o¤ between inﬂation and output ﬂuctuations worsens.
Announcement of the objective function not only requires the announcement of l
and the inﬂation target, but it also requires the central bank to announce its estimates
of the current and future output gaps and hence its estimate of potential output and
its growth rate. The announcement of estimates of potential output, and particularly
its growth rate, may increase the probability that the public sees them as a target for
monetary policy and thus may increase political pressures on the central bank to
eliminate output gaps and pursue high growth in the short run, with the resulting
negative consequences mentioned above. This problem is likely to be even moredamaging because potential output is very hard to measure.
One measurement problem for potential output occurs because the monetary pol-
icy authorities have to estimate it with real-time data, that is, data that are availableCan Central Bank Transparency Go Too Far? 99

at the time they set the policy instrument. GDP data are frequently revised substan-
tially and this is one reason why output gaps are mismeasured in real time. Even
more important: it is notoriously hard to know what potential GDP and its growth
rate actually are without hindsight. For example, in the United States it was not until
the 1980s that policy-makers recognised that potential GDP growth had slowed
markedly after 1973: Orphanides (2001) has shown that the errors in measures ofoutput gaps have been very large in the post-war period.
An even more severe measurement problem occurs because conceptually the y
t
that belongs in the aggregate supply curve in Equation (5.1) is not at all clear and
may be quite di¤erent from conventionally measured output gaps. Clarida et al.
(1999) point out that new Keynesian aggregate supply curves should have ytspeci-
ﬁed as a marginal cost measure rather than an output gap and they ﬁnd that the
marginal cost measure has substantially di¤erent movements and timing than the
conventionally measured output gap. McCallum and Nelson (2000) and McCallum
(2001) argue that conventionally measured output gaps, which estimate the gap as
deviations from a trend, di¤er substantially from more theoretically grounded mea-
sures based on the output level that would prevail in the absence of nominal pricestickiness. It is true that there are measurement problems with inﬂation as well as
output gaps, but both the conceptual and real-time measurement problems for inﬂa-
tion are of a far smaller magnitude.
The severe measurement problems for the output gap could interact with an
increased focus on eliminating output gaps to produce serious policy mistakes as
occurred in the United States in the 1970s. Orphanides (1998) shows that the use of
real-time data on output gaps might lead to such inaccurate estimates that active
monetary policy which reacts strongly to output gaps increases economic instability.
Indeed, Orphanides (2002) argues that the reason for the Federal Reserve’s poor per-formance during the 1970s was notthat it was unconcerned with inﬂation, but rather
that it focused too much on eliminating output gaps.
Given the objections raised here, it is not surprising that no central bank has
revealed its objective function to the public. Furthermore, the discussion here
suggests that even if the central bank does not announce its objective function, an-
nouncement of current and future potential output and output gap estimates still
has the potential to worsen monetary policy performance. Thus the discussion also
argues against the publication of central bank estimates and forecasts of potential
output and the output gap even if publication of inﬂation and output forecasts is
felt to be beneﬁcial. Indeed, although the majority of inﬂation-targeting central
banks publish output and inﬂation forecasts, only the central banks of Colombia,the Czech Republic, Hungary, Iceland, New Zealand and Norway publish their fore-
casts of potential output or output gaps, while the central banks of Canada and Swe-
den publish only current estimates of the output gap (table 5.1).100 Chapter 5

5.4 How Should Central Banks Talk about Output Fluctuations?
One advantage of a central bank announcing its objective function is that it would
make clear the central bank’s views on how it will deal with output ﬂuctuations. But
since central banks do not announce their objective functions, and arguments against
doing this are strong, they still have the problem of how to talk about output ﬂuctu-
ations. The reality is that central bankers, whether they target inﬂation or not, are
extremely reluctant to discuss concerns about output ﬂuctuations even though their
actions show that they do care about them. This lack of transparency is the ‘‘dirty
little secret of central banking.’’ One remarkable manifestation of this occurred in
August 1994 at the Federal Reserve Bank of Kansas City’s Jackson Hole Confer-
ence, when Alan Blinder, then the vice-chairman of the FOMC, had the temerity
to mention that a short-run trade-o¤ between output and inﬂation exists and that,
therefore, monetary policy should be concerned about minimising output as well asinﬂation ﬂuctuations. Blinder was then pilloried by many central bankers and in the
press, with a Newsweek columnist declaring that he was not qualiﬁed to be a central
banker (Samuelson 1994). From an academic economist’s perspective, this was quite
amazing since Alan Blinder didn’t say anything that was inconsistent with what our
models tell us or what central bankers deep down believe. However, it does indicate
the discomfort that central bankers as a group have with discussing the role of output
ﬂuctuations in the conduct of monetary policy.
The problems with revealing the objective function discussed in the previous sec-
tion explain why central bankers have di‰culty with being transparent about theirconcerns about output ﬂuctuations. Central bankers fear that if they are explicit
about the need to minimise output ﬂuctuations as well as inﬂation ﬂuctuations, poli-
ticians will use this to pressure the central bank to pursue a short-run strategy of
overly expansionary policy that will lead to poor long-run outcomes. Furthermore,
a focus on output gaps could lead to policy mistakes similar to those that occurred
in the United States in the 1970s. The response to these problems is that central
bankers engage in a ‘‘don’t ask, don’t tell’’ strategy.
However, the unwillingness of central banks to talk about their concerns regarding
reducing output ﬂuctuations creates two very serious problems. First, a don’t-ask-
don’t-tell strategy is just plain dishonest. Doing one thing but saying another is the
height of non-transparency, and central banks not admitting that they care aboutoutput ﬂuctuations can erode conﬁdence in other elements of their transparency
that are clearly beneﬁcial. Second, if central bankers do not discuss their concerns
about output ﬂuctuations, they may end up being characterised as ‘‘inﬂation
nutters,’’ and this can cause an erosion of support for a central bank’s policies
and independence because this set of preferences is clearly inconsistent with the
public’s.Can Central Bank Transparency Go Too Far? 101

The case for increasing transparency with regard to central banks’ concerns about
output ﬂuctuations is quite strong. But how can central banks do this?
One answer is that a central bank can discuss the setting of its policy instruments
in terms of the target rule in Equation (5.6). It can announce that it will not try to hit
its inﬂation target over too short a horizon because this would result in unacceptably
high output losses, especially when the economy gets hit by shocks that knock it sub-stantially away from its long-run inﬂation goal. Inﬂation-targeting central banks
have been moving in this direction: for example, the Reserve Bank of New Zealand
has modiﬁed its inﬂation-targeting regime to lengthen the horizon over which it tries
to achieve its inﬂation target. 16
Although inﬂation-targeting central banks have lengthened the horizon for their
targets to two years or so, with the Bank of England being a prominent example,
this still does not solve the problem because it gives the impression that the horizon
for inﬂation targets is ﬁxed, which is not ﬂexible enough. 17Up to now, the use of a
speciﬁc horizon like two years has not been a problem for inﬂation targeting in
advanced countries like the United Kingdom; because inﬂation has not been subject
to large shocks, it has remained close to the target level. In this case, having the ho-rizon for the target equal to the two-year horizon at which policy changes take e¤ect,
as in Equation (5.5), is consistent with optimal policy. However, as we have seen in
Equation (5.6), when there is a concern about output ﬂuctuations and the inﬂation
rate is shocked su‰ciently away from its long-run target, the path for the medium-
term inﬂation-target horizon needs to be modiﬁed.
A striking example of how large shocks to inﬂation can be handled occurred in
Brazil recently (Fraga, Goldfajn and Minella 2003). Brazil experienced a major ex-
change rate shock in 2002 because of concerns that the likely winner in the presiden-
tial election would pursue populist policies that would lead to currency depreciation.The resulting depreciation then led to a substantial overshoot of the Brazilian inﬂa-
tion target. In January 2003, the Banco Central do Brasil announced a procedure
for how it would modify its inﬂation targets. First, the central bank estimated the
regulated-price shock to be 1.7 percent. Then taking into account the nature and per-
sistence of the shocks, it estimated the inertia from past shocks to be 4.2 percent of
which two-thirds was to be accepted, resulting in a further adjustment of 2.8 percent.
Then the central bank added these two numbers to the previously announced target
of 4 percent to get an adjusted target for 2003 of 8.5 percent ( ¼4%ț1.7% ț2.8%).
The central bank then announced the adjusted target in an open letter sent to the
Minister of Finance in January 2003, which explained that getting to the non-
adjusted target of 4 percent too quickly would entail far too high a loss of output.Speciﬁcally, the announcement indicated that an attempt to achieve an inﬂation rate
of 6.5 percent in 2003 would be expected to entail a decline of 1.6 percent of GDP,102 Chapter 5

while trying to achieve the previous target of 4 percent would be expected to lead to
an even larger decline of GDP of 7.3 percent.
The procedure followed by the Banco Central do Brasil had tremendous transpar-
ency, both in articulating why the inﬂation target was missed and also in explaining
why the new target path for inﬂation was chosen. The discussion of alternative target
paths, with the explanation that lower inﬂation paths would lead to large outputlosses, showed that the central bank did indeed care about output ﬂuctuations, thus
demonstrating that it was not an ‘‘inﬂation nutter’’ and that its concern about output
losses was aligned with similar concerns by the public.
Even though advanced economies have not yet had inﬂation shocks of the magni-
tude that Brazil has recently experienced, outlining the procedures that they will use
to respond to future adverse shocks provides a vehicle for them to explain that they
do indeed care about output ﬂuctuations. 18By announcing that they would do what
the Brazilians did if a situation arose in which inﬂation shifted substantially away
from the long-run goal, central bankers can get the dirty little secret out of the closet
that they do have an appropriate concern about output ﬂuctuations. Yet, they will
still be able to assure the public that they continue to worry about the long run andthe importance of achieving price stability. A procedure like the one followed by
Brazil conveys the idea that the central bank cares about output ﬂuctuations in a
forward-looking context because it highlights decisions that the central bank will
make about the future path of inﬂation and the horizon over which inﬂation
will return to the target. It therefore continues to make clear that the central bank is
focused on output ﬂuctuations in a longer-run and not a short-run context, which
is necessary for minimising the time-inconsistency problem.
Monetary authorities can further the public’s understanding that they care about
reducing output ﬂuctuations in the long run by emphasising that monetary policyneeds to be just as vigilant in preventing inﬂation from falling too low as it is in pre-
venting it from being too high. They can do this (and some central banks have) by
explaining that an explicit inﬂation target may help the monetary authorities stabilise
the economy because they can be more aggressive in easing monetary policy in the
face of negative demand shocks to the economy without being concerned that this
will cause a blowout in inﬂation expectations. However, in order to keep the commu-
nication strategy clear, the explanation of a monetary policy easing in the face of
negative demand shocks needs to indicate that it is consistent with the preservation
of price stability.
In addition, central banks can also clarify that they care about reducing output
ﬂuctuations by indicating that when the economy is very far below any reasonablemeasure of potential output, they will take expansionary actions to stimulate eco-
nomic recovery. In this case, measurement error of potential output is likely to beCan Central Bank Transparency Go Too Far? 103

swamped by the size of the output gap. Thus, it is far clearer that expansionary pol-
icy is appropriate and that inﬂation is unlikely to rise from such actions. In this situ-
ation, the case for taking actions to close the output gap is much stronger and does
not threaten the credibility of the central bank in its pursuit of price stability.
5.5 Concluding Remarks
Transparency is a virtue, but like all virtues it can go too far. The famous fashiondesigner Chanel came up with the marvelous dictum that ‘‘You can never be too
rich or too thin.’’ But you can be too thin—either anorexia or starvation is a killer.
Similarly central banks can be too transparent. Central bank transparency must
always be thought of as a means to an end. Transparency is beneﬁcial when it serves
to simplify communication with the public and helps generate support for central
banks to conduct monetary policy optimally with an appropriate focus on long-run
objectives. Some types of transparency may not do this.
This chapter has argued that some suggestions for increased transparency, particu-
larly a central bank announcement of its objective function or projections of the pathof the policy interest rate, will complicate the communication process and weaken
support for a central bank focus on long-run objectives. Transparency can indeed go
too far.
However, there is one area in which the lack of central bank transparency does
create problems: the unwillingness of many central banks to honestly discuss that
they do care about reducing output ﬂuctuations. Here transparency could be sub-
stantially improved. By describing procedures for how the path and horizon of in-
ﬂation targets would be modiﬁed in the face of large shocks, by emphasising that
monetary policy will be just as vigilant in preventing inﬂation from falling too lowas it is in preventing it from being too high, and by indicating that expansionary pol-
icies will be pursued when output falls very far below potential, central banks can get
the dirty little secret out of the closet that they do care about output ﬂuctuations.
These steps to improve transparency will increase support for the central bank’s pol-
icies and independence, but avoid a focus on the short run that could interfere with
the ability of the central bank to do its job e¤ectively.
Notes
I thank Emilia Simeonova for her excellent research assistance. I also thank Don Kohn, Ken Kuttner, my
discussant Warwick McKibbin, and participants at the conference. Any views expressed in this chapter are
those of the author only and not those of Columbia University or the National Bureau of Economic
Research.
1. As quoted in ‘‘Monetary zeal: how Federal Reserve under Volcker ﬁnally slowed down inﬂation,’’ Wall
Street Journal , 7 December, 1984, p 23.104 Chapter 5

2. The model of Barro and Gordon (1983) has the time-inconsistency problem residing inside the central
bank. But as I have argued elsewhere in Mishkin (2000), the source of the time-inconsistency problem is in
the political process because central bankers are very aware of the time-inconsistency problem and are in-deed extremely averse to falling into a time-inconsistency trap.
3. For example, see Bernanke et al. (1999) and Mishkin (1999).4. The so-called Taylor curve ﬁrst outlined in Taylor (1979).5. The Bank of Israel publishes an inﬂation forecast based on a survey of private sector expectations, but
not its own inﬂation forecast. The Central Bank of the Republic of Turkey (CBRT) does not o‰cially callits framework inﬂation targeting but instead refers to it as ‘‘implicit inﬂation targeting.’’ However, the end-of-year inﬂation target is agreed on by the government and the IMF. Like Israel, the CBRT does notpublish its own forecasts, but does publish inﬂation forecasts based on a private sector survey. Note thatalthough the European Central Bank (ECB) does not call itself an inﬂation targeter, it does have an ex-plicit inﬂation objective and so has some elements of an inﬂation-targeting regime. The ECB does publish
its inﬂation and output forecasts.
6. The central banks of Australia and South Korea do announce output forecasts in other settings, but the
frequency of these forecasts is not as high as in Inﬂation Reports .
7. The central banks of Brazil, the Czech Republic, Hungary, Iceland, Norway, Poland and the United
Kingdom do publish projections of the future policy-rate path, but it is based on market expectationsand not their assessment of the expected policy-rate path. The central bank of Norway does have an exten-sive discussion of future monetary policy in their Inﬂation Report , but it is still quite qualitative. Other
inﬂation-targeting central banks, such as the central banks of the Czech Republic, Iceland and Romania,have provided less formal discussions of their assessment of the future policy-rate path.
8. Models with more forward-looking behaviour such as the dynamic new Keynesian model in Clarida,
Galı´and Gertler (1999) would yield similar conclusions.
9. However, for reasons outlined in the next section, there are arguments against the publication of fore-
casts of output gaps.
10. See Svensson (2003a, 2003b) and Woodford (2003).11. Goodhart (2001, p 173).12. Kohn (2000) comes to a similar conclusion. He reports that members of the Bank of England’s
Monetary Policy Committee stressed the di‰culty of getting agreement on a future path of interestrates.
13. The central banks of Brazil, the Czech Republic, Norway and the United Kingdom publish forecasts
based on projections of the future policy-rate path that are based on market expectations . Norway does
have an extensive section in its Inﬂation Report on the setting of future policy rates which is qualitative.
14. This criticism of the Bank of England’s published forecasts has been raised by Martijn and Samiei
(1999).
15. Although a forecast based on a constant-interest-rate path is logically inconsistent, it is internally con-
sistent: that is, a forecast can be conditioned on any assumption about an interest-rate path. Indeed, Edey
and Stone (this volume) argue that if a monetary policy committee makes decisions based on unchangedfuture policy then the publication of these forecasts is consistent with transparency.
16. See Sherwin (1999), Drew and Orr (1999) and Reserve Bank of New Zealand (2000).17. The ﬁxed horizon is also problematic because it is inconsistent with optimal monetary policy: for ex-
ample, see Woodford (2004). Indeed, critics of inﬂation targeting, most notably Don Kohn (2004), who isa member of the Board of Governors of the Federal Reserve, have also worried that inﬂation targetingmay be too rigid because inﬂation-targeting central banks in advanced economies have often adopted aﬁxed horizon for their inﬂation targets.
18. Central banks in advanced countries do have an awareness of the need to modify the inﬂation path if
the economy is subjected to large shocks. For example, in the United Kingdom, the inﬂation-targeting re-gime stipulates that if inﬂation is knocked more than 1 percentage point away from the target (now 2 per-
cent), then the Bank of England will need to specify the path of inﬂation and the length of time that it will
take to get back to the target.Can Central Bank Transparency Go Too Far? 105

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6Is There a Role for Monetary Aggregates in the Conduct of
Monetary Policy?
Arturo Estrella and Frederic S. Mishkin
6.1 Introduction
The economics literature contains prescriptions for the use of monetary aggregates in
macroeconomic policy that range from exclusive focus on the aggregates to their al-most complete disregard. In principle, there are various potential uses for monetary
aggregates. For instance, the aggregates may be used as information variables to pro-
vide a guide for the conduct of monetary policy. Such an informal role places only
minimal demands on the aggregates, concerning mainly their informational content.
More ambitious uses of the aggregates are also possible. For example, they could be
used to signal the intentions of the central bank so as to make it accountable for car-
rying out policies that are consistent with its basic mandates and to enhance its cred-
ibility and the public’s expectations of the attainment of its goals. Alternatively, the
aggregates could be used in the context of a policy rule, such as the McCallum (1988)proposal for using the monetary base to target nominal income growth. 1Such rules
pose the greatest demands on the performance of the aggregates, presupposing stable
causal relationships with the ultimate policy goals.
In all of these potential applications, however, it is necessary ﬁrst and foremost
that the aggregates have some value as information variables. It is therefore on this
question that we focus in this chapter. We look at some recent proposals for the use
of monetary aggregates in formal rules and perform empirical tests of the strength
and stability of the empirical relationships that those rules presuppose. More gener-
ally, we ask what role the aggregates can have even if the approach to policy is more
eclectic than that implied in these recent proposals.
Section 6.2 of the chapter presents preliminary empirical analysis of the relation-
ships between money and nominal income and between money and inﬂation thatneed to hold if the aggregates are to be successfully used in any of the ways men-
tioned above. We focus on the monetary base, which is McCallum’s (McCallum,
1988) preference, and on M2, which was advocated by Feldstein and Stock (1994).
Some results for M1 are also included in the appendix. This chapter di¤ers from

most previous work in this literature in that we rely primarily on monthly data, which
provide a richer sample than quarterly data although, as the appendix shows, the
results are largely consistent with those obtained with quarterly data.
In section 6.3 of the chapter, we formulate a theoretical model that establishes con-
ditions under which a rule such as McCallum’s is optimal. The analysis suggests
ways to improve on the rule while retaining its general form. With these results inhand, we return in section 6.4 to the performance of the base and of M2 in multivari-
ate analysis of their relationships with money and nominal income or inﬂation, in
both cases incorporating adjustments based on the improvements suggested by the
analysis of section 6.3. Section 6.5 presents results from incorporating additional
adjustments to these aggregates based on decomposing velocity into spectral compo-
nents corresponding to low, medium (business cycle) and high frequency cycles.
Since economists and policymakers in Germany are more likely supporters of
monetary aggregates than those in the United States, we repeat in section 6.6 some
of the analysis of sections 6.2, 6.4 and 6.5 with German data. We focus on the infor-
mational content of M3 for growth and inﬂation in western Germany.
Our analysis, summarized in the ﬁnal section, concludes that the empirical rela-
tionships involving monetary aggregates, nominal income, and inﬂation are notsu‰ciently strong and stable in the United States and Germany to support a straight-
forward role for monetary aggregates in the conduct of monetary policy.
6.2 Preliminary Multivariate Analysis
The use of monetary aggregates in policy is feasible only if the relationships between
money and income or prices are both strong and stable over time. In this section, we
examine these empirical relationships in a multivariate vector autoregression (VAR)
context that includes nominal income, inﬂation and either the monetary base or M2.
The analysis in this section is similar to that of Feldstein and Stock (1994), who
focus on what may be interpreted as alternative formulations of the nominal income
equation from a series of VARs with di¤erent sets of variables. There are two main
di¤erences, however. First, we use monthly rather than quarterly data. Although the
concept of nominal income is most directly captured by nominal GDP, as used by
Feldstein and Stock, our proxy based on the Commerce Department/Conference
Board index of coincident indicators and the consumer price index is very similar
and allows for the use of the available monthly money series. Speciﬁcally, nominal
growth is deﬁned as the sum of the log changes in the coincident index and the con-
sumer price index.
The results using monthly data do not di¤er appreciably from those using quar-
terly data, as evidenced by the similarity between the monthly results in the text and
the quarterly results provided for reference in the appendix. Testing for the appropri-110 Chapter 6

ate lag length in our VAR led to the use of nine monthly lags. This is consistent with
the Feldstein–Stock speciﬁcation, which uses three quarterly lags.
A second key di¤erence between this and the Feldstein–Stock paper is related to a
break in the data that is frequently identiﬁed as having occurred in 1979–1980. We
focus on the period since October 1979 as one in which the performance of the mon-
etary aggregates is poor, rather than on identifying the exact timing of the break,which seems to be a higher priority for Feldstein and Stock. A detailed discussion
of the timing of the break is also found in Huizinga and Mishkin (1986).
Table 6.1 contains summary Granger–Sims causality statistics for a VAR contain-
ing nominal growth, inﬂation and growth in the monetary base. Speciﬁcally, the
table reports the signiﬁcance probability ( p-value) of each of the Ftests that corre-
sponds to the joint hypothesis that the coe‰cients of all the lags of a given variableare equal to zero. The full sample results in the upper panel of the table suggest an
orderly pattern in which, at a 5% level of signiﬁcance, the monetary aggregate helps
predict both income and inﬂation, but is itself not predicted by income and inﬂation.
However, this apparent order is called into question by the analysis of subperiods.
The upper panel, which contains the p-value for a Chow test of a break in October
1979, presents strong evidence that the model is not stable. Furthermore, the resultsfor the post-October 1979 sample, presented in the lower panel, give a totally di¤er-
ent picture of the relationships. In this panel, only a variable’s own lags are signiﬁ-
cant at the 5% level. Speciﬁcally, the monetary base is very insigniﬁcant in both the
nominal income and inﬂation equations. 2Although we will look at various reﬁne-
ments of this analysis, these results do not bode well for the use of the monetarybase in a policy rule, or even for its use as an information variable. Table 6.1 (like
some subsequent tables) also contains tstatistics for the sums of the lag coe‰cients
of the key regressors. In addition to the signiﬁcance of these sums, the tstatistics in-
dicate whether the relationships have the appropriate signs.
Table 6.2 contains analogous results for a VAR containing M2. The results di¤er
from those of table 6.1 in several important respects. First, the pattern of the fullsample results is di¤erent: lags of M2 do not help explain inﬂation, but lags of both
inﬂation and nominal growth help explain money growth. Second, the evidence of a
break in October 1979 is much weaker in the ﬁrst two equations, especially in the
nominal income equation. This is consistent with the Feldstein–Stock results, and it
is a point that they emphasize in their reading of the results.
Nevertheless, if we turn to the results in the lower panel for the latter part of the
sample, the signiﬁcance levels of M2 growth are not encouraging in either the nomi-
nal income or the inﬂation equations. In this sense, the post-October 1979 results arevery similar to those obtained with the monetary base. One di¤erence encountered
here is that lags of inﬂation are signiﬁcant in the equation for M2. This could be po-
tentially important if M2 had been used over this period in countercyclical policy toIs There a Role for Monetary Aggregates? 111

Table 6.1
Joint Signiﬁcance Tests in VAR with Nominal Growth, Inﬂation, and Monetary Base (Monthly, 9 Lags)
p-values for
PeriodDependentvariableNominalgrowth Inﬂation Money R
2p-values
for break(Oct. 79)Coe¤.sum on tStatisticp-
value
Mar. 60–Dec. 95 Nominal growth 0.000 0.002 0.021 0.289 0.019 Money 2.70 0.007
Inﬂation 0.001 0.000 0.001 0.608 0.006 Money 1.44 0.150Money 0.162 0.384 0.000 0.366 0.020 Growth /C00.10 0.918
Inﬂation 0.49 0.627
Oct. 79–Dec. 95 Nominal growth 0.000 0.078 0.673 0.310 Money 1.68 0.096
Inﬂation 0.092 0.000 0.384 0.631 Money 0.34 0.731
Money 0.693 0.852 0.000 0.353 Growth /C01.58 0.115
Inﬂation 0.10 0.919
Nominal growth ¼DlogðCOIN ȚțDlogðCPIȚ¼Dx
t.
Inﬂation ¼DlogðCPIȚ¼Dpt.
Money ¼DlogðBASE Ț¼Dmt.112 Chapter 6

Table 6.2
Joint Signiﬁcance Tests in VAR with Nominal Growth, Inﬂation, and M2 (Monthly, 9 Lags)
p-values for
PeriodDependent
variableNominalgrowth Inﬂation Money R
2p-values
for break(Oct. 79)Coe¤.sum on tStatisticp-
value
Mar. 60–Dec. 95 Nominal growth 0.000 0.036 0.009 0.293 0.449 Money 3.74 0.000
Inﬂation 0.002 0.000 0.484 0.590 0.080 Money 0.03 0.977
Money 0.004 0.007 0.000 0.625 0.036 Growth /C01.87 0.063
Inﬂation 1.50 0.134
Oct. 79–Dec. 95 Nominal growth 0.000 0.130 0.456 0.319 Money 1.55 0.122
Inﬂation 0.253 0.000 0.482 0.628 Money 0.71 0.477
Money 0.122 0.014 0.000 0.643 Growth /C00.45 0.656
Inﬂation 0.35 0.730
Nominal growth ¼DlogðCOIN ȚțDlogðCPIȚ¼Dx
t.
Inﬂation ¼DlogðCPIȚ¼Dpt.
Money ¼DlogðM2Ț¼Dmt.Is There a Role for Monetary Aggregates? 113

control the variability of inﬂation because, in that case, successful monetary policy
might make it impossible to detect a predictive relationship running from money to
inﬂation. This possibility is explored further in section 6.4.
Feldstein and Stock also estimate what amounts practically to the nominal growth
equation in our VAR using an error correction speciﬁcation, which allows for cointe-
gration of M2 velocity and short-term interest rates. 3We performed a similar exer-
cise by estimating a cointegrating equation with the level of M2 velocity and the
three-month Treasury bill rate and inserting the ﬁrst lag of the residual from this
equation into the nominal growth equation in the VAR. For the full 1959–1995 sam-
ple, the results were consistent with those of Feldstein and Stock in that the joint sig-
niﬁcance of the M2 lags and the error correction term was somewhat stronger, with
the latter term in itself signiﬁcant at the 1% level ( joint p-value of 0.005 compared
with 0.009 for M2 in table 6.2). In the post-1979 sample, however, the error correc-
tion term was not signiﬁcant and there was no improvement in the joint signiﬁcance
level with its introduction ( joint p-value of 0.547 compared with 0.456 for M2 in
table 6.2).
6.3 Optimal Policy and the McCallum Rule
Proponents of the monetary aggregates have generally recognized that the lack
of stability in the relationships identiﬁed in the previous section exist. McCallum
(1988), for example, saw the need for adjusting for the fact that the relationship be-
tween the monetary base and nominal output changes over time, albeit in his view
slowly and systematically. Thus, he proposed a policy rule that incorporates a time-
varying adjustment.
The potential usefulness of McCallum’s (McCallum, 1988) rule may be justiﬁed
and interpreted in various ways. Although McCallum (1988) was not an attempt to
come up with an optimal rule, we use his general reasoning in this section to develop
a parsimonious framework in which a monetary policy rule of the McCallum type is
optimal. This approach is then used to suggest possible improvements in the rule.
This also has the advantage that it suggests how a monetary aggregate can be
adjusted to provide empirical testing of the rule, which is conducted in section 6.4.
Previous research has been largely silent on the issue of the theoretical justiﬁcation
of money-based rules. The arguments given are generally informal, for example, in
McCallum (1988) and Judd and Motley (1991), and the justiﬁcation provided is typ-
ically based on artiﬁcial simulation results. Feldstein and Stock (1994) do calculate
the optimal policy rule in a general vector autoregression context, but they too relyon simulations as the primary basis for their policy conclusions. Here, we connect
these two approaches by deriving a policy rule which is formally similar—under
some conditions identical—to that of McCallum.114 Chapter 6

Our model is based on the following assumptions. First, we use the identity asso-
ciated with the quantity theory: nominal income equals money times velocity. Since
this relationship may be viewed as the deﬁnition of velocity, it presupposes very little
structure. Second, we assume that money is exogenous in the sense that its growth
rate can be determined independently of current-period information. Third, we as-
sume that velocity in the current period is unknown, but that the optimal predictionof velocity can be adequately characterized by a univariate ARIMA model. Fourth,
we assume that the policy objective is to minimize the mean squared deviations of
nominal income from a pre-speciﬁed target path. This objective is consistent with
the analysis of all the papers cited in the previous paragraph.
The quantity theory, in log-di¤erence form, may be expressed as:
Dx
t¼DmtțDvt ð6:1Ț
where xis the log of nominal income, mis the log of money, and vis the log of money
velocity. The process for velocity is assumed to have an ARIMA speciﬁcation. For
convenience, this ARIMA relationship is written in the form:
Dvt¼aðLȚDvt/C01țutțbðLȚut/C01 ð6:2Ț
where uis white noise. The objective function is to minimize the mean squared devi-
ation of nominal income ðxtȚfrom its target level ðx/C3
tȚ, conditional on the informa-
tion available at time t.
To derive the policy rule, ﬁrst write
Dvt¼Et/C01Dvtțut ð6:3Ț
where Etrepresents the expectation based on information available at time t. Com-
bining Eqs. (6.1) and (6.3), and deﬁning x/C3
tas the target nominal income in period t,
we obtainDx
/C3
t/C0Dxt¼Dx/C3
t/C0Dmt/C0Et/C01Dvt/C0ut
and, rearranging terms,
x/C3
t/C0xt¼x/C3
t/C0xt/C01/C0Dmt/C0Et/C01Dvt/C0ut: ð6:4Ț
Since utis orthogonal to all the other terms in the right-hand side of Eq. (6.4), which
are either policy choices or are predetermined as of time t, the conditional variance
of Eq. (6.4) is given by
Vt/C01ðx/C3
t/C0xtȚ¼Vt/C01wtțVt/C01ut
where
wt1x/C3
t/C0xt/C01/C0Dmt/C0Et/C01Dvt: ð6:5ȚIs There a Role for Monetary Aggregates? 115

Thus, the conditional variance of Eq. (6.4) is minimized by setting wt¼0, that is, by
applying a money supply rule of the form
Dm/C3
t¼Dx/C3
t/C0Et/C01Dvtțx/C3
t/C01/C0xt/C01: ð6:6Ț
The ARIMA representation, Eq. (6.2), for Dvtimplies that
Et/C01Dvt¼aðLȚDvt/C01țbðLȚut/C01: ð6:7Ț
Substituting Eq. (6.7) into Eq. (6.6), and noting from Eqs. (6.4) and (6.5) that wt¼0
implies that ut¼/C0 ð x/C3
t/C0xtȚ, produces the optimal monetary policy rule
Dm/C3
t¼Dx/C3
t/C0aðLȚDvt/C01țð1țbðLȚȚðx/C3
t/C01/C0xt/C01Ț: ð6:8Ț
Example 6.1 If the lag polynomials in the ARIMA expression for Dvtare of the form
aðLȚ¼1
nXn/C01
j¼0Lj
that is, the autoregressive part consists of a simple average of lagged Dvt, and if
bðLȚ¼b, a constant, then the optimal rule, Eq. (6.8), becomes
Dm/C3
t¼Dx/C3
t/C0Dvt/C01țð1țbȚðx/C3
t/C01/C0xt/C01Țð 6:9Ț
where
Dvt¼1
nXn/C01
j¼0Dvt/C0j¼1nðv
t/C0vt/C0nȚ:
With ncorresponding to 48 months, Eq. (6.9) is the rule suggested by McCallum
(1988). 4
The resulting rule is plausible, but does not ﬁt the data well. The ﬁrst equation in
table 6.3 provides an empirical estimate of b, which is the only parameter in the
McCallum rule, obtained by estimating the constrained form of the ARIMA Eq.
(2), over the period from March 1963 to December 1995. As noted in the introduc-
tion, we use the index of coincident indicators and the consumer price index as
monthly measures of real activity and prices. McCallum (1988) does not estimate
this parameter, but uses a range of values 0 al¼1țba0:5 in his simulations.
Our estimate of l¼1țbis 1.175, which is substantially larger than any of McCal-
lum’s assumed values. In fact, when inserted in the monetary rule, this estimateimplies that the reaction to a gap between actual and target nominal income in the
previous period is larger than the gap itself. 5
The ARIMA formulation may be relaxed to allow the simple average of the
lagged Dv
tto have a coe‰cient di¤erent from 1. These results appear in the second116 Chapter 6

Table 6.3
Univariate ARIMA Models of Velocity for the Monetary Base and M2 (Monthly)
Coe‰cient estimates (standard error)
EquationMonetary
aggregateEstimationperiod AR1 ( a) MA1 ( b) McCallum ( g)Standarderror (Eq.) R
2
(1) Base Mar. 63–Dec. 95 0 0.175
(0.050)1 0.00509 0.076
(2) Base Mar. 63–Dec. 95 0 0.173
(0.050)0.629
(0.162)0.00506 0.089
(3) Base Mar. 63–Dec. 95 0.889
(0.046)/C00.708
(0.071)0 0.00494 0.133
(4) Base Mar. 63–Dec. 95 0.846
(0.073)/C00.662
(0.097)0.062
(0.067)0.00494 0.135
(5) Base Mar. 59–Dec. 95 0.846
(0.056)/C00.647
(0.081)0 0.00502 0.127
(6) Base Oct. 79–Dec. 95 0.871
(0.064)/C00.613
(0.103)0 0.00487 0.168
(7) M2 Mar. 59–Dec. 95 0.753
(0.062)/C00.403
(0.086)0 0.00514 0.221
(8) M2 Oct. 79–Dec. 95 0.736
(0.092)/C00.342
(0.128)0 0.00519 0.250
Equation is of the form:
Dvt¼aDvt/C01țetțbet/C01țgDvt/C01
where Dvt¼DlogðCOIN ȚțDlogðCPIȚ/C0DlogðMȚ
COIN ¼Commerce Department/Conference Board index of coincident indicators
CPI¼consumer price index
M¼Monetary base or M2
Dvt¼1=48ðvt/C0vt/C048Ț.Is There a Role for Monetary Aggregates? 117

equation of table 6.3. The ﬁt is somewhat better and equality of the parameter to 1 is
rejected. However, the estimate of the moving average parameter bis very close to
the estimate from the previous equation and is therefore also outside the anticipated
range of values. As the following example shows, a simpler ARIMA formulation
produces a better ﬁt.
Example 6.2 Consider an ARIMA(1 ;1;1) model for vt, that is, with both aðLȚ¼a
andbðLȚ¼bconstant. Then the optimal monetary rule is
Dm/C3
t¼Dx/C3
t/C0aDvt/C01țð1țbȚðx/C3
t/C01/C0xt/C01Ț: ð6:10Ț
The empirical support for Eq. (6.10) is considerably stronger than that for Eq.
(6.9). Estimates of the ARIMA(1 ;1;1) model corresponding to Eq. (6.2) are shown
in line 3 of table 6.3 (higher-order terms are insigniﬁcant for both the autoregressiveand the moving average components). The autoregressive component implies a
lagged velocity adjustment of 0.889 times the previous period’s change in velocity,
plus a reaction to the previous period’s gap between actual and target nominal in-
come that corresponds to 0.292 of the gap. This latter ﬁgure is well within the range
assumed by McCallum in his simulations, but is used in conjunction with a velocity
adjustment based on only one lag.
In order to decide which speciﬁcation is better, the ARIMA(1 ;1;1) model versus
the model with the McCallum-type 48-month term, in Eq. (6.4) of table 6.3, we in-clude both the one-lag velocity adjustment corresponding to the ARIMA(1 ;1;1)
model and the McCallum-type term. Only the one-lag term is signiﬁcant; the longermoving average adjustment is insigniﬁcant with a t-statistic on its coe‰cient smaller
than one. In the ﬁfth equation in the table, the ARIMA(1 ;1;1) form is estimated
over the longer sample period starting with March 1959, since the MA(1) term only
requires using up one observation at the beginning while the model with the McCal-
lum average uses up 48 observations. The results are stable in comparison with
the same model estimated over shorter periods, as in the third and sixth equations.
A test for a break at October 1979 in Eq. (6.5) is insigniﬁcant, with a p-value of
0.24.
In the seventh equation of table 6.3, the ARIMA(1 ;1;1) model is estimated using
M2 in place of the monetary base, with very similar results. The parameter esti-
mates are close to those obtained with the base, and higher-order autoregressive and
moving average terms are again insigniﬁcant. The implication is that the monetary
policy rule represented by Eq. (6.10) is also feasible with M2 as the instrument
and with parameters that are similar to those that are optimal with the base. The
M2 velocity equation is also stable, as illustrated by the last equation in the table. A
test for a break at October 1979 is also insigniﬁcant in this case, with a p-value of
0.43.118 Chapter 6

6.4 Multivariate Analysis with Time Domain Adjustments
Although the Granger-causality tests presented in section 6.2 are not very encourag-
ing for the use of monetary aggregates in a policy rule, the analysis in section 6.3
suggests that forecasts of velocity, explicit or implicit, might be used to help improve
the performance of a money-based policy rule. For instance, the McCallum rule may
be interpreted as a way of adjusting for changing trends in velocity in order to target
nominal income more accurately. In this section, we adjust the money growth vari-
able that appears in the VARs of the previous section by adding to it some measure
of the expected change in velocity. Formally, the variable in the VAR is
DmA
t¼DmtțAt
where, for example,
At¼1
48ðvt/C01/C0vt/C049Ț¼1
48ðDvt/C01ț/C1/C1/C1ț Dvt/C048Ț
the McCallum 4-year simple average of changes in velocity. Alternatively,A
t¼1
48ðvt/C01/C0vt/C049Țțbet/C01
the McCallum average adjusted for moving average errors, or
At¼aDvt/C01țbet/C01
the change in velocity forecast from the ARIMA(1 ;1;1) model.
Table 6.4 presents the p-values for the adjusted monetary base in the nominal
growth and inﬂation equations from the VAR. The ﬁrst row repeats results from
table 6.1 for comparison, and the results of the above adjustments are shown in the
next three rows. (The results in the last row are discussed in the following section.)
In the nominal growth equation, none of the three adjustments do anything to im-
prove the signiﬁcance of the aggregate; in fact, the p-values are higher. Note, how-
ever, that in each case, the Chow test for the break becomes insigniﬁcant, so that
the adjustments do succeed in producing more stable equations.
The e¤ect of the adjustments on the inﬂation equation is in a sense the opposite.
With each of the three adjustments, there is a reduction in the p-values, although
clearly even the lowest ﬁgure of 0.334 (for the 48-month average with a moving av-erage term) is unacceptably high. In this case, however, the adjustments fail to make
a dent in the stability problem, with very strong signals of a break for all three
adjustments.
Comparable results for M2 are found in table 6.5. As in the case of the monetary
base, there is no improvement in the signiﬁcance of M2 in the nominal incomeIs There a Role for Monetary Aggregates? 119

Table 6.4
Signiﬁcance and Stability ( p-values) of Adjusted Monetary Base in Nominal Growth and Inﬂation Equa-
tions (Monthly, 9 Lags, Oct. 79 to Dec. 95)
Equation
Nominal growth Inﬂation
Adjustment to base Signiﬁcance Break a Signiﬁcance Break a
None 0.673 0.019 0.384 0.006
48-monthly average 0.796 0.105 0.351 0.00648-monthly average with MA term 0.792 0.160 0.334 0.004ARIMA(1,1,1) 0.772 0.127 0.373 0.002Low frequencies excluded 0.460 0.265 0.285 0.003
Adjusted base ¼Dm
A
t¼DmtțAtwhere
At¼1=48ðvt/C01/C0vt/C049Țð48-month average Ț
¼1=48ðvt/C01/C0vt/C049Țț1:171et/C01ð48-month average with MA term Ț
¼0:846Dvt/C01ț0:353et/C01ðARIMA ð1;1;1ȚȚ
¼components of VAR variables with cycles >8 yrs excluded ðlow frequencies excluded Ț
aBreak in Oct. 79 when estimated from Feb. 59 to Dec. 95.
Table 6.5
Signiﬁcance and Stability ( p-values) of Adjusted M2 in Nominal Growth and Price Equations (Monthly, 9
Lags, Oct. 79 to Dec. 95)
Equation
Nominal growth Inﬂation
Adjustment to M2 Signiﬁcance Break a Signiﬁcance Break a
None 0.456 0.449 0.482 0.080
48-monthly average 0.562 0.589 0.532 0.25548-monthly average with MA term 0.503 0.635 0.432 0.290ARIMA(1,1,1) 0.546 0.444 0.366 0.131Low frequencies excluded 0.294 0.395 0.255 0.019
Adjusted M2 ¼Dm
A
t¼DmtțAtwhere
At¼1=48ðvt/C01/C0vt/C049Țð48-month average Ț
¼1=48ðvt/C01/C0vt/C049Țț1:304et/C01ð48-month average with MA term Ț
¼0:753Dvt/C01ț0:597et/C01ðARIMA ð1;1;1ȚȚ
¼components of VAR variables with cycles >8 yrs excluded ðlow frequencies excluded Ț
aBreak in Oct. 79 when estimated from Feb. 59 to Dec. 95.120 Chapter 6

equation with any of the three adjustments. In the inﬂation equation, two of the
three adjustments improve signiﬁcance, but not nearly enough to make the levels
acceptable.
Thus, the McCallum insight of adjusting for predictable components in the change
in velocity produces some empirical gains, especially in the inﬂation equation, but
these gains are too marginal to make the relationships useful in practice. This conclu-
sion holds even with the weak requirements associated with the use of the aggregates
as information variables, and even more strongly in the context of their employment
in formal policy rules.
We must note one caveat to the foregoing interpretation of the results. The insig-
niﬁcance of the aggregates, adjusted or unadjusted, in the nominal income growthand inﬂation equations since October 1979 might be attributable to their use in
smoothing ﬂuctuations in those variables. Faster growth in the target variable would
prompt a slowing down of money growth, leading to a negative relationship. 6
Table 6.6 investigates this phenomenon. For any VAR equation described in sec-
tions 6.2, 6.4 and 6.5, estimated from October 1979 to December 1995, in which a
target variable is signiﬁcant in the money equation, the table shows the sum of the
coe‰cients of the lags of the target variable and the level of signiﬁcance of the sum.For example, the ﬁrst line shows the signiﬁcance of lags of nominal income growth
in the equation for the monetary base, the latter adjusted by McCallum’s four-yearTable 6.6
Signiﬁcance ( p-values) of Target Variables in Money and Interest Rate Equations (Monthly, 9 Lags,
Oct. 79 to Dec. 95)
Dependent
variable Adjustment aTarget variable(lags)Jointsigniﬁcanceof lagsSumof lagsSigniﬁcanceof sum
Base 48-month average
with MA termNominal income 0.007 /C00.098 0.311
Base ARIMA(1,1,1) Nominal income 0.003 0.293 0.013
M2 48-month average
with MA termNominal income 0.000 0.036 0.710
M2 ARIMA(1,1,1) Nominal income 0.000 0.338 0.005
M2 None Inﬂation 0.014 0.036 0.730M2 48-month average Inﬂation 0.007 0.174 0.164M2 48-month average
with MA termInﬂation 0.008 0.167 0.183
M2 ARIMA(1,1,1) Inﬂation 0.023 /C00.022 0.841
M2 Low frequencies
excludedInﬂation 0.020 /C00.292 0.160
aAdjustments are described in Tables 6.4 and 6.5.Is There a Role for Monetary Aggregates? 121

velocity adjustment with a moving average term. The lags of income growth are
signiﬁcant at the 0.007 level and the sum of the lag coe‰cients is negative ( /C00.098),
as suggested by the above discussion. However, the negative sum is not signiﬁcant,
and the support for the explanation is not compelling.
However, in two-thirds of the cases, the coe‰cient sums in table 6.6 are positive,
contradicting the proposed explanation. In fact, these positive sums are in some cases
signiﬁcant, lending very little credence to the story that the poor performance of the
aggregates as information variables is due to their use to smooth out nominal income
or inﬂation ﬂuctuations.
6.5 Multivariate Analysis with Frequency Domain Adjustments
An alternative way to adjust monetary aggregates to improve their performance in
explaining income and inﬂation is to remove components in the frequency domain
that might be obscuring the relationship between the monetary aggregates and nom-
inal income and inﬂation. An informal justiﬁcation for the long (four-year) moving
average of changes in velocity in the McCallum policy rule is that it would tend tocapture persistent changes in the velocity process without placing too much emphasis
on short-term ﬂuctuations. McCallum (1988, note 13) states that
As the purpose of this term is to take account of possible changes in velocity growth resulting
from regulatory and technological sources, the period of averaging should be long enough to
avoid dependence on cyclical conditions (which are reﬂected in the third term).
Here ‘‘the third term’’ refers to the previous period’s gap between target and actual
nominal income, as in Eq. (6.9).
As shown in section 6.3, this interpretation is not entirely consistent with the opti-
mization framework presented there, since the empirical estimates suggest a simpler
form with only one lag. Nevertheless, we show in this section that McCallum’s rea-
soning does have some empirical support. If the velocity series is decomposed by
spectral methods into various frequency bands, the evidence suggests that only the
low frequency band exhibits instability across the October 1979 break point.
Thus, as before, deﬁne the change in velocity by
Dvt¼Dxt/C0Dmt:
To construct the frequency band decomposition, we computed the Fourier trans-
form of the demeaned Dvtseries using data from February 1959 to December
1995. 7The decomposition was accomplished by retaining only the points in each of
three frequency bands and applying the inverse Fourier transform. 8The frequency
bands are:122 Chapter 6

Low frequencies cycles longer than eight years,
Medium frequencies cycles longer than one year and no longer than eight (corre-
sponding to the business cycle), 9and
High frequencies cycles up to one year.
The stability test applied to these components is very simple: each one is regressed
on a constant term and a dummy that is 1 starting with October 1979 and 0 other-
wise. The results are shown in table 6.7. It is fairly clear that the velocity of the
monetary base is lower in the second part of the sample. When the frequency band
components are examined, only the low frequencies exhibit instability, much more
strongly so than the aggregate series.
The results are similar for M2 velocity, although the change in trend is positive
and not as noticeable in the aggregate series, for which the break has a level of sig-
niﬁcance of 22%. However, once the frequency decomposition is applied, it is clear
that there is a break and that it is exclusively concentrated in the low-frequency com-
ponent, as was the case for the velocity of the monetary base. Figure 6.1 plots the
low-frequency components of both base and M2 velocities over the sample period.The trends found in table 6.7 are readily apparent in the ﬁgure, although it is also
clear that these low-frequency ﬂuctuations are more complicated than a simple step
function.
This evidence of instability in the low-frequency components of the base and
M2 velocities suggests that the higher-frequency relationships between money and
Table 6.7
Structural Break in Velocity: Analysis by Frequency Bands (Monthly Data, Feb. 59 to Dec. 95)
Velocity of Frequencies atStatistic for
break in Oct. 79Signiﬁcance
(tprob)
Base All /C05.51 0.000
Base Low /C023.5 0.000
Base Medium 0.12 0.907
Base High 0.01 0.993M2 All 1.22 0.223M2 Low 4.38 0.000M2 Medium /C00.06 0.956
M2 High 0.07 0.943
Velocity ¼Dv
t¼Dxt/C0Dmt;
Dxt¼nominal growth ¼DlogðCOIN Ț¼DlogðCPIȚ;
Dmt¼growth in base or M2.
aVariables are decomposed by computing the inverse Fourier transform of 3 spectral frequency bands: low
(cycles longer than 8 yrs), medium (between 1 and 8 yrs, corresponding to business cycle), and high (up to
one year).Is There a Role for Monetary Aggregates? 123

nominal income may be stronger and more stable than those of the aggregate series.
This point is examined in the last row of tables 6.4 and 6.5, which report the results
of performing the VAR exercise of the previous section on only the medium and
high-frequency components of nominal income, inﬂation and money growth. 10This
is equivalent to running a band-spectrum VAR in the sense of the band-spectrum
regressions proposed by Engle (1974).
Although there is a noticeable improvement in the signiﬁcance level of the mone-
tary variables in the band-spectrum equations, it is still insu‰cient to achieve stan-
dard levels of acceptability. In each case, the signiﬁcance level is lower than in any
of the other equations, either unadjusted or with time-domain adjustments. Never-
theless, the best performance is in the inﬂation equation with the monetary base,
where the signiﬁcance level is 28.5%. Another unattractive feature of the spectral
VARs is that for both the base and M2, the inﬂation equation has a break in October
1979. Of course, with the low signiﬁcance levels, this is of secondary importance.
6.6 Some Evidence from Germany: Output, Prices, and M3
Even though there are in the United States some notable proponents of the use of
monetary aggregates in monetary policy, there are many more who would argue
that the US evidence in this regard is far from compelling. It is useful, therefore, to
perform some of the analysis of the foregoing sections with German data, since
Figure 6.1
Low frequency component of change in velocity: proportion of standard deviation of change in velocity.124 Chapter 6

German economists and policymakers are more likely to be strong advocates of the
monetary aggregates than their US counterparts. In this section, we apply the princi-
pal tests of sections 6.2, 6.4 and 6.5 to data for western Germany: nominal GDP
growth, growth in the GDP deﬂator, and the broad M3 aggregate (on which the
Bundesbank focuses). 11
VAR results analogous to those presented for the United States in table 6.1 appear
in table 6.8. The results are in fact very consistent with those obtained with US M2.
For example, there is evidence that M3 is a strong predictor of nominal and real
growth over the full sample, but not of inﬂation. In the German case, the joint test
of the lags of M3 in the nominal growth equation for the full sample is not obviously
conclusive with a p-value of 0.074. However, the sum of those coe‰cients is signiﬁ-
cant at the 1% level. Moreover, if the post-reuniﬁcation period is excluded, recogniz-
ing the di‰culty in making these data fully consistent with the past, the results are
very strong. Both the joint test and the test of the sum are signiﬁcant at the 1% level.
Also consistent with the US results are the consequences of focusing on data since
October of 1979. For Germany, this is not as clear a break point as it is for the
United States. Nevertheless, the 1980s and 1990s are associated with ﬁnancial inno-
vations that may have changed the traditional relationships among economic vari-
ables. Table 6.9 shows the German results for this latter period, both including and
excluding the post-reuniﬁcation period. There are essentially no signiﬁcant results ineither panel of table 6.9.
Other than the own lags of M3 in the top panel, the only result that is signiﬁcant
at the 5% level is that for the sum of the lags of inﬂation in the money equation, alsoTable 6.8
Joint Signiﬁcance Tests in VAR for Germany with Income Growth, Inﬂation, and M3 (Quarterly, 3 Lags)
p-values for
PeriodDependent
variableIncomegrowth Inﬂation Money R
2Coe¤.sum ontStatisticp-
value
Mar. 70–Dec. 95Nominal growth 0.178 0.367 0.074 0.132 Money 2.65 0.009Inﬂation 0.043 0.247 0.096 0.253 Money 0.87 0.389
Money 0.749 0.444 0.000 0.340 Growth /C00.43 0.668
Inﬂation 1.35 0.180
Real growth 0.315 0.058 0.046 0.135 Money 2.34 0.022
Mar. 70–Sep. 90Nominal growth 0.200 0.305 0.008 0.195 Money 3.59 0.001Inﬂation 0.179 0.263 0.129 0.266 Money 0.89 0.379
Money 0.880 0.658 0.001 0.342 Growth /C00.42 0.677
Inﬂation 0.75 0.458
Real growth 0.071 0.011 0.013 0.206 Money 3.21 0.002
Nominal growth ¼Dlogðnominal GDP Ț¼Dx
t;
Inﬂation ¼DlogðGDP deﬂator Ț¼Dpt;
Money ¼DlogðM3Ț¼Dmt.Is There a Role for Monetary Aggregates? 125

in the top panel. As discussed in section 6.4, the signiﬁcance of this sum might be an
indication that M3 was set in reaction to current observed inﬂation, a procedure
which, if successful, could obscure the observed e¤ects of M3 on inﬂation. This inter-
pretation is not supported, however, since the positive sign would imply that M3
would grow faster in reaction to higher inﬂation.
When interpreting the results of table 6.9, it should be noted that the post-1979 and
pre-reuniﬁcation sample is not very large, which could certainly a¤ect signiﬁcance.
The problem is worse in Germany than in the United States because of the possible
di¤erences in the post-reuniﬁcation data.
To summarize, the results of the multivariate analysis in Germany are very similar
to those obtained for the United States. For the full sample period, there is evidencein both countries that monetary aggregates are predictors of subsequent economic
growth. However, for the period since October 1979, there are no clear signs that
M3 is useful as an information variable. While it is possible that the estimation of a
more detailed structural model could extract more information than our straightfor-
ward predictive analysis, it seems unlikely that strong relationships can be ascer-
tained for the latter period. 12
6.7 Conclusion
At the outset, we identiﬁed various possible roles for monetary aggregates in mone-
tary policy, but noted that all those roles presuppose that the aggregates perform atTable 6.9
Joint Signiﬁcance Tests in VAR for Germany with Income Growth, Inﬂation, and M3 (Quarterly, 3 Lags)
p-values for
PeriodDependent
variableIncomegrowth Inﬂation Money R
2Coe¤.sum ontStatisticp-
value
Dec. 79–Dec. 95Nominal growth 0.551 0.433 0.667 0.108 Money 0.20 0.840Inﬂation 0.741 0.156 0.335 0.168 Money /C00.65 0.517
Money 0.378 0.160 0.001 0.390 Growth /C01.51 0.137
Inﬂation 2.02 0.048
Real growth 0.634 0.097 0.197 0.207 Money 0.51 0.613
Dec. 79–
Sep. 90Nominal growth 0.453 0.716 0.749 0.130 Money /C00.55 0.587
Inﬂation 0.809 0.174 0.201 0.240 Money /C00.45 0.653
Money 0.682 0.130 0.867 0.245 Growth /C01.13 0.265
Inﬂation 1.13 0.267
Real growth 0.443 0.091 0.288 0.243 Money /C00.43 0.669
Nominal growth ¼Dlogðnominal GDP Ț¼Dx
t;
Inﬂation ¼DlogðGDP deﬂator Ț¼Dpt;
Money ¼DlogðM3Ț¼Dmt.126 Chapter 6

least as information variables. Our empirical results show that in the United States
since 1979, the monetary aggregates fall considerably short of those requirements.
We have tried to present the aggregates in the best possible light by employing sensi-
ble adjustments suggested in the literature and by developing further adjustments to
increase their precision. Some of the new adjustments proved more successful than
the earlier suggestions, but not enough to make a compelling case.
The results with German M3 were hardly more favorable for the use of M3 as an
information variable. In fact, the German results are very consistent with those forthe United States, particularly with US M2, and do not exhibit any obvious signiﬁ-
cance in the period since 1979.
Although our results have not ruled out that monetary aggregates cannot be used
in some complicated way as an information variable, they do indicate that the mon-
etary aggregates, the monetary base and M2 in particular, currently cannot be used
in a straightforward way for monetary policy purposes. Whatever their informational
content may have been in earlier time periods, they do not seem to provide adequate
and consistent information at present in the United States. The inability of monetary
aggregates to perform well as straightforward information variables in recent periodshas the implication that they cannot be used to signal the stance of monetary policy,
an important requirement if money growth targets are to be used as part of a strategy
to increase the transparency of monetary policy to the public and the markets.
We should note, however, that the majority of the period we focus on has been one
of relative price stability in the United States and Germany. The problem with mon-
etary aggregates as a guide to monetary policy is that there frequently are shifts in
velocity that alter the relationship between money growth and nominal income. A
way of describing this situation is to think of velocity shocks as the noise that
obscures the signal from monetary aggregates. In a regime in which changes in nom-inal income, inﬂation and the money supply are subdued, the signal-to-noise ratio is
likely to be low, making monetary aggregates a poor guide for policy. However, in
other economies or in other time periods in which we experience more pronounced
changes in money and inﬂation, the velocity shocks might become small relative to
the swings in money growth, thus producing a higher signal-to-noise ratio. In these
situations, the results could very well be di¤erent and monetary aggregates could use-
fully play a role in the conduct of monetary policy.
Acknowledgments
We thank Ben McCallum and participants at the Swiss National Bank’s 1996 Ger-
zensee Conference, and participants at a seminar at the Federal Reserve Bank of New
York for their helpful comments, and Betsy Reynolds for her research assistance.Is There a Role for Monetary Aggregates? 127

Any views expressed in this chapter are those of the authors only and not those of
Columbia University, the NBER, the Federal Reserve Bank of New York or the
Federal Reserve System.
Appendix A: Quarterly Results and VARs with Both Money and Interest Rates
Previous papers examining the relationship between monetary aggregates, incomegrowth and inﬂation have typically focused on GNP/GDP and have therefore used
quarterly data. To facilitate comparison of the results of this paper with the earlier
literature, tables 6.10 and 6.11 present quarterly results based on nominal GDP
growth and the GDP deﬂator. In general, the results with quarterly data are less sig-
niﬁcant than the corresponding results with monthly data. The one exception is the
signiﬁcance of the monetary base in the equation for inﬂation in which low-frequency
components have been excluded from all three variables. The lags of the base are
jointly signiﬁcant and the sum of their coe‰cients is positive with a p-value of 0.001.
These results suggest that there is information in the monetary base with regard tofuture inﬂation, not with regard to nominal GDP as the McCallum approach wouldrequire.
In the past, M1 has also been proposed as an instrument of monetary policy, al-
though recent experience has been less encouraging than that for M2. Table 6.12
presents results from a VAR with monthly data for M1 growth, inﬂation and nomi-
nal income growth. The results tend to be less signiﬁcant than those for M2 (e.g.,
table 6.2 in the text).
Table 6.10
Joint Signiﬁcance Tests in VAR with Nominal Growth, Inﬂation, and Monetary Base (Quarterly, 3 Lags)
p-Values for
PeriodDependentvariableNominalgrowth Inﬂation Money R
2p-Values
for break
(Oct. 79)
Q1 60–Q4 95 Nominal growth 0.031 0.518 0.249 0.171 0.004
Inﬂation 0.955 0.000 0.164 0.672 0.006
Money 0.337 0.508 0.000 0.560 0.069
Q4 79–Q4 95 Nominal growth 0.021 0.137 0.085 0.306
Inﬂation 0.534 0.000 0.091 0.764
Money 0.225 0.933 0.000 0.417
Low frequencies excluded:
Q4 79–Q4 95 Nominal growth 0.027 0.196 0.109 0.243
Inﬂation 0.278 0.354 0.036 0.260
Money 0.152 0.055 0.002 0.427
Nominal growth ¼Dlogðnominal GDP Ț¼Dxt;
Inﬂation ¼DlogðGDP deﬂator Ț¼Dpt;
Money ¼DlogðBASE Ț¼Dmtðquarterly average of monthly data Ț:128 Chapter 6

Table 6.11
Joint Signiﬁcance Tests in VAR with Nominal Growth, Inﬂation, and M2 (Quarterly, 3 Lags)
p-Values for
PeriodDependent
variableNominalgrowth Inﬂation Money R
2p-Values
for break(Oct. 79)
Q1 60–Q4 95 Nominal growth 0.592 0.690 0.000 0.256 0.244
Inﬂation 0.933 0.000 0.369 0.667 0.817
Money 0.522 0.390 0.000 0.564 0.032
Q4 79–Q4 95 Nominal growth 0.073 0.235 0.172 0.286
Inﬂation 0.478 0.000 0.873 0.739
Money 0.130 0.694 0.000 0.527
Low frequencies excluded:
Q4 79–Q4 95 Nominal growth 0.051 0.160 0.557 0.186
Inﬂation 0.268 0.662 0.943 0.143
Money 0.196 0.284 0.424 0.226
Nominal growth ¼Dlogðnominal GDP Ț¼Dx
t;
Inﬂation ¼DlogðGDP deﬂator Ț¼Dpt;
Money ¼DlogðM2Ț¼Dmtðquarterly average of monthly data Ț:
Table 6.12
Joint Signiﬁcance Tests in VAR with Nominal Growth, Inﬂation, and M1 (Monthly, 9 Lags)
p-Values for
PeriodDependent
variableNominalgrowth Inﬂation Money R
2p-Values
for break(Oct. 79)
Jan. 60–Dec. 95 Nominal growth 0.000 0.016 0.227 0.275 0.016
Inﬂation 0.001 0.000 0.194 0.594 0.041
Money 0.001 0.028 0.000 0.362 0.013
Oct. 79–Dec. 95 Nominal growth 0.000 0.159 0.910 0.300
Inﬂation 0.195 0.000 0.615 0.626
Money 0.009 0.126 0.000 0.473
Low frequencies excluded:
Oct. 79–Dec. 95 Nominal growth 0.000 0.056 0.867 0.261
Inﬂation 0.117 0.007 0.418 0.347
Money 0.015 0.313 0.000 0.414
Nominal growth ¼DlogðCOIN ȚțDlogðCPIȚ¼Dx
t;
Inﬂation ¼DlogðCPIȚ¼Dpt;
Money ¼DlogðM1Ț¼Dmt.Is There a Role for Monetary Aggregates? 129

Notes
1. The basic structure of the McCallum rule has been analyzed and extended in the recent literature, for
example, by Judd and Motley (1991), Hess et al. (1993), and Feldstein and Stock (1994).
2. These results are consistent with those obtained by Friedman and Kuttner (1992) with quarterly data
for the 1970–1990 period. In this paper, however, we examine whether it is possible to improve on theFriedman–Kuttner results by using monthly data, by adding data since 1990, and by including severalreﬁnements in the measure of money. We do not include here Friedman and Kuttner’s preferred measure,the commercial paper-Treasury bill spread, since it has been shown elsewhere to perform poorly in the
1990s. See, for example, Watson (1991) and Estrella and Mishkin (1998).
3. A seminal discussion of cointegration, error correction, and their relationship with VARs is found in
Engle and Granger (1987).
4. McCallum uses quarterly data, in which case n¼16. Also, in more recent papers, e.g., McCallum
(1993a, 1994), he has considered variants of this rule in which the target is deﬁned in terms of nominal in-
come growth, rather than its level. The available simulation evidence for these variants is not as extensive
as for the levels version, but McCallum (1993b) ﬁnds that it works better in Japan with an interest rateinstrument.
5. McCallum has indicated that a lof this magnitude leads to instability when used in his simulation
experiments. We should note that our estimates using monthly data may produce in principle an implicit
value of lthat di¤ers from that obtained with quarterly data, which is the frequency used by McCallum.
Nevertheless, time aggregation of an MA(1) or ARIMA(1 ;1;1) process from monthly to quarterly data
leads to an ARMA structure of the same order (see Harvey, 1981, p. 44), and our estimate of bwith quar-
terly data is 0.191, which is very close to the monthly estimate of 0.175.
6. Note however that the expected signs of these relationships may depend on whether policymakers are
reacting to demand shocks or to supply shocks. The presence of supply shocks in the sample could make itmore di‰cult to observe the signs we postulate in the text. A more careful analysis of these possibilitiescould proceed by formulating and estimating a policy reaction function, which is beyond the scope of thischapter. Some analysis of a policy reaction function may be found in Taylor (1993) for the United Statesand in Clarida and Gertler (1996) for Germany.
7. We used the Fourier and inverse Fourier transforms in the RATS econometrics package with the algo-
rithm provided for choosing the number of frequency points in the frequency domain. No smoothing was
applied.
8. For a thorough discussion of Fourier transforms and spectral analysis in general, see Brillinger (1981).
9. The recent literature typically adopts frequencies of 18 months or two years as the lower bound for the
business cycle. We ﬁnd, however, that such representations do not coincide with the NBER turning points,
particularly with regard to the two separate recessions in 1980–1982. Our convention ﬁts the NBER dates
more closely and corresponds to that of Granger and Hatanaka (1964).
10. We also estimated the VAR with either the high- or the medium-frequency component (rather than the
low-frequency component) excluded from all three variables. In both cases, the signiﬁcance of the key pa-rameter estimates was reduced considerably. Thus, the only frequency domain adjustment that seemspromising is the exclusion of the low frequencies, as reported in the text.
11. Data for GDP, the GDP deﬂator and M3 were obtained from the Bundesbank. GDP and the deﬂator
are for western Germany only, even in the post-reuniﬁcation period.
12. Clarida and Gertler (1996) have found evidence that the German repo rate reacts to deviations of both
real growth and inﬂation from target levels. Also, Bernanke and Mihov (1996) have found evidence thatexpected German M3 inﬂuences the Lombard rate. Their results are not directly comparable to those ofthis chapter, since they test whether money is a target for the Bundesbank, not whether it inﬂuences or is
inﬂuenced by output or inﬂation.
References
Bernanke, B. S., Mihov, I., 1996. What Does the Bundesbank Target? International Seminar on Macro-
economics, NBER and Institute for Advanced Studies.130 Chapter 6

Brillinger, D. R., 1981. Time Series: Data Analysis and Theory . Holden Day, San Francisco.
Clarida, R., Gertler, M., 1996. How the Bundesbank Conducts Monetary Policy. New York University
Working Paper RR # 96–14.
Engle, R. F., 1974. Band spectrum regression. International Economic Review 15, 1–11.
Engle, R. F., Granger, C. W. J., 1987. Cointegration and error correction: representation, estimation, and
testing. Econometrica 55, 251–276.
Estrella, A., Mishkin, F. S., 1998. Predicting U.S. recessions: ﬁnancial variables as leading indicators. Re-
view of Economics and Statistics , 80.
Feldstein, M., Stock, J. H., 1994. The use of a monetary aggregate to target nominal GDP. In: Gregory
Mankiw, N. (Ed.), Monetary Policy . University of Chicago, Chicago, pp. 7–62.
Friedman, B. M., Kuttner, K. N., 1992. Money, income, prices, and interest rates. American Economic Re-
view 82, 472–492.
Granger, C. W. J., Hatanaka, M., 1964. Spectral Analysis of Economic Time Series . Princeton University
Press.
Harvey, A. C., 1981. Time Series Models . Philip Allan, Oxford.
Hess, G. D., Small, D. H., Brayton, F., 1993. Nominal income targeting with the monetary base as instru-
ment: an evaluation of McCallum’s rule. Federal Reserve Board Finance and Economic Discussion Series.
Huizinga, J., Mishkin, F. S., 1986. Monetary policy regime shifts and the unusual behavior of real interest
rates. Carnegie-Rochester Conference Series on Public Policy , 231–274.
Judd, J. P., Motley, B., 1991. Nominal feedback rules for monetary policy. Federal Reserve Bank of San
Francisco Economic Review 3–17.
McCallum, B. T., 1988. Robustness properties of a rule for monetary policy. Carnegie-Rochester Confer-
ence Series on Public Policy 29, 173–204.
McCallum, B. T., 1993a. Concluding observations. In: Goodfriend, M., Small, D. H. (Eds.), Proceedings
of the Conference on Operating Procedures and the Conduct of Monetary Policy . Federal Reserve Board.
McCallum, B. T., 1993b. Speciﬁcation and analysis of a monetary policy rule for Japan. Bank of Japan
Monetary and Economic Studies 11, 1–45.
McCallum, B. T., 1994. ‘Comment’ on Feldstein, M., Stock, J. H., The Use of a Monetary Aggregate to
Target Nominal GDP. In: Gregory Mankiw, N. (Ed.), Monetary Policy . University of Chicago, Chicago,
66–69.
Taylor, J. B., 1993. Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on
Public Policy , 195–214.
Watson, M., 1991. Using econometric models to predict recessions. Federal Reserve Bank of Chicago Eco-
nomic Perspectives 15, 14–25.Is There a Role for Monetary Aggregates? 131

7Rethinking the Role of NAIRU in Monetary Policy: Implications of
Model Formulation and Uncertainty
Arturo Estrella and Frederic S. Mishkin
7.1 Introduction
Because the e¤ects of monetary policy on the aggregate economy have long lags,
monetary policy must necessarily be preemptive; that is, it must act well before inﬂa-tion starts to rise. 1This, of course, is easier said than done. In order to act preemp-
tively, monetary policymakers must have signals that help them forecast future
changes in inﬂation. One such signal that has received substantial attention both
in the academic literature and in the press is the gap between unemployment and
NAIRU, the nonaccelerating inﬂation rate of unemployment. 2In other words,
NAIRU is the unemployment rate at which inﬂation is expected to neither increase
or decrease.
The NAIRU concept has come under quite serious attack in recent years. In the
early to mid-1990s, the common view in the economics profession was that NAIRUin the United States was around 6 percent. However, when the unemployment rate
began to fall below 6 percent in 1995 and remained well below that level thereafter
without any increase in inﬂation—indeed inﬂation actually fell—concern arose that
the NAIRU concept might be seriously ﬂawed. In addition, recent academic research
has shown that there is great uncertainty in the estimates of NAIRU (e.g., Staiger
et al. 1997a, 1997b), suggesting that looking at the unemployment rate relative to
NAIRU might not be a very helpful guide for monetary policy.
In this chapter, we rethink the NAIRU concept and examine whether NAIRU
might have a useful role in monetary policy making. We argue that the answer is
yes. However, the positive answer depends critically on redeﬁning NAIRU very care-
fully and distinguishing it from a long-run concept like the natural rate of unemploy-ment, something that is not typically done in the literature. Furthermore, as we will
see, the view that the NAIRU concept implies that the monetary authorities should
try to move the economy toward the NAIRU, thus to some extent treating it as a
target, is both incorrect and misguided.
The ﬁrst step in our analysis, in section 7.2, is to think about deﬁning NAIRU
in the context of setting monetary policy instruments. We adopt a deﬁnition that

focuses on NAIRU as a reference point for monetary policy and show that our deﬁ-
nition of NAIRU is a short-run concept and is not the same as the natural rate of
unemployment. Understanding that short-run NAIRU and the natural rate of un-
employment di¤er is important, not only for the theoretical analysis to follow, but
also because it suggests that short-run NAIRU is likely to be highly variable, in con-
trast to the natural rate of unemployment. One immediate implication is that think-ing of NAIRU as a level at which the unemployment rate should settle is not very
useful for policy purposes.
Our approach to the construction of short-run NAIRU is fairly general. Although
we deﬁne this concept in the context of a particular model of inﬂation that is adapted
from the current literature, the same approach can be applied to any predictive
model of inﬂation in which unemployment plays an important role.
Once we have deﬁned short-run NAIRU, we then go on to examine how it might
be used in policy making. We do this in several steps. First, we look in section 7.3 at
the certainty-equivalent case, when only inﬂation enters the policymakers’ objective
function and then when unemployment (or equivalently, output) as well as inﬂation
are part of policymakers’ objectives. Although the certainty-equivalent case is usefulas a starting point for the analysis, we cannot stop here because several sources of
uncertainty have important implications for how monetary policy should be con-
ducted. In addition to uncertainty about estimates of the actual value of NAIRU,
there is uncertainty about the estimated parameters of the model, especially the
parameters that measure the e¤ect of the NAIRU gap on inﬂation and the impact
of monetary policy instruments on the NAIRU gap. We examine in section 7.4 what
e¤ect these sources of uncertainty have on how short-run NAIRU might be used in
monetary policy making, again under the pure price stability objective and then
when unemployment as well as inﬂation enter the policymakers’ objective function.
Our theoretical analysis shows that uncertainty about the level of short-run
NAIRU does not necessarily imply that monetary policy should react less to the
NAIRU gap. However, uncertainty about the e¤ect of the NAIRU gap on inﬂation
does require an adjustment to the reference point for monetary tightening in terms of
the level of unemployment and to the weight applied to the gap between actual and
target inﬂation. Furthermore, as in Brainard (1967), uncertainty about the e¤ect of
the monetary policy instrument on the NAIRU gap reduces the magnitude of the
policy response.
There is another sense in which uncertainty about NAIRU may have an e¤ect on
policy. There may be uncertainty not just about the level of NAIRU or its e¤ect but
about the way it is modeled: the exact form of the model speciﬁcation may be un-known. Errors in model selection may result in excess uncertainty regarding both
inﬂation forecasts and the parameters of the model. Thus model selection has the
potential to increase uncertainty about the e¤ect of the NAIRU gap and to reduce
the e¤ectiveness of policy, and the magnitude of this problem may be more di‰cult134 Chapter 7

to determine than that of simple parameter uncertainty. In section 7.5, we focus on
the losses associated with leaving out key information from the model.
Although our theoretical framework shows the qualitative e¤ects of uncertainty on
how monetary policy should be conducted, it cannot tell us whether these e¤ects are
economically important. To examine this question, we estimate in section 7.6 a sim-
ple NAIRU gap model for the United States to obtain quantitative measures of un-certainty and to assess how these measures a¤ect our view of the optimal reaction of
monetary policy to movements in unemployment relative to short-run NAIRU. Us-
ing an analogous model based on monthly data, we then examine how in practice the
short-run NAIRU concept could be used in the actual conduct of monetary policy.
The estimated models provide us with measures of short-run NAIRU that indicate
that it is highly variable, suggesting that trying to drive the unemployment rate to-
ward NAIRU, whether it is a short-run or a long-run concept, would be an inappro-
priate way to think about how monetary policy should be conducted. In particular,
we use our analysis to evaluate whether the setting of monetary policy instruments in
the face of rapidly falling unemployment rates in recent years makes sense.
7.2 Defining Short-Run NAIRU: Why It Differs from the Natural Rate of Unemployment
The concept of the natural rate of unemployment was ﬁrst developed by Friedman(1968) and Phelps (1968) to argue that there would be no long-run trade-o¤ between
unemployment and inﬂation. The natural rate of unemployment is deﬁned as the
level of unemployment to which the economy would converge in the long run in
the absence of structural changes to the labor market. An implication of this deﬁni-
tion is that expansionary monetary policy that leads to higher inﬂation would not be
able to produce lower unemployment on average. Indeed, as mentioned in Friedman(1968), higher inﬂation might even have the opposite e¤ect of raising unemployment
in the long run because it would interfere with e‰cient functioning of labor markets.
The concept of a natural rate of unemployment leads to the following characteriza-
tion of an expectations-augmented Phillips curve:
p
t¼pe
tțbðLȚðut/C0utȚțd0ztțet;
where
pt¼inﬂation rate from t/C01t o t
pe
t¼inﬂation rate expected at t/C01
ut¼unemployment rate at time t
ut¼natural rate of unemployment at time t, which could be a constant but could
shift with structural changes in the economyRethinking the Role of NAIRU: Model Formulation and Uncertainty 135

zt¼a vector of variables such as supply shocks, which have zero ex ante expectation
et¼an unspeciﬁed disturbance term
In order to estimate this expectations-augmented Phillips curve, researchers typi-
cally assume that the expected inﬂation can be measured as a distributed lag on past
inﬂation and other variables, and that the inﬂation rate is integrated of order one, so
thatDptis stationary. The resulting Phillips curve is then
Dpt¼bðLȚðut/C0utȚțgðLȚDpt/C01țd0ztțet: ð7:1Ț
The NAIRU concept was ﬁrst developed in a paper by Modigliani and Papademos
(1975) and is deﬁned as the rate of unemployment at which there is no tendency
for inﬂation to increase or decrease. In empirical work such as Staiger et al. (1997a,
1997b) and Gordon (1997), NAIRU is viewed as being equivalent to the natural rate
of unemployment, ut, in equation (7.1) and is typically estimated by assuming that ut
is a constant, a random walk, or a linear transformation of some step function orspline. 3
For policy purposes, equation (7.1) indicates that it is perfectly appropriate to
think about the unemployment gap, u
t/C0ut, as one determinant of changes in the
rate of inﬂation, recognizing that other factors, represented by the past history ofinﬂation and the z
tvariables, also a¤ect the inﬂation process. However, current un-
employment is frequently compared with the estimated value of NAIRU, and the
resulting NAIRU gap is taken to be an indicator of inﬂationary pressure. Under a
strong form of this view, if policymakers wish to drive inﬂation down, they need to
raise the unemployment level above NAIRU, whereas if inﬂation is at its desired
level, monetary policy needs to keep unemployment from falling below NAIRU.
Policy discussions, therefore, frequently focus on the di¤erence between the current
level of unemployment and NAIRU as estimated above, in other words, on the vari-
able that enters the ﬁrst term of equation (7.1) in a distributed lag. This implicit com-
parison has the advantage of simplicity: it focuses the discussion on a single indicator
of inﬂationary pressure, the unemployment gap, that we know from the model shouldbe zero in long-run equilibrium. However, this advantage is overwhelmed by a num-
ber of serious problems associated with this procedure.
First, monetary policy does not generally focus only on long-run equilibrium, so
the gap as deﬁned above may be of limited usefulness. Second, even if equation (7.1)
is viewed as a short-run forecasting equation, the dependent variable is contempora-
neous monthly or quarterly inﬂation, which is quite unlikely to be the policy target in
practice. Third, the current unemployment gap is only one of many explanatory vari-
ables in the equation, including several lags of the gap itself. Focusing on only one
variable gives an incomplete picture. Fourth, the equation may not even represent136 Chapter 7

the optimal forecast of inﬂation, since other potentially important variables may be
omitted.
Finally, focusing on the unemployment gap may create the impression that the
goal of policy is to drive unemployment toward NAIRU as a target level. As equa-
tion (7.1) illustrates, the current unemployment gap, ut/C0ut, is only one of many ex-
planatory variables in the Phillips curve equation. The presence of lags of Dpin the
equation suggests that inﬂation may decelerate because expected inﬂation is falling,
even if the unemployment rate is below the natural rate of unemployment. Similarly,
if there have been favorable supply shocks, inﬂation in the future may decelerate even
though the unemployment rate is well below the natural rate. The presence of lags of
the unemployment gap suggests complicated dynamics in which a current negative
unemployment rate could also be associated with decelerating inﬂation. The presence
of many other variables besides the current unemployment gap in the expectations-
augmented Phillips curve equation therefore implies that the unemployment rate
at which there is no tendency for inﬂation to rise or fall over the policy horizon can
be quite di¤erent from the natural rate of unemployment, ut. In other words, it can be
quite misleading to focus on NAIRU, as an estimate in equation (7.1) of the naturalrate of unemployment, because it is not clear that the introduction of policy shocks
designed to drive unemployment toward this characterization of NAIRU will do
anything to control inﬂation either in the short run or in the long run.
Therefore, we propose an alternative way of thinking about NAIRU as a refer-
ence point for unemployment that reﬂects inﬂationary pressures over the short- or
intermediate-run policy horizon. The key idea is that the reference point for un-
employment at which inﬂation will neither increase nor decrease over the relevant
policy horizon, which can be thought of as a short-run NAIRU, embodies not only
ut, the natural rate of unemployment, but also the other variables that help predict
inﬂation. In other words, we would like to express the change in inﬂation over the
relevant policy horizon as a function of ut/C0nt, where ntis an appropriately con-
structed short-run NAIRU.
Thus suppose that the policy horizon for inﬂation is from jtojțkmonths ahead
and deﬁne
Dpðj;kȚ
t¼ð1200 =kȚlogðptțjțk=ptțjȚ/C0100 log ðpt=pt/C012Ț
as the di¤erence between current annual inﬂation and inﬂation over the policy hori-
zon, where ptis the price level in month t. We then construct equation (7.2):
Dpðj;kȚ
t¼ațbðLȚmtțgðLȚDptțd0xtțet; ð7:2Ț
which is similar to equation (7.1), save for the dependent variable and the inclusion
of a vector xthat contains any predetermined variables that help predict inﬂation at
the targeted horizon. 4Rethinking the Role of NAIRU: Model Formulation and Uncertainty 137

In order to express the change in inﬂation as a function of the di¤erence between
unemployment and a short-run NAIRU, equation (7.2) can always be rewritten as
Dpðj;kȚ
t¼b0ðmt/C0ntȚțet ð7:3Ț
with
nt¼short-run NAIRU
¼/C0 ½ ațðbðLȚ/C0bð0ȚȚutțgðLȚDptțd0xt/C138=bð0Ț; ð7:4Ț
where all the predictive power of the equation has been subsumed in the short-run
NAIRU nt. This short-run NAIRU is not an estimate of the long-run equilibrium
natural rate, but a reference rate that represents the level of current unemployment
that would correspond to a forecast of no inﬂation change over the policy horizon. 5
Another important point that immediately falls out of this equation is that since
short-run NAIRU is related to past lags of unemployment, inﬂation, and any other
variables that help forecast changes in inﬂation, short-run NAIRU may undergo
substantial ﬂuctuations even if the natural rate of unemployment is a constant.
Equation (7.3) has several important advantages over equation (7.1). In contrast to
the conventional equation, the dependent variable in equation (7.3) is the change in
inﬂation over the target horizon. Second, the current NAIRU gap, ut/C0nt, is the only
explanatory variable in the equation and it subsumes all the predictive power of the
equation. Third, the equation provides an optimal forecast of targeted inﬂation,
given current information.
We note, however, that our approach to short-run NAIRU is fairly general and is
largely independent of the particular form of equation (7.3). The deﬁnition of short-
run NAIRU in equation (7.4) simply collects all the systematic terms in equation
(7.3), other that the current rate of unemployment. Hence, this technique is applica-
ble to any forecasting equation for Dpðj;kȚ
t, as long as the current unemployment rate
utenters signiﬁcantly in the equation. 6
The analysis of this chapter will focus on equations (7.2) and (7.3) and on our cor-
responding deﬁnition of short-run NAIRU. For the purposes of theoretical analysis,we use a simpliﬁed version of these equations with a limited lag structure. We return
to the more general speciﬁcation, however, when we consider empirical estimates us-
ing monthly data in section 7.6.
7.3 The Role of NAIRU in Policy Making: The Certainty-Equivalent Case
7.3.1 Objective Function with Inflation Only
For the theoretical analysis, we start with a simple joint model of unemployment and
inﬂation that is isomorphic to the one employed by Svensson (1997) with an output138 Chapter 7

gap. In addition to inﬂation pand an unemployment gap ~uu, the model contains an
exogenous variable xand a monetary policy control variable r. This model will be
the basis for the next few sections of the chapter. However, some speciﬁc assump-
tions will be adjusted in subsequent sections in order to address particular issues. As-
sume for the purposes of this section that the parameters of the model are known
with certainty.
pt¼pt/C01/C0a1~uut/C01ța3xt/C01țet; ð7:5Ț
~uut¼b1~uut/C01țb2rt/C01țb3xt/C01țht; ð7:6Ț
xt¼c3xt/C01țvt; ð7:7Ț
where ~uut¼ut/C0uandrtis the monetary policy variable. Equation (7.5) is a dynamic
Phillips curve in which both unemployment and xare predictors of inﬂation one pe-
riod ahead, say a year. Equation (7.6) is an IS curve, and equation (7.7) deﬁnes the
dynamics of the exogenous variable x. The equilibrium level of all the variables is
zero. Note, therefore, that the policy variable rmight be more similar to a change
in the interest rate rather than the level.
The reduced-form expression for inﬂation two periods ahead based on current
values of the variables is
ptț2¼pt/C0a1ð1țb1Ț~uut/C0a1b2rtț½a3ð1țc3Ț/C0a1b3/C138xtțxtț2; ð7:8Ț
where
xtț2¼/C0a1htț1ța3vtț1țetț1țetț2:
Assume now that the policy objective is to minimize
Etðptț2/C0p/C3Ț2¼ðEtptț2/C0p/C3Ț2țVtptț2:
Although this assumption seems simplistic, Svensson (1997) has shown that the solu-
tion obtained in this manner is equivalent to the dynamic solution of a model in
which the target is a weighted sum of all future squared deviations of inﬂation from
the target level. Note also that equation (7.8) is analogous to equation (7.2) above in
that it corresponds to an optimal forecast of inﬂation acceleration over the policy ho-
rizon, which is given by
Etptț2¼pt/C0a1ð1țb1Ț~uut/C0a1b2rtț½a3ð1țc3Ț/C0a1b3/C138xt:
The conditional variance of inﬂation is
Vtptț2¼s2
x:
Since the variance of inﬂation does not depend on the policy variable, the result
is determined by certainty equivalence; that is, the optimal rule may be obtained byRethinking the Role of NAIRU: Model Formulation and Uncertainty 139

setting expected inﬂation equal to the target, p/C3, and solving for the value of the pol-
icy variable. The optimal value of the policy variable is given by
r/C3
t¼/C01țb1
b2~uutța3ð1țc3Ț/C0a1b3
a1b2xtț1
a1b2ðpt/C0p/C3Ț
¼/C01țb1
b2ð~uut/C0ntȚț1
a1b2ðpt/C0p/C3Ț; ð7:9Ț
where the short-run NAIRU (deﬁned as a deviation from u)i s
nt¼a3ð1țc3Ț/C0a1b3
a1ð1țb1Țxt: ð7:10Ț
Equation (7.9) is a variant of the Taylor (1993) rule, which di¤ers in that it is
expressed in terms of unemployment rather than output. In addition, it allows forthe reference point for monetary tightening in terms of the level of unemployment
to be a short-run NAIRU rather than a ﬁxed natural rate. In e¤ect what this varia-
tion on the Taylor rules does is bring in additional information that helps forecast
inﬂation in deriving an optimal setting of the policy instruments.
Even in this relatively simple setting, short-run NAIRU n
tis not a constant but is
instead a function of the exogenous variable x. If lags of inﬂation, unemployment,
and the policy variable appear in equations (7.5) and (7.6), their role in the policy
rule—and therefore in the deﬁnition of short-run NAIRU—would be like that of xin
the model. Of course, if the only variable that helps predict inﬂation over the policy
horizon, other than the unemployment rate, is a constant, then NAIRU will be con-
stant as in a more standard formulation. Note also that, like ~uu, the short-run NAIRU
of our theoretical model is measured in relation to u. In empirical applications, we
would want to focus on the equivalent of ntțuas a measure of short-run NAIRU.
Equation (7.9) also helps to clarify the proper use of NAIRU for policy purposes.
The policy objective is not to drive unemployment to NAIRU, which is a temporary
and variable reference point, but to use the NAIRU unemployment gap as one indi-
cator of the direction to move the policy variable, by an amount dictated by the co-
e‰cients of the model. Also, the NAIRU gap indicator is not to be interpreted in
isolation but must be weighed against the e¤ect on the optimal setting of the policy
variable suggested by the other indicator that is also included in the reaction func-tion, the gap between actual and target inﬂation.
It is also important to recognize that our equation (7.9) variant of the Taylor rule
is completely consistent with the result of Svensson (1997). Setting the policy instru-
ment according to equation (7.9) is equivalent to setting expected inﬂation over the
policy horizon equal to the inﬂation target p
/C3, which is the Svensson (1997) optimal-
ity condition if only inﬂation is in the objective function.140 Chapter 7

We can also draw some conclusions about the sign of the coe‰cient of xin the
deﬁnition of NAIRU, based on whether xrepresents a supply or a demand e¤ect.
For example, if xis a supply e¤ect such as an oil price shock, then a3andb3would
have the same sign. Since the other parameters in equation (10) were chosen to have
positive values, the two terms in the coe‰cient would be o¤setting and the net e¤ect
ofxon short-run NAIRU would be indeterminate. In contrast, if xrepresents a de-
mand e¤ect, then a3andb3would have opposite signs and the two terms would be
reinforcing. The sign of the e¤ect is positive if the demand variable xincreases inﬂa-
tion and vice versa. In other words, a demand shock that raises inﬂation would lead
to a higher value of short-run NAIRU, which implies more tightening given the same
value of unemployment.
Supply and demand shocks also have di¤erential e¤ects on the overall implication
about the optimal setting of the policy variable. The cumulation of supply e¤ects
would tend to drive both unemployment and inﬂation in the same direction, produc-
ing o¤setting e¤ects in equation (7.9). Cumulated demand e¤ects, however, would
drive inﬂation and unemployment in di¤erent directions, providing an unambiguous
policy reaction. Therefore, demand e¤ects that raise inﬂation should provoke a pol-icy tightening.
7.3.2 Output as well as Inflation in the Objective Function
Even when inﬂation is the only concern of policymakers, as in subsection 7.3.1, theoptimal policy assigns a signiﬁcant role to the level of unemployment or to the un-
employment gap, as seen in equation (7.9). In this section, we explore how policy
should be conducted when policymakers include both inﬂation and output in their
objectives. We do this by including a second term in the objective function, which
now becomes
E
tðptț2/C0p/C3Ț2țlEt~uu2
tț1:
The economic signiﬁcance of this change is that the policy objective assigns some
weight to reducing the variability of unemployment around zero, which is the equi-
librium level. 7
The optimal value of the policy variable in this case is
rðlȚ
t¼1
ða2
1țlȚb2f/C0½ð1țb1Țða2
1țlȚ/C0l/C138~uut
ț½a1a3ð1țc3Ț/C0ð a2
1țlȚb3/C138xtța1ðpt/C0p/C3Țg:
The modiﬁcation of the objective function to reﬂect an unemployment target changes
the weights on u,x, and pt/C0p/C3in the optimal policy rule but does not a¤ect its
general form. Speciﬁcally, the weight on ~uutrelative to the weight on pt/C0p/C3risesRethinking the Role of NAIRU: Model Formulation and Uncertainty 141

with l. In the extreme, if the weight on unemployment becomes inﬁnitely large ( l
approaches inﬁnity), the optimal rule simpliﬁes to
rðyȚ
t¼/C0b1
b2~uut/C0b3
b2xt;
in which the inﬂation gap has disappeared and only an unemployment gap remains.
This result may also be obtained by certainty equivalence, setting expected un-
employment equal to its equilibrium level and solving for the value of the policy
variable.
7.4 NAIRU and Policy Making: Implications of Parameter Uncertainty
7.4.1 Objective Function with Inflation OnlyUncertainty about the Natural Rate of Unemployment
We begin to examine the conse-
quences of uncertainty in the model of section 7.3 by looking at the e¤ects of un-
certainty regarding the natural rate of unemployment or, equivalently, long-run
NAIRU. We start with this particular question for two reasons. First, it seems that
in the policy discussion on the use of NAIRU, it is this question that is most fre-quently in the mind of the policymaker, although it is not always precisely formu-
lated. Second, the examination of this narrower issue provides helpful intuition for
the more general results that follow in the rest of this section.
Thus consider a more focused version of the model of section 7.3 in which tradi-
tional long-run NAIRU is the appropriate reference point for monetary policy in
terms of the unemployment rate:
p
t¼pt/C01/C0a1ðut/C01/C0uȚțet
¼pt/C01/C0a1ut/C01ța0țet; ð7:5aȚ
ut/C0u¼b1ðut/C01/C0uȚțb2rt/C01țht; ð7:6aȚ
where a0¼a1uand, as in section 7.3, uis the natural rate and rtis the monetary pol-
icy variable. We write these equations explicitly in terms of uin order to focus on
uncertainty with regard to this parameter. For the same reason, we assume that the
parameters b1andb2in equation (7.6a) are known.
The second expression for equation (7.5a), under the natural stochastic assump-
tions, may be estimated using least squares. It is straightforward then to calculate
the asymptotic distribution of the parameter estimates, which are consistent. In par-
ticular, we can derive that TVð^aa1;^aa0Ț, the asymptotic variance of the vector of esti-
mates ð^aa1;^aa0Țmultiplied by the number of observations T,i s142 Chapter 7

s2
e
s2
u !
1 u
uu2țs2
u/C20/C21
;
where uand s2
uare the unconditional asymptotic mean and variance of utand
s2eis the variance of et. Now, if Jis the Jacobian of the transformation ða1;a0Ț
7!ða1;uȚ¼ð a1;a0=a1Ț, then asymptotically TVð^aa1;^uuȚ¼ TJV ð^aa1;^aa0ȚJ0, which
equals
s2
e=s2
u 0
0 s2
e=a2
1/C20/C21
;
where we have made use of the fact that the unconditional mean of equation (7.5a) is
Dp¼0.
The foregoing derivations may now be incorporated into the optimization problem
of section 7.3, again with the objective function Etðptț2/C0p/C3Ț2, but now
Etptț2¼pt/C0a1ð1țb1Țðut/C0uȚ/C0a1b2rt
and
Vtptț2¼s2
a1½ð1țb1Țð/C0utțuȚ/C0b2rt/C1382ța2
1ð1țb1Ț2s2
uțs2
a1s2
uð1țb1Ț2țs2
x:
In the expression for the variance, the terms that include s2
udo not depend on the
policy variable. Since the estimators of uand a1are orthogonal, the optimal rule
will not depend on the uncertainty with regard to u, as shown in the expression
r/C3
t¼/C01țb1
b2ðut/C0uȚț1
1țt/C02
1/C1pt/C0p/C3
a1b2;
where t1¼a1=sa1.
Thus uncertainty about the natural rate, in and of itself, does not a¤ect the solu-
tion to the policymaker’s optimization problem, as deﬁned in this section and in
section 7.3. However, the uncertainty about the natural rate does increase the cost
function because, as seen above, it increases the conditional variance of ptț2. The un-
certainty about the parameter a1, the e¤ect on inﬂation acceleration of the gap be-
tween unemployment and the natural rate, does ﬁgure in the optimal policy throughthe term ð1țt
/C02
1Ț/C01, which is essentially a function of the t-statistic on a1. Its ef-
fect, however, is not on the term containing the unemployment gap, but rather on
the term containing the gap between current and target inﬂation. The greater the un-
certainty about a1, the lower t1and therefore ð1țt/C02
1Ț/C01, so the less weight the pol-
icymaker should place on the current inﬂation gap. This result is very robust, as it
obtains in the models of subsequent sections, in which we introduce more complex
speciﬁcations with fairly general parameter uncertainty.Rethinking the Role of NAIRU: Model Formulation and Uncertainty 143

General Parameter Uncertainty Consider again the model deﬁned by equations (7.5),
(7.6), and (7.7) of subsection 7.3.1, but assume now that there is uncertainty at time
tabout all the coe‰cients of the model ða1;a3;b1;b2;b3;b3;c3Țand about the disturb-
ance of the reduced form ðxȚ, but that the uncertainty in all of these variables
is pairwise orthogonal. Although these uncertainty assumptions are not entirely
general—on account of the assumed orthogonality—they are more extensive than
those that the previous literature has examined. 8The orthogonality assumptions are
easily relaxed for coe‰cients belonging to the same equation, but the inclusion of the
corresponding covariances does not provide greater intuition and is therefore not
pursued here. Thus, at time t, the expectation and variance of inﬂation at time tț2
are given by
Etptț2¼pt/C0a1ð1țb1Ț~uut/C0a1b2rtț½a3ð1țc3Ț/C0a1b3/C138xt
and
Vtptț2¼½a2
1s2
b1țs2
a1ð1țb1Ț2țs2
a1s2
b1/C138~uu2
tțða2
1s2
b2țs2
a1b2
2țs2
a1s2
b2Țr2
t
ț½a2
3s2
c3țs2
a3ð1țc3Ț2țs2
a3s2
c3ța2
1s2
b3țs2
a1b2
3țs2
a1s2
b3/C138x2
t
ț2s2
a1½ð1țb1Țb2~uutrtțb2b3rtxtțð1țb1Țb3~uutxt/C138țs2
x;
where the values of the coe‰cients denote their expected values. 9
As in subsection 7.3.1, the policy objective is to choose rtso as to minimize the ob-
jective function
Etðptț2/C0p/C3Ț2¼ðEtptț2/C0p/C3Ț2țVtptț2:
In this case, the optimal value of the policy variable is given by
r/C3
t¼1
1țt/C02
2/C01țb1
b2~uut/C0b3
b2xtț1
1țt/C02
1pt/C0p/C3
a1b2ța3ð1țc3Ț
a1b2xt/C18/C19"#
; ð7:11Ț
where t1¼a1=sa1and t2¼b2=sb2. Equation (7.11) can be rewritten as
r/C3
t¼1
1țt/C02
2/C01țb1
b2ð~uut/C0ðntțftȚȚ ț1
1țt/C02
1/C11
a1b2ðpt/C0p/C3Ț !
; ð7:12Ț
where
ft¼/C01
1țt2
1/C1a3ð1țc3Ț
a1ð1țb1Țxt:
Comparison of equations (7.9) and (7.12) indicates that the presence of uncertainty
introduces two multiplicative terms of the form ð1țt/C02
iȚ/C01. These terms are essen-144 Chapter 7

tially functions of the t-statistics corresponding to the parameters a1andb2, respec-
tively, which correspond to the one-period-ahead e¤ects of unemployment on inﬂa-
tion and of the policy variable on unemployment. All other variance-related terms
in the objective function drop out of the calculation. When there is no uncertainty
about a1and b2, the two multiplicative terms become one, reverting to the cer-
tainty-equivalent case of subsection 7.3.1.
One of the two uncertainty e¤ects—the one related to b2, the coe‰cient on the
policy variable in equation (7.6)—takes a form that is predictable from the analysis
by Brainard (1967). Speciﬁcally, as sb2rises, the term ð1țt/C02
2Ț/C01falls so that un-
certainty about the magnitude of the e¤ect of the policy variable leads to a partial
policy reaction—a reaction that is less than that in the certainty-equivalent case.
In contrast, uncertainty about a1, the e¤ect of unemployment on the change
in inﬂation in equation (7.5), has an e¤ect not on the scale of the policy reaction,
but rather on the weight applied to pt/C0p/C3and on the reference point in terms of
unemployment at which that reaction occurs. Speciﬁcally, as sa1rises, the term
ð1țt/C02
1Ț/C01falls so that the weight on pt/C0p/C3falls. A rise in sa1causes the term
ð1țt2
1Ț/C01and the absolute value of the adjustment term ftto rise. If xhas a positive
impact on inﬂation (i.e., a3xtis positive), then ftis negative and so the reference
point for monetary tightening in terms of unemployment, ntțft, falls.
The e¤ect of uncertainty about a1on how the reference point responds to change
inxis somewhat more complex. The net e¤ect on the reference point ntțftdepends
on whether xis a supply or demand variable, as discussed in subsection 7.3.1. Con-
sider the combined expression
ntțft¼1
1țt/C02
1/C1a3ð1țc3Ț
a1ð1țb1Ț/C0b3
1țb1 !
xt:
Ifxis a supply variable, the direction of the e¤ect of uncertainty on the magnitude of
the reference point is unclear. It is clear, however, that as uncertainty about a1
approaches inﬁnity, the sign of the coe‰cient is the same as the sign of /C0b3.I fxis
a demand variable, uncertainty reduces the absolute magnitude of the reference pointunambiguously.
7.4.2 Output as well as Inflation in the Objective Function
We now modify the results of the previous subsection by assuming that the policyobjective function includes both inﬂation and unemployment. As in subsection 7.3.2,
the objective function becomes
E
tðptț2/C0p/C3Ț2țlEt~uu2
tț1:
The optimal value under parameter uncertainty isRethinking the Role of NAIRU: Model Formulation and Uncertainty 145

rðlȚ
t¼1
1țt/C02
2"
/C01țb1
b2țl
a2
1țs2
a1țl !
~uut
ț/C0b3
b2ța1a3ð1țc3Ț
a2
1țs2
a1țl !
xtța1ðpt/C0p/C3Ț
a2
1țs2
a1țl#
:
The e¤ect of including a target for unemployment, as represented by l, is analo-
gous to the e¤ect of uncertainty about a1. In the above equation, these two terms oc-
cur additively in the same expression in the terms corresponding to the exogenous
variable and the inﬂation gap. Only in the unemployment term does lappear sepa-
rately. Intuitively, the reason for this is that uncertainty about a1makes the relation-
ship expressed in equation (7.5) less reliable, so policy becomes more concerned with
a¤ecting the ‘‘intermediate target’’ of equilibrium unemployment.
If the weight on unemployment becomes inﬁnitely large, the optimal rule simpliﬁes to
rðyȚ
t¼1
1țt/C02
2/C0b1
b2~uut/C0b3
b2xt/C18/C19
in which, as in the certainty-equivalent case, the inﬂation gap has disappeared and
only an unemployment gap remains. Here the only e¤ect of uncertainty is of the
rescaling type, as identiﬁed by Brainard (1967).
7.5 NAIRU and Policy Making: The Implications of Model Selection
In this section, we discuss another type of uncertainty that a¤ects the deﬁnition ofshort-run NAIRU, its computation, and the policy rule that results from inﬂation
targeting. Speciﬁcally, we focus on uncertainty regarding the correct form of the
basic model and the associated problem of model selection. Whereas in section 7.4
we assumed that the form of the model was known but that the parameters were
estimated with uncertainty, we now suppose that the policymaker ignores some key
information variable in the optimization problem. 10
In general, if inﬂation two periods ahead is the policy target, and if a variable
helps predict inﬂation at that horizon, it is ine‰cient not to include the information
in the model. For example, the models of sections 7.3 and 7.4 deﬁne the policy rule in
terms of a short-run NAIRU, which in turn is a function of the exogenous variable x.
What is the result of ignoring the predictive content of x? Alternatively, what is the
cost of relying on a long-run equilibrium NAIRU (zero in this case) when a short-run
informative NAIRU is available?
Thus suppose that the policymaker ignores the presence of xin the basic model
(7.5)–(7.7). The values of a
3andb3are implicitly set to zero, while the third equation
is dropped altogether. Under these conditions, the constrained optimal rule for inﬂa-146 Chapter 7

tion targeting becomes
~rr/C3
t¼1
1țt/C02
2/C01țb1
b2~uutț1
1țt/C02
1/C1pt/C0p/C3
a1b2 !
:
We know, of course, that the value of the objective function has to be higher (i.e.,
worse) when evaluated at this constrained optimum than when evaluated at the
unconstrained optimum r/C3
tas in subsection 7.4.1. In fact, we can calculate the di¤er-
ence between the constrained and unconstrained values as
1
1țt/C02
2/C11
a2
1țs2
a1½a1a3ð1țc3Ț/C0ð a2
1țs2
a1Țb3/C1382x2
t:
Somewhat surprisingly, uncertainty about b2ameliorates the left-out-variable prob-
lem. 11Uncertainty about a1, in contrast, can make matters worse.
The left-out-variable problem can also increase uncertainty regarding the estimates
of the included coe‰cients, with consequences for the size of the policy response or
the reference point for monetary tightening in terms of unemployment. To see this,
suppose the inﬂation equation (7.5) is estimated by ordinary least squares, leaving
out the variable x, after rewriting it in the following form
pt/C0pt/C01¼/C0a1~uut/C01țet: ð7:50Ț
One implication of leaving out x, well known from econometrics textbooks, is that
the estimate of a1may be biased. This occurs unless xanduare contemporaneously
uncorrelated. 12However, even if the two regressors are indeed uncorrelated so that
the estimate of a1is unbiased, uncertainty in the estimate is greater by the amount
Stp2
t
St~uu2
t/C01/C1R2
u/C0R2
c
n;
where the numerator of the last term is the di¤erence between the R2s of the un-
constrained and constrained models. Thus excluding the variable xfrom the model,
in addition to producing a policy rule that improperly excludes x, increases un-
certainty about a1. One possible consequence is that, for the reasons provided in sec-
tion 7.4, the policymaker may react to the higher level of sa1by adjusting the weight on
pt/C0p/C3downward and by increasing the absolute size of the NAIRU adjustment ft.
7.6 Empirical Estimates of Short-Run NAIRU
7.6.1 Empirical Evidence on the Importance of Uncertainty
Although our theoretical framework shows qualitatively the e¤ects of uncertainty on
how monetary policy should be conducted, it cannot tell us whether these e¤ects areRethinking the Role of NAIRU: Model Formulation and Uncertainty 147

economically important. To examine this question, we estimate in this section a sim-
ple NAIRU gap model for the United States to obtain measures of uncertainty and
to assess how these measures a¤ect our view of the optimal reaction of monetary pol-
icy to movements in unemployment relative to short-run NAIRU. In order to have
in the model a simple lag structure that mimics that of the theoretical model (7.5)–
(7.7), we start by estimating a model with annual U.S. data over the period 1956–96.
The model is
pt/C0pt/C01¼a0/C0a1ut/C01ța2ut/C02țet; ð7:13Ț
ut¼b0țb1ut/C01țb2ut/C02țb3rt/C01țb4rt/C02țht; ð7:14Ț
where pis the log change in the CPI from December of year t/C01 to December
of year t,uis the unemployment rate in December of year t, and ris the average
monthly three-month Treasury bill rate during year t. Note that a1and b3corre-
spond to a1andb2in the theoretical model, and that the key uncertainty ratios t/C02
1
and t/C02
2will be based on the former. The results are presented in table 7.1.
These estimates provide some guidelines regarding the importance of uncertainty
for monetary policy in this context. First, the adjustments to the unemployment ref-
erence point and to the policy reaction as a result of parameter uncertainty are not
large. The key parameters are estimated with some precision, and the implied multi-
plicative adjustment factors are both close to one. The Brainard-type adjustment—a
2.5 percent reduction—is particularly small, suggesting that the magnitude of thepolicy reaction should only be shaded down slightly to reﬂect parameter uncertainty.
However, the unemployment e¤ect adjustment is also less than 5 percent.
These results are conﬁrmed by looking at the implicit optimal policy that corre-
sponds to the two-year-ahead inﬂation target of the theoretical model in which onlyTable 7.1
Estimates of Annual U.S. Model, 1956–96
Coe‰cient Estimate t ð1țt/C02Ț/C01
a0 1.67 1.49
a1 1.24 4.68 .956
a2 .98 3.70
R2.366
b0 .70 1.31
b1 1.00 7.06
b2 /C0.23 /C02.18
b3 .48 6.30 .975
b4 /C0.36 /C03.84
R2.833148 Chapter 7

inﬂation is included in the objective function. The rule that results is very similar to
the simple Taylor (1993) rule when adjustments are made for the fact that Taylor’s
rule was deﬁned in terms of quarterly data and an output gap. The annual and
quarterly results are presented in table 7.2. If dis the weight on the lagged interest
rate in the annual model, the corresponding quarterly lag is assigned a weight
ofd1=4and the weights on the inﬂation and unemployment gaps are divided by
1țd1=4țd2=4țd3=4. A rule based on the output gap is obtained by applying a sim-
ple Okun’s law adjustment, dividing the unemployment weight by 2.
The table conﬁrms that the practical signiﬁcance of parameter uncertainty is quite
small. Furthermore, the quarterly results with the output gap are remarkably similar,
even numerically, to the parameters suggested by Taylor (1993). The only key di¤er-ence is that the interest rate is assumed to be much more persistent here, since Taylor
did not include a lagged interest rate in the form of his rule. 13
7.6.2 Empirical Estimates of Short-Run NAIRU
In this subsection, we present estimates of short-run NAIRU. For these purposes,
we return to the more general model (7.2)–(7.4) and estimate the equations with
monthly data from January 1954 to November 1997, using a 12-month-ahead, 12-
month horizon ðj¼k¼12Țand 12 lags of both the change in inﬂation and un-
employment. 14Figure 7.1 shows estimated short-run NAIRU together with the
contemporaneous unemployment rate, as well as the short-run NAIRU gap. This ﬁg-
ure demonstrates the high variability of short-run NAIRU, in contrast with long-run
measures designed to estimate a natural rate as in Gordon (1997) and Staiger et al.
(1997a, 1997b). For example, consider a version of our equation (7.1), which may be
used to estimate a constant uthat is comparable to the long-run measure of those
papers:
Dpt¼bðLȚðut/C0utȚțgðLȚDpt/C01țet: ð7:10ȚTable 7.2
Implicit Interest Rate Rules
RuleWeight on lagged
interest rateInﬂation
gapUnemployment
or output gap
Unadjusted
Annual .77 1.70 /C02.56
Quarterly .94 .47 /C0.70
With output gap .94 .47 .35
Uncertainty adjusted
Annual .77 1.59 /C02.49
Quarterly .94 .44 /C0.69
With output gap .94 .44 .34Rethinking the Role of NAIRU: Model Formulation and Uncertainty 149

When estimated over the same period as equations (7.2), (7.3), and (7.4), the estimate
ofuis 6.1 percent, as shown in ﬁgure 7.1.
Staiger et al. (1997a) have pointed out that such estimates of a constant long-run
NAIRU tend to be quite imprecise. Using the delta method in an equation similar to
(7.10), they obtain an estimate of u¼6:2 percent, with a standard error of about 0.6.
Our estimate of u¼6:1 has a standard error of 0.43, which is somewhat smaller—
perhaps partly because of our larger sample—but is of the same order of magnitude.
Estimates of short-run NAIRU ntare more precise. The standard error of ntis a
time-varying function of the values of the variables in expression (7.4). Over the sam-
ple period, the standard errors range from 0.11 to 0.42, with a mean of 0.20, less than
half of the standard error of u.15
Thus short-run NAIRU is estimated with more than twice the precision than stan-
dard long-run NAIRU. The practical signiﬁcance of this result, however, is limited,
since we have shown in the theoretical sections that this type of uncertainty plays no
Figure 7.1
Short-run NAIRU, unemployment, and short-run NAIRU gap, January 1954 to November 1997.150 Chapter 7

role in the determination of the policy rule. Nevertheless, a reduction in the un-
certainty may produce a reduction in the value of the cost function, as shown in sec-
tion 7.5, even if the policy rule remains unaltered.
7.6.3 A Case Study: Recent Signals from a Short-Run NAIRU
Using the estimates of the NAIRU gap from subsection 7.6.2, we now examine
the hypothetical results of using the methodology of this chapter in the conduct
of monetary policy in the United States since June 1992, when the unemployment
rate began a prolonged decline. The results will of course be somewhat simplistic,
but they may provide some general support for the concepts developed in this
chapter.
If we refer to one of the policy rules in the theoretical part of the chapter, say
to equation (7.9), we note that the appropriate interest rate is determined essentially
by two gaps: the di¤erence between unemployment and short-run NAIRU and
the di¤erence between actual and target inﬂation. We present in ﬁgure 7.2a the gap
between short-run NAIRU and unemployment (signed so that a positive value indi-
cates that monetary policy should be tightened) and the level of inﬂation (12 previousmonths) since 1992.
From June 1992 to the end of 1993, declining unemployment brought the NAIRU
gap from levels suggesting, if anything, the need for ease to relatively neutral levels.
Meanwhile, inﬂation declined over the period and, in fact, continued to decline into
the beginning of 1994. Beginning in 1994, however, the NAIRU gap became positive
and remained so until early 1995, suggesting a need for tightening. In addition, inﬂa-
tion stopped declining, remaining around the 3 percent level. These two factors com-
bined are consistent with the monetary tightening undertaken by the Federal Reserve
throughout 1994 and into early 1995.
Since then, the NAIRU gap has indicated some pressure to tighten twice, in 1996
and 1997. In the ﬁrst case, the pressure from the NAIRU gap was accompanied by a
rise in inﬂation. Even though inﬂation subsided toward the end of the year, this epi-
sode may seem somewhat inconsistent with the absence of further tightening. Figure
7.2b suggests one reason for this result. Figure 7.2b presents the results of repeating
the analysis of ﬁgure 7.2a, but using core inﬂation (excluding food and energy prices)
instead of total inﬂation. Core inﬂation tends to be a better signal of persistent
changes in inﬂation than total inﬂation.
Figure 7.2b shows both the level of core inﬂation as well as the gap between un-
employment and short-run NAIRU computed using core inﬂation in equations
(7.2), (7.3), and (7.4). Comparisons of the two panels of ﬁgure 7.2 suggests that thee¤ect of using core inﬂation in the calculation of the NAIRU gap is very slight. But
core inﬂation was falling in 1996, in contrast to the rising total inﬂation, and this fall
may have o¤set the tightening signals from the NAIRU gap.Rethinking the Role of NAIRU: Model Formulation and Uncertainty 151

In 1997, the pressure arising from the unemployment gap seemed stronger than in
the previous year. Inﬂation, however, both total and core, moved downward again,
o¤setting at least partially the signals from the NAIRU gap indicator. Arguably,
only during 1994 and early 1995 were there consistent signals for tightening, and
this is when the Federal Reserve engaged in most of its monetary tightening.
In order to evaluate the net e¤ect of the unemployment and inﬂation indicators, it
would be helpful to summarize the information in a single measure, as in the policy
rules of table 7.2. We would like to do this, not to explain actual policy, but to sug-
gest how the theoretical constructs of this chapter could be used in practice. How-
ever, this is a problem for two reasons. First, we would have to construct a full
Figure 7.2
NAIRU gap ( solid line, left-hand scale ) and inﬂation ( dashed line, right-hand scale ), June 1992 to Novem-
ber 1997.152 Chapter 7

optimization model in the context of the monthly equations, which is beyond the
scope of the present chapter. 16Second, we would have to know or make an assump-
tion about the target level of inﬂation. Thus we present only a limited version of a
policy rule in which we deal with those problems as follows.
First, we take the weights for the NAIRU and inﬂation gaps from the annual
results of table 7.2 allowing for uncertainty, making allowance also for the monthlyfrequency of our data. Since the coe‰cient of the lagged interest rate, d
1=12¼0:98, is
very close to one, we further simplify by assuming that the weights are used to calcu-
late a monthly change in the interest rate. We then divide the annual weights by
1țd1=12ț/C1/C1/C1ț d11=12to obtain weights of /C00.23 for the NAIRU gap and 0.15 for
the inﬂation gap with total inﬂation and /C00.25 and 0.19, respectively, using core in-
ﬂation. 17To deal with the second problem, the fact that the inﬂation target is un-
known, we scale the results so that the policy rule with total inﬂation is neutral, on
average, over the period since June 1992. This assumption is equivalent to an inﬂa-
tion target of 3 percent.
The results are presented as the solid lines in the two panels of ﬁgure 7.3. Note that
the weighted results are consistent with our earlier discussion of the individual com-ponents. In panel 7.3a, which contains the results using the total CPI, the strongest
signal for tightening comes during 1994. Note also, however, that there were distinct
signals for tightening in 1992–93 and 1996–97, and that there were fairly strong sig-
nals for easing at the beginning and toward the end of the sample period. In panel
7.3b, which contains results using the core CPI, there are also strong signals to tight-
en in 1994, but because the core inﬂation rate was higher than total CPI in late 1992
and early 1993, there are also strong signals to tighten in this period. In contrast to
panel 7.3a, the results with the core CPI do not suggest any need to tighten in 1996.
We may contrast these results with a rule based on the standard unemployment
gap—the gap between unemployment and a constant long-run NAIRU. The results
are presented as the dashed lines in the two panels of ﬁgure 7.3. To obtain weights
that are consistent with the assumption of a constant NAIRU, we estimated equa-
tions (7.13) and (7.14) without the second lag of unemployment, which produces an
estimate of NAIRU that is constant. These new weights are /C00.35 for the NAIRU
gap and 0.34 for the inﬂation gap using total inﬂation and /C00.36 and 0.37, respec-
tively, using core inﬂation. Note, however, that if we use the same weights as before,
the qualitative results are the same as with these weights.
The results for the long-run NAIRU gap, which are driven by the large steady de-
cline in unemployment over this period, are fairly robust. The main feature of the al-
ternative rule is that it argues for easing throughout the ﬁrst part of the period, andthen for tightening throughout the second part of the period. What this rule misses is
that a long-run natural rate is not the best reference point for unemployment if the
goal is to target inﬂation in the short run.Rethinking the Role of NAIRU: Model Formulation and Uncertainty 153

7.7 Summary and Conclusions
In this chapter, we examine how a variant of the NAIRU concept can be usefully
employed in the conduct of monetary policy. By thinking of NAIRU in this way, we
obtain insights that might be quite useful to monetary policymakers. Because there
are quite a few results sprinkled throughout the chapter, we list the main ones here.
/C15The NAIRU concept that is useful for the conduct of monetary policy di¤ers from
the estimate of the natural rate of unemployment, the long-run concept used previ-
ously by many researchers. Instead, NAIRU can be viewed as a short-run construct,
Figure 7.3
Simple policy rules based on short-run NAIRU ( solid line ) and long-run NAIRU ( dashed line ), June 1992
to November 1997.154 Chapter 7

which is related to past levels of unemployment and inﬂation as well as other eco-
nomic variables, that helps forecast future accelerations or decelerations of inﬂation.
/C15Short-run NAIRU should be viewed, not as a target for policy, but as an aid in
deﬁning the reference point that policymakers can compare to the current rate of un-
employment to derive a signal for the appropriate stance of policy. Furthermore, as
long as inﬂation is an element in the policymakers’ objective function, the NAIRU
gap is not the only signal that should a¤ect the setting of policy instruments: the de-
viation of inﬂation from its target level also has an important role in the determina-
tion of the appropriate stance of policy.
/C15The policy rule that comes out of our analysis is a variant of a Taylor rule using an
unemployment gap rather than an output gap, but it has one major di¤erence from
more standard formulations. The standard Taylor rule implicitly assumes that the
reference point to which unemployment should be compared in the unemployment
gap term is constant, while in our formulation, the reference point is related to
short-run NAIRU, which can have substantial short-run ﬂuctuations over time.
/C15Uncertainty about the level of NAIRU has no inﬂuence on the setting of policy
instruments, although it does a¤ect the value of the objective function. This type of
uncertainty makes the economy worse o¤ but does not alter policy behavior.
/C15Uncertainty about the e¤ect of unemployment on inﬂation leads to an additive
adjustment to short-run NAIRU to calculate the reference point for monetary tight-
ening in terms of the level of unemployment. In addition, uncertainty about the unem-
ployment e¤ect on inﬂation changes the weight on the inﬂation gap in the policy rule.
/C15Uncertainty about the e¤ect of the policy variable leads to a scaling down of the
reaction of the policy variable, the well-known Brainard (1967) result.
/C15Uncertainty about model selection can have important e¤ects on the form of the
policy rule. In particular, if a constant NAIRU is used—as occurs if NAIRU is
viewed as a long-run concept—so that information about the state of the economy
that could be used to forecast inﬂation is ignored, the performance of the policy rule
can be substantially worse. In addition, leaving out relevant variables that help fore-
cast inﬂation increases the uncertainty about the e¤ect of unemployment on inﬂation,
with the resulting implications described above.
/C15Although parameter uncertainty has potentially large e¤ects on how policy should
be conducted, our empirical results suggest that parameter uncertainty may not be all
that important for the setting of policy. We ﬁnd some evidence of changes in the pol-
icy rule resulting from the parameter uncertainty we explored in our theoretical
model, but these e¤ects are very modest. They a¤ect the weights in the policy rule
by less than 5 percent in both the case of uncertainty about the impact of unemploy-ment and the case of uncertainty about the e¤ect of the policy variable.Rethinking the Role of NAIRU: Model Formulation and Uncertainty 155

/C15Estimates of short-run NAIRU are highly variable over time. However, there is a
fair degree of precision in these estimates.
/C15Substantial positive NAIRU gap estimates arose throughout 1994 and early 1995
and in parts of 1996 and 1997. However, core inﬂation was substantially lower in
1996 and 1997 than in 1994. Thus the one period since June 1992 during which there
were consistent signals for tightening occurred during 1994 and early 1995, which is
when the Fed engaged in most of its monetary tightening.
These results suggest that a short-run NAIRU is indeed a useful concept and that
it can be used by policymakers, particularly in deciding how monetary policy should
be conducted. However, there are some subtle issues in how the short-run NAIRU
concept might be used correctly. First, because our view of NAIRU sees it as ashort-run construct, it is dangerous to think of NAIRU as a potential target for un-
employment that stays around a particular value, such as 6 percent, for any period of
time. Second, deviation of inﬂation from its target is every bit as important a factor
in thinking about setting policy as is the NAIRU gap. Third, uncertainty about pa-
rameter values and model selection does have e¤ects on the optimal setting of policy
instruments but does not appear to be a barrier to a useful role for the NAIRU con-
cept in policy decisions.
We hope that this chapter helps resurrect NAIRU as a useful concept, but only if
it is used properly. As we have shown, a short-run NAIRU is a useful construct be-
cause it helps tell policymakers what might happen to inﬂation in the future. Further-
more, the model of this chapter suggests that policymakers may want to avoid theimpression that an objective of policy is to raise unemployment when it falls below
NAIRU or to lower it when it is above NAIRU. To view policy in this way might
lead the public to think that policymakers are against low unemployment, an out-
come that can reduce support for central bank e¤orts to control inﬂation.
Notes
The authors thank participants at the conference and at seminars at the Federal Reserve Bank of New
York and Columbia University for their helpful comments, and Elizabeth Reynolds for excellent research
assistance. The views expressed in this chapter are those of the authors and do not necessarily represent
those of the Federal Reserve Bank of New York, the Federal Reserve System, Columbia University, orthe National Bureau of Economic Research.
1. If price stability has already been achieved, then inﬂation falling below its target is every bit as damag-
ing as a rise in inﬂation above the target. Thus, in this situation, monetary policy must also be just as pre-emptive against declines in inﬂation below target levels.
2. See, e.g., Stiglitz (1997), Gordon (1997), Staiger, Stock, and Watson (1997a, 1997b), and Council of
Economic Advisers (1997, 45–54). For a history of NAIRU, see Espinosa-Vega and Russell (1997). TheNAIRU acronym would better be expressed as NIIRU (the nonincreasing inﬂation rate of unemployment)because it is the unemployment rate at which inﬂation is expected to neither increase or decrease.
3. See, e.g., Staiger et al. (1997a).156 Chapter 7

4. The variable xdi¤ers from zin the Gordon (1997) and Staiger et al. (1997a, 1997b) equations in that z
represents primarily supply shocks that are contemporaneous with the dependent variable, whereas xis
more general in that it includes any predetermined variables other than unemployment and inﬂation (andtheir lags) that help predict future inﬂation.
5. Eq. (7.4) is a generalization of the model of short-run NAIRU in Estrella (1997). After writing this
chapter, we discovered that Layard and Bean (1988) also have a similar deﬁnition of short-run NAIRUin the context of a one-period change in inﬂation.
6. In eq. (7.2), we think of pas an I(1) process, which is consistent with current econometric evidence and
practice. See, e.g., Stock (1991) and King and Watson (1994, sec. 4). Alternatively, one could think of pas
an I(0) process and include a level of pin the x-vector in eq. (7.2).
7. Once again, this is a relatively simple objective function designed to highlight the key points of this
chapter. A more complex dynamic solution of a similar model may be found in Svensson (1997), whichexhibits properties that are qualitatively analogous to those of the simpler model of this chapter.
8. Other papers that look at the e¤ect of parameter uncertainty in a similar context are Svensson (1997),
Clarida, Galı ´, and Gertler (1999), and Wieland (1998).
9. This convention economizes on notation and is correct by deﬁnition if the coe‰cient estimates are
unbiased.
10. The complementary problem of including too many variables in the model is in principle less serious,
since consistent parameter estimates should assign zero weight to the superﬂuous variables.
11. The intuition is that as uncertainty about b
2grows, the optimal response of the policy variable ris
reduced so that there is less loss from using the incorrect model.
12. See, e.g., Theil (1971, sec. 11.2). This problem may be bypassed formally by thinking of xas the com-
ponent of the additional variable that is uncorrelated with u.
13. Recent estimates of the Taylor rule by Rudebusch and Svensson (1999) and Rotemberg and Woodford
(1999), among others, suggest that the persistence parameter is close to one. Fuhrer and Moore (1995) as-sume that it equals one.
14. Somewhat surprisingly, extending the horizon to jțk¼60 months or even longer does not materially
a¤ect the point estimates of short-run NAIRU. Of course, the ﬁt of the equation deteriorates with longerhorizons.
15. All our standard errors are estimated consistently using the Newey-West technique with a 24-lag win-
dow (Newey and West 1987).
16. A model along those lines has been developed for the United States in Clarida et al. (1999). See also
the references in that paper.
17. Adjusting fully for coe‰cient uncertainty would require, in addition to the adjusted weights, an adjust-
ment to short-run NAIRU corresponding to the term f
tdeﬁned in subsection 7.4.1. We do not make
this adjustment here because our equation for monthly NAIRU is essentially a reduced form and the com-ponents are di‰cult to disentangle, and also because the coe‰cient of the adjustment factor
ð1țt
2
1Ț/C01a0:065 is empirically small.
References
Brainard, William. 1967. Uncertainty and the e¤ectiveness of policy. American Economic Review Papers
and Proceedings 57: 411–25.
Clarida, Richard, Jordi Galı ´, and Mark Gertler. 1999. The science of monetary policy: A new Keynesian
perspective. Journal of Economic Literature 37 (December): 1661–1707.
Council of Economic Advisers. 1997. Economic report of the president . Washington, D.C.: Government
Printing O‰ce.
Espinosa-Vega, Marco A., and Steven Russell. 1997. History and theory of the NAIRU: A critical review.
Federal Reserve Bank of Atlanta Economic Review 82: 4–25.Rethinking the Role of NAIRU: Model Formulation and Uncertainty 157

Estrella, Arturo. 1997. Aggregate supply and demand shocks: A natural rate approach. Research Paper
no. 9737. New York: Federal Reserve Bank of New York.
Friedman, Milton. 1968. The role of monetary policy. American Economic Review 58: 1–21.
Fuhrer, Je¤rey C., and George R. Moore. 1995. Monetary policy trade-o¤s and the correlation between
nominal interest rates and real output. American Economic Review 85: 219–39.
Gordon, Robert J. 1997. The time-varying NAIRU and its implications for economic policy. Journal of
Economic Perspectives 11: 11–32.
King, Robert G., and Mark W. Watson. 1994. The post-war U.S. Phillips curve: A revisionist econometric
history. Carnegie-Rochester Conference Series on Public Policy 41: 157–219.
Layard, Richard, and Charles R. Bean. 1988. Why does unemployment persist? Discussion Paper no. 321.
London: London School of Economics, Centre for Labour Economics, August.
Modigliani, Franco, and Lucas Papademos. 1975. Targets for monetary policy in the coming year. Brook-
ings Papers on Economic Activity , no. 1: 141–63.
Newey, Whitney K., and Kenneth D. West. 1987. A simple-positive semi-deﬁnite, heteroskedasticity and
autocorrelation consistent covariance matrix. Econometrica 55: 703–8.
Phelps, Edmund. 1968. Money-wage dynamics and labor-market equilibrium. Journal of Political Econ-
omy 76: 678–711.
Staiger, Douglas, James H. Stock, and Mark W. Watson. 1997a. How precise are estimates of the natural
rate of unemployment? In Reducing inﬂation: Motivation and strategy , ed. Christina D. Romer and David
H. Romer. Chicago: University of Chicago Press.
———. 1997b. The NAIRU, unemployment and monetary policy. Journal of Economic Perspectives 11:
33–49.
Stiglitz, Joseph. 1997. Reﬂections on the natural rate hypothesis. Journal of Economic Perspectives 11:
3–10.
Stock, James H. 1991. Conﬁdence intervals for the largest autoregressive root in U.S. macroeconomic time
series. Journal of Monetary Economics 28: 435–59.
Svensson, Lars E. O. 1997. Inﬂation forecast targeting: Implementing and monitoring inﬂation targets. Eu-
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Taylor, John B. 1993. Discretion versus policy in practice. Carnegie-Rochester Conference Series on Public
Policy 39: 195–214.
Theil, Henri. 1971. Principles of econometrics . New York: Wiley.
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and Economics Discussion Paper no. 98-22. Washington, D.C.: Board of Governors of the Federal Re-serve System.158 Chapter 7

IIMonetary Policy Strategy in Advanced Economies

Introduction to Part II
The chapters in this part of the book examine monetary policy strategy in advanced
economies with an unapologetic case-study approach. Chapters 8 to 11 approach the
study of monetary policy strategy through detailed discussions of the experiences in
the major advanced countries. Chapter 8 was written with Ben Bernanke, now the
chairman of the Federal Reserve, for the NBER Macroeconomics Annual confer-
ence in 1992. The use of case studies in monetary economics is often highly contro-
versial, and Ben and I experienced a contentious reception at the NBER MacroAnnual conference. Many economists object to case-study research because they be-
lieve that the methodology is too ad hoc. Indeed, the discussion on our paper at the
Macro Annual Conference focused almost entirely on whether a case-study approach
is appropriate to study macroeconomic issues and focused very little on the content
of the paper itself. The discussion of this paper was one of the most disappointing
discussions of my research in my entire career.
Despite this discouragement, I continued to use (and strongly believe in) a case-
study approach in my research as many of the following chapters prove. There are
two strong reasons why case-study research is so valuable in monetary economics.The ﬁrst is that case studies—the study of historical episodes, although some may
be quite recent—can provide another way of identifying exogenous shocks to the
economy, which enables the researcher to be more conﬁdent of which way causality
runs in the data. (I have used this identiﬁcation strategy in my monetary research in
Huizinga and Mishkin [1986], as have Romer and Romer [1989].) Identiﬁcation
in econometric research is often more suspect because it frequently requires ad hoc
assumptions. This case-study approach is the strength of Friedman and Schwartz’s
Monetary History of the United States , which argued convincingly that monetary
policy matters: they ﬁrst identify exogenous shocks to monetary policy, such as the
one that occurred in 1936 and 1937 when the Fed raised reserve requirements and
thereby lowered the money supply for purely technical reasons, and then demon-strate that the economy responded strongly afterwards. Indeed, it was the case-study
approach in Friedman and Schwartz using historical episodes (what Romer and

Romer [1989] call the narrative approach), and not econometric research, that had
the greatest impact on economists’ views regarding whether monetary policy matters.
The second reason for pursuing case-study research is that details matter, particularly
when thinking about how to design successful policies. Only case studies can reveal
the details that are often the di¤erence between the success and failure of particular
policies, and that can highlight the di¤erences between theory and actual policyexperience.
Chapter 8 focuses on monetary targeting by examining the monetary policy expe-
rience in six advanced economies from 1973 to 1991. Even though no countries today
are pursuing monetary targeting, it is still worth studying this monetary policy re-
gime because it has important historical lessons for other approaches currently in use,
such as inﬂation targeting. Indeed, it was by learning what did and did not work in
these countries that has resulted in the monetary policy strategies being pursued
today. One pattern revealed by these case studies is that central banks adopted
money-growth targets when inﬂation got out of control. Central banks also appeared
to use money-growth targets both as guideposts for assessing the stance of monetary
policy and as a means of signaling their intentions to the public; however, no centralbank has adhered to monetary targets in the short run. The case studies also suggest
that money-growth targets might be useful in providing a medium-term framework
for monetary policy if the targeting is done in a clear and straightforward manner
and if targets can be adjusted for changes in the link between target and goal vari-
ables. It appears that rigid adherence to money-growth targets in the short run is not
necessary to gain some beneﬁts of targeting, as long as there is some ultimate com-
mitment by the central bank to reverse short-term deviations from the target. Finally,
the choice of operating procedure seems to have little bearing on the success of policy.
My interest in monetary policy strategy naturally heightened when I moved from
being an academic to a policymaker upon becoming the director of research at the
Federal Reserve Bank of New York in September 1994. In advising the president of
the bank, William McDonough, I was made increasingly aware of how important a
role communication plays in the success of monetary policy. I also saw that a new
policy framework, inﬂation targeting, seemed to be having tremendous success not
only in lowering inﬂation in the countries that adopted it, but also in simplifying the
central bank’s communication strategy. As the director of research, I started a proj-
ect on inﬂation targeting and, given my previous successful collaboration with him,
I asked Ben Bernanke to participate. I also announced to my sta¤ that I would be
working on this project and one of the economists in my group, Adam Posen, imme-
diately asked if he could come on board. Ben then brought in his student, ThomasLaubach, into the project, and thus began a highly successful collaboration among
the four of us. This project not only produced chapter 9, written in 1996 with Ben
Bernanke, but also led to a very long paper with Adam Posen, ‘‘Inﬂation Targeting:162 Introduction to Part II

Lessons from Four Countries’’ (Mishkin and Posen 1997), which took up a whole
issue of the Federal Reserve Bank of New York’s Economic Policy Review and is
therefore too long to be included in this book. (It is available on the Federal Reserve
Bank of New York’s Web site at http://www.ny.frb.org/research/epr/1997.html.) In
addition, the project led to chapter 10, and ﬁnally to our book, Bernanke, Laubach,
Mishkin, and Posen (1999), Inﬂation Targeting: Lessons from the International Expe-
rience. This book, which draws heavily on the case-study approach, is one of my
proudest accomplishments because I have been told it has had a substantial impact
on central banking practice.
Chapter 9 describes how inﬂation targeting has been implemented in practice and
argues that it is best understood as a broad framework for policy, which allows the
central bank ‘‘constrained discretion’’ rather than an ironclad policy rule in the Fried-
man sense. The chapter discusses the potential of the inﬂation targeting approach for
making monetary policy more coherent and transparent, and for increasing mone-
tary policy discipline. A noteworthy feature of this work is that the term constrained
discretion , which to the best of my knowledge Ben Bernanke and I coined, has
become standard for describing inﬂation-targeting regimes. It clariﬁes that the tradi-tional dichotomy in the academic literature between rules and discretion is mislead-
ing: useful strategies can be rule-like in that their forward-looking nature constrains
policymakers from systematically engaging in policies with undesirable long-run con-
sequences, but can also allow some discretion for dealing with unforeseen or unusual
circumstances. We argue that inﬂation targeting should be viewed exactly in this
way, rather than as a rigid policy rule.
Chapter 10, which was written for a conference at the Swedish central bank in
1998, examines the international experiences with four basic types of monetary pol-
icy regimes: 1) exchange-rate targeting, 2) monetary targeting, 3) inﬂation targeting,and 4) monetary policy with an implicit but not an explicit nominal anchor. The ba-
sic theme that emerges from this analysis is that transparency and accountability are
crucial to constraining discretionary monetary policy so that it produces desirable
long-run outcomes. Because the devil is in the details in achieving transparency and
accountability, what strategy will work best in a country depends on its political, cul-
tural, and economic institutions, as well as on its history.
Part II ends with an unabashedly polemical essay, chapter 11, which was presented
at the American Economic Association meetings in 2004. I argue that despite the
Federal Reserve’s superb performance in recent years under Alan Greenspan,
the Fed should change its monetary policy strategy and adopt a ﬂexible form of in-
ﬂation targeting. The Federal Reserve strategy under Greenspan has some seriousdisadvantages and continuing pursuit of this approach is likely to work less well in
the future. Adoption of an inﬂation target would help ensure that the legacy of the
Greenspan Fed of low and stable inﬂation is maintained.Introduction to Part II 163

References
Bernanke, Ben S., Thomas Laubach, Frederic S. Mishkin, and Adam S. Posen. 1999. Inﬂation Targeting:
Lessons from the International Experience . Princeton University Press: Princeton.
Huizinga, John, and Frederic S. Mishkin. 1986. ‘‘Monetary Policy Regime Shifts and the Unusual Behav-
ior of Real Interest Rates.’’ Carnegie-Rochester Conference Series on Public Policy 24 (Spring): 231–274.
Mishkin, Frederic S., and Adam S. Posen. 1997. ‘‘Inﬂation Targeting: Lessons from Four Countries.’’ Fed-
eral Reserve Bank of New York, Economic Policy Review vol. 3, no. 3 (August 1997): 9–110.
Romer, Christina, and David Romer. 1989. ‘‘Does Monetary Policy Matter? A New Test in the Spirit of
Friedman and Schwartz.’’ NBER Macroeconomics Annual : 121–183.164 Introduction to Part II

8Central Bank Behavior and the Strategy of Monetary Policy:
Observations from Six Industrialized Countries
Ben Bernanke and Frederic S. Mishkin
8.1 Introduction
In the United States, it has long been the practice of central bankers to meet period-
ically with outside consultants, including academic and business economists, in orderto discuss the current economic situation. In the authors’ experience as invited con-
sultants, these meetings invariably end with a ‘‘go-round,’’ in which each consultant
is asked to give his or her views on current monetary policy. Often the go-round is
prefaced by a question of the following sort: ‘‘The Federal Open Market Committee
[the group that determines U.S. monetary policy] meets next Tuesday. What actions
do you recommend that we take?’’
We have each found it quite di‰cult to give a good answer to this type of question,
not only because, as ivory-tower academics, we tend to have a less-detailed knowl-
edge of current conditions than do the central bankers. The larger problem is thatthe question lacks context: Implicitly, it asks for advice on tactics without specifying
the strategy. Probably the most enduring lesson of Lucas’s (1976) famous critique is
that the e¤ects of any given policy action depend greatly on the expectations it
engenders: Is the policy intended to be temporary or permanent? Under what circum-
stances will it be changed? Expectations about policy in turn depend on the public’s
perceptions of the authorities’ policy strategy, as determined both by policymakers’
explicit choices and by deeper political and institutional factors. Thus, if we hope
ever to give a really satisfactory answer to the central banker’s question, we must ﬁrst
develop some clear views about monetary policy strategy as well as tactics. These
concerns motivate this chapter.
What is the optimal strategy for the monetary authorities to follow? There is a
large and venerable academic literature on this question, which has tended to cast
the central banker’s options rather starkly as following either rules ordiscretion .A
monetary rule speciﬁes future monetary actions as a simple function of economic or
monetary conditions 1; at least in principle, monetary rules do not allow the monetary
authorities to respond to unforeseen circumstances. Examples of rules are Milton

Friedman’s k% money growth rule and (strict) nominal GNP targeting. Fischer
(1990) describes the rationales that have been advanced for rules: The most compel-
ling is probably Kydland and Prescott’s (1977) argument that rules increase the
central bank’s ability to precommit to avoiding monetary surprises, which in turn
permits a lower steady-state rate of inﬂation.
In contrast to rules, the strategy of discretion 2puts no prior restrictions on the
actions that the central bank can take at each date. The basic rationale for discretion,
as discussed by Fischer (1990), is that the beneﬁt of allowing the central bank to re-
spond ﬂexibly to unanticipated contingencies is greater than any advantage gained
from precommitment.
The debate about rules and discretion, although motivated by real policy concerns
and some (mostly U.S.) experience, has been cast largely in abstract and ahistorical
terms. An alternative, and complementary, research strategy is simply to observe
what central bankers at di¤erent places and times have actually done, and to see
what results they have obtained. This more ﬂatly empirical approach is taken by the
present chapter. We use a simple case study methodology to analyze the conduct and
performance of monetary policy in six industrialized countries for the period fromthe breakup of the Bretton Woods system until the present. In doing so, we hope to
gain some insight into the objectives and constraints that determine central bank be-
havior and—at this stage, in a very tentative way—to develop some hypotheses
about the attributes of successful monetary strategies.
The case study method has a poor reputation in economics, largely because of the
tendency of its users to treat anecdotes as evidence. We fully agree that case studies
are not a substitute either for more systematic empirical work or formal theoretical
modeling. However, in our opinion, this approach can be a valuable preliminary to
the more standard types of research. First, case studies can help establish the histori-cal and institutional context, an essential ﬁrst step in good applied work. Second,
historical analysis of actual policy experiences is a natural way to ﬁnd substantive
hypotheses that subsequent work can model and test more formally. We believe that
the method of developing initial hypotheses exhibited here is superior to the more
typical, implicit method of developing hypotheses, which relies on introspection or
on knowledge of only a few episodes.
The bulk of this chapter consists of brief narrative discussions of recent monetary
policy-making in the United States, the United Kingdom, Canada, Germany, Swit-
zerland, and Japan. From these case histories, as well as from our reading of central
bank reports and the commentaries of observers, we distill a number of hypotheses—
candidate empirical regularities, if you will—about central bank behavior, policystrategies, and policy outcomes. These hypotheses are of two types. Positive hypoth-
eses, which receive most of our attention, are based on observations that hold for all
or nearly all of the cases examined; to the extent that these observations are con-166 Chapter 8

ﬁrmed by additional research, they need to be explained by positive theories of cen-
tral bank behavior. Normative hypotheses , in contrast, are about di¤erences in the
characteristics of monetary policy strategies between more and less successful econo-
mies. We call these hypotheses normative because—despite the great di‰culties
involved in inferring causation from correlation—we believe that these cross-
sectional di¤erences ultimately may help to provide useful lessons about the designof monetary policy. We emphasize again, though, that at this stage both the positive
and normative hypotheses are to be treated not as conclusions but as suggestive
propositions that are advanced for further discussion, analysis, and testing.
Of the various positive hypotheses that we extract from the case studies, three of
the most important are the following:
First, in their conduct of monetary policy, central bankers appear to be pursuing
multiple economic objectives; they care not only about the behavior of inﬂation and
unemployment but sometimes also, independently, about the behavior of variables
such as exchange rates and interest rates. Further, instead of giving equal weight
to all objectives, a large part of the monetary policymaker’s attention at any given
time is devoted to the variable that is currently ‘‘in crisis,’’ to the neglect of otherconcerns.
Each of the central banks we consider has employed o‰cial money growth targets
over all or a substantial part of the recent period. A second positive hypothesis is
that—consistent, perhaps, with their ‘‘crisis mentality’’—central bankers are more
likely to adopt targets for money growth, or to increase their emphasis on meeting
existing targets, when inﬂation is perceived as the number one problem.
This tendency of central bankers to retreat to money growth targets when inﬂation
increases is something of a puzzle. For example, as we discuss later, this behavior is
not easily explained by Poole’s (1970) classic analysis of target choice. We conjecture(based in part on what the central bankers themselves say) that there are two reasons
why central bankers cling to money targets when inﬂation threatens: (1) High inﬂa-
tion causes policymakers to become less conﬁdent in their ability to assess the stance
of policy; intermediate targets such as money growth targets are perceived to be use-
ful as guideposts or compasses that aid in choosing the appropriate policy setting. (2)
Perhaps more important, money growth targets may be particularly useful as signals
of the monetary authorities’ intention to get tough on inﬂation. As we explain later,
signalling its anti-inﬂationary intentions may help the central bank both to manage
the public’s expectations and to defend its policies against political pressures for
more expansionary policies.
A third positive observation is that—although banks occasionally conduct policy
using a strategy approaching pure discretion—they never adhere to strict, ironclad
rules. Indeed, a common strategy resembles most nearly a hybrid of rules and discre-
tion, in which the central bank attempts (with varying degrees of success) to applyCentral Bank Behavior and Strategy 167

rules to its medium-term and long-term policies, while retaining ‘‘ﬂexibility’’ or dis-
cretion to respond to developments in the economy in the short run. We view this
observation as quite interesting because it challenges the simple view of much of the
received literature that pure rules and pure discretion are the only policy strategies
available.
Perhaps the most intriguing normative hypothesis suggested by our case studies is
that—contrary to what might be inferred from Kydland and Prescott (1977)—hybrid
monetary strategies of the type just described appear to be consistent with low and
stable inﬂation rates. For example, as we will see, Germany and Switzerland—and
to a lesser extent, Japan—have been able to pursue money growth targets as an
intermediate-term objective, while at the same time maintaining considerable short-
run discretion to meet objectives such as exchange rate stabilization. Several factors
seem to be associated with successful use of a hybrid strategy, each of which can be
construed as helping to make credible the central bank’s claim that it will follow
rules in the medium run, though not in the short run:
First, we observe particularly in the German and Swiss cases that the central
bank’s intermediate targets are explicitly linked, via a simple and public calculation,to the ultimate goals of policy (e.g., the desired inﬂation rate). In principle, this ex-
plicit linkage of targets to goals allows the central bank to adjust its targets when
the target–goal relationship changes, without compromising its credibility.
Second, the central banks who successfully use the hybrid strategy tend to conduct
policy in a more straightforward and transparent way, avoiding devices such as mul-
tiple targets, ‘‘base drift,’’ and irregular changes in targets or target growth rates.
Finally, achieving low inﬂation via the hybrid strategy seems to require some com-
mitment by the central bank to reverse short-term deviations from target over a
longer period. In the case of a money growth rule, for example, periods of above-target money growth tend to be compensated for (in low-inﬂation countries) by sub-
sequent money growth reductions.
The rest of the chapter is organized as follows. Section 8.2, the bulk of the chapter,
presents the six case studies of monetary policy-making. Section 8.3 lists and discusses
our positive hypotheses about central bank behavior. Section 8.4 both discusses our
normative hypotheses and addresses important issues that remain unresolved.
8.2 The Conduct of Monetary Policy in Six Industrialized Countries, 1973–1991
To provide some empirical basis for discussing the conduct of monetary policy, this
section provides brief narrative descriptions of monetary policy in six industrializedcountries over the period since the breakdown of the Bretton Woods system. The
countries discussed are the United States, the United Kingdom, Canada, Germany168 Chapter 8

(representing the EMS bloc), Switzerland, and Japan. These six countries represent
‘‘independent’’ observations in the sense that, for most of the period, no two of
them belonged to a common system of ﬁxed exchange rates. 3Other countries with
independent monetary policies, such as Sweden and Australia, would be interesting
to study but are excluded because of space and data limitations.
Our focus here is on general strategies and approaches used by monetary policy-
makers; where possible, we abstract from the ﬁne institutional details of monetary
policy operations in the various countries, except as they impinge on the broader
issues. 4In discussing the experiences of the various countries, however, it is useful
to draw the familiar distinctions among policy goals, instruments, and intermediate
targets (see, e.g., McCallum, 1989, or Friedman, 1990). Goals are the ﬁnal objectives
of policy, for example, price stability and economic growth. Instruments are variables
that the central bank controls closely on a daily or weekly basis, such as nonbor-
rowed reserves or the interbank lending rate; the choice of instruments and the
mechanisms by which they are controlled determine the central bank’s operating pro-
cedure. Intermediate targets —monetary aggregates are the most common example—
are variables that are neither under the direct day-to-day control of the central banknor are the ultimate goals of policy, but that are used to guide policy. Values for
instruments are usually set so that, given estimates of behavioral parameters such as
the interest elasticity of money demand, intermediate targets for variables such as
M1 growth are reached in the longer term (quarter-to-quarter or year-to-year). In
turn, intermediate targets are set or reset periodically so as to be consistent with the
central bank’s ultimate economic objectives.
The narrative discussions that follow are supplemented by two types of more
quantitative evidence. First, tables 8.1–8.6 present, for each country separately, the
record of announced targets for money growth, the actual money growth outcomes,and the implied excess money growth (actual growth less the midpoint of the target
range). Second, comparisons across countries of the behavior of several key mone-
tary and macroeconomic variables are provided by ﬁgures 8.1–8.7 at the end of the
chapter. The monthly data shown in the ﬁgures are as follows: 5
(Fig. 8.1) money growth rates (from 1 year earlier) of both the narrow and the
broad monetary aggregate focused on by the central bank in each country (M0,
M1, M2, OR M3).
(Fig. 8.2) the variability of narrow and broad money growth (e.g., SDM1 or
SDM2); measured as the standard deviation over the previous 12 months of the
money growth rates in ﬁgure 8.1. 6
(Fig. 8.3) interest rates on overnight interbank loans (RS) and on long-term gov-
ernment bonds (RL).Central Bank Behavior and Strategy 169

Figure 8.1
Growth rates of narrow and broad monetary aggregates. Data are the growth rates (log changes) from one
year earlier of monetary aggregates. M0 refers to the monetary base for the United Kingdom and Switzer-
land and to central bank money for Germany. M1, M2, and M3 refer to conventional national deﬁnitions.
Sources: Federal Reserve Bulletin and releases; Bank of England Quarterly Bulletin (tables 11.1 and 2);
Bank of Canada Review (table E.1); Bundesbank Monthly Reports (tables I.2, I.3; supplement 4, table 33);
Banque Nationale Suisse, Bulletin mensuel (tables 9 and 11); Bank of Japan, unpublished.170 Chapter 8

Figure 8.2
Variability of narrow and broad money growth rates. SDM0, SDM1, SDM2, and SDM3 are the standard
deviations over the previous 12 months of the growth rates of the monetary aggregates M1, M1, M2, and
M3, as shown in ﬁgure 8.1.
Sources: Same as ﬁgure 8.1.Central Bank Behavior and Strategy 171

Figure 8.3
Interest rates on overnight bank loans (RS) and on long-term bonds (RL). Interest data by country are
as follows: United States—federal funds rate (RS), 10-year Treasury bonds and notes (RL); United
Kingdom—call money with discount market (RS), medium-dated (10-year) government bonds (RL);
Canada—overnight money market ﬁnancing (RS), government bonds, over 10 years (RL); Germany—
day-to-day money (RS), federal government bonds, all maturities (RL); Switzerland—day-to-day money
(RS), confederation bonds (RL); Japan—call money (unconditional) (RS), government bonds, interest-
bearing (RL). RS for Switzerland refers to Euromarket rate, other short rates are money market rates.
Long rates are secondary market rates. Rates are monthly averages, except the U.K., Canadian, Swiss,
and Japanese long rates and the Canadian short rate, which are month-end.
Sources: Federal Reserve Bulletin ;Bank of England Quarterly Bulletin (tables 9.2 and 9.1); Bank of Canada
Review (ﬁgure F.1); Bundesbank Monthly Reports (table TV.6; supplement series 2, table 8.b); Banque
Nationale Suisse, Bulletin mensuel (tables T.20 and T.24); Bank of Japan, Economic Statistics Monthly
(table 63) and Tokyo Stock Exchange, Monthly Statistics Report .

Figure 8.4
Variability of changes in short- and long-term interest rates. SDRS and SDRL are the standard deviations
over the previous 12 months of RS and RL, as shown in ﬁgure 8.3.
Sources: Same as ﬁgure 8.3.Central Bank Behavior and Strategy 173

Figure 8.5
Indices of nominal exchange rates (March 1973 ¼100). Shown are indices of nominal exchange rates,
March 1973 ¼100, with an increase indicating an appreciation. For the United States the exchange rate
is the Federal Reserve’s e¤ective exchange rate index; for other countries the value of the currency in
U.S. dollars is used.
Source: Federal Reserve Bulletin .174 Chapter 8

Figure 8.6
Inﬂation rates. Inﬂation rates are measured as the growth over the last 12 months of the broadest available
measure of consumer prices, as follows: United States—CPI-U, all items; United Kingdom—retail price
index, all items; Canada—CPI, all items; Germany—cost-of-living index, all households; Switzerland—
consumer prices, all items; Japan—CPI, all households, excluding farmers, ﬁshermen, and single persons.
Sources: U.S. Bureau of Labor Statistics; U.K. Central Statistical O‰ce, Monthly Digest of Statistics ,
table 18.1; Bank of Canada Review , table H.12; Bundesbank Monthly Reports , table V.III; (Swiss) Dept.
Fed. L’Economie Publique, La Vie Economique , table B5.1; Bank of Japan, unpublished.Central Bank Behavior and Strategy 175

Figure 8.7
Unemployment rates. Data are civilian unemployment rates, national deﬁnitions. U.K. rate excludes
school leavers.
Sources: U.S. Dept. of Labor, The Employment Situation , table A.1; U.K. Central Statistical O‰ce, Eco-
nomic Trends , table 36, col. 5; Bank of Canada Review , table H.7; Bundesbank, supplement to the Monthly
Reports , series 4, table 7; (Swiss) Dept. Fed. L’Economie Publique, La Vie Economique , p. 3; (Japan)
Labor Force Survey, Economic Planning Agency, Japan Economic Indicators .176 Chapter 8

(Fig. 8.4) the variability of changes in overnight interbank and long-term interest
rates (SDRS or SDRL); measured using the same 12-month moving-average proce-
dure as in ﬁgure 8.2.
(Fig. 8.5) indices of nominal exchange rates (ER); measured as the Federal
Reserve’s e¤ective exchange rate index for the United States and as the value of the
currency in U.S. dollars for other countries (an increase in the index always implies
an appreciation).
(Fig. 8.6) inﬂation rates (PI); measured as the log-change of consumer prices over
the last 12 months.
(Fig. 8.7) unemployment rates (UN); civilian labor force, national deﬁnitions.
The United States .7We begin with the United States because it is the best docu-
mented case and because the U.S. experience has played an important role in setting
the agenda for previous analyses of monetary policy.
The conduct of monetary policy in the United States since the early 1970s is
conventionally divided into three regimes. During the ﬁrst regime (approximately
1970–1979), the federal funds rate—the interbank lending rate—was the primary in-
strument of monetary policy, serving in various degrees as a target of policy as well.
Open market operations were used to keep the funds rate within a narrow target
band (usually on the order of 50–75 basis points); over time, the band was adjusted
smoothly (usually in 25 or 50 basis point increments) in response to general macro-
economic conditions. 8
In principle, during this period, the Fed paid attention to money growth as well as
to interest rates: Beginning in 1970, the FOMC selected weekly tracking paths for
M1 and indicated its preferred behavior for M2 (Meulendyke, 1990), and in 1975,
in response to a congressional resolution, the Fed began to announce publicly its tar-
gets for money growth (table 8.1). In practice, however, the Fed did not consider
meeting money growth targets to be of high priority, placing greater weight on
reducing unemployment while maintaining a relatively smooth path for interest rates.
Devices employed by the Fed to avoid being overly constrained by money growth
targets included the setting of targets for more than one aggregate, which usuallyallowed it to claim that it was hitting at least some target; and the frequent resort to
‘‘base drift,’’ that is, the ignoring of past deviations of money growth from target
when setting new targets. 9
As can be seen from table 8.1 or ﬁgure 8.1a, M1 growth had an upward trend after
1975 despite declining target ranges. With hindsight, the money expansion of 1975–
1978 appears to have been excessive: Unemployment came down steadily during the
1975–1978 period (ﬁg. 8.7a), but the dollar fell (ﬁg. 8.5a) and inﬂation heated up
sharply (ﬁg. 8.6a), even in advance of the second oil shock.Central Bank Behavior and Strategy 177

Table 8.1
Money Growth Targets and Outcomes: United States
Year Aggregate Target OutcomeOutcome
less target
1975 M1 5.0–7.5 5.3 /C01.0
M2 8.5–10.5 9.7 ț0.2
M3 10.0–12.0 12.3 ț1.3
1976 M1 4.5–7.5 5.8 /C00.2
M2 7.5–10.5 10.9 ț1.9
M3 9.0–12.0 12.7 ț2.2
1977 M1 4.5–6.5 7.9 ț2.4
M2 7.0–10.0 3.8 /C04.7
M3 8.5–11.5 11.7 ț1.7
1978 M1 4.0–6.5 7.2 ț2.0
M2 6.5–9.0 8.7 ț1.0
M3 7.5–10.0 9.5 ț0.8
1979 M1 3.0–6.0 5.5 ț1.0
M2 5.0–8.0 8.3 ț1.8
M3 6.0–9.0 8.1 ț0.6
1980 M1 4.0–6.5 7.3 ț2.1
M2 6.0–9.0 9.6 ț2.1
M3 6.5–9.5 10.2 ț2.2
1981 M1 3.5–6.0 2.3 /C03.0
M2 6.0–9.0 9.5 ț2.0
M3 6.5–9.5 11.4 ț3.4
1982 M1 2.5–5.5 8.5 ț4.5
M2 6.0–9.0 9.2 ț1.7
M3 6.5–9.5 10.1 ț2.1
1983 M1 4.0–8.0 10.0 ț4.0
M2 7.0–10.0 8.3 /C00.2
M3 6.5–9.5 9.7 ț1.7
1984 M1 4.0–8.0 5.2 /C00.8
M2 6.0–9.0 7.7 ț0.2
M3 6.0–9.0 10.5 ț3.0
1985 M1 4.0–7.0 11.9 ț6.4
M2 6.0–9.0 8.6 ț1.1
M3 6.0–9.5 7.4 /C00.4
1986 M1 3.0–8.0 15.2 ț9.7
M2 6.0–9.0 8.9 ț1.4
M3 6.0–9.0 8.8 ț1.3
1987 M2 5.5–8.5 4.3 /C02.7
M3 5.5–8.5 5.6 /C01.4
1988 M2 4.0–8.0 5.2 /C00.8
M3 4.0–8.0 6.1 ț0.1
1989 M2 3.0–7.0 4.7 /C00.3
M3 3.5–7.5 3.3 /C02.2
1990 M2 3.0–7.0 3.8 /C01.2
M3 2.5–6.5 1.5 /C03.0
1991 M2 2.5–6.5 2.7 /C01.8
M3 1.0–5.0 1.5 /C01.5178 Chapter 8

The funds rate targeting regime—or its ﬁrst act—came to an end with the dra-
matic news conference of Fed Chairman Paul Volcker on October 6, 1979, in which
Volcker signalled a new commitment to reduce inﬂation by a change in Fed operat-
ing procedures. The new regime that followed the 1979 announcement was described
by the Fed as targeting nonborrowed bank reserves, an operating procedure some-
times characterized (e.g., by Lombra, 1993) as intermediate between the perfectly
elastic supply of reserves associated with an interest rate target and the inelastic sup-
ply of reserves associated with a strict money target. Under a system of targeted non-
borrowed reserves, increases in the overall demand for reserves, arising, for example,from an increase in money demand, are reﬂected both by an increase in the money
stock (as banks increase borrowed reserves) and by an increase in the funds rate
(which must increase to make banks indi¤erent between borrowing more from the
discount window and purchasing more federal funds on the interbank market).
Because nonborrowed reserves targets were not set far in advance and were often
adjusted, however, the 1979 change in operating procedure did not in itself necessar-
ily require a major change in the conduct of U.S. monetary policy, except perhaps at
very high (daily or hourly) frequencies. For example, nonborrowed reserve targets
could in principle have been set week to week to keep the funds rate from straying
far from a preferred range. However, the change in operating procedures seems to
have been accompanied by a decision by the Fed to place greater weight on mone-tary targets and to tolerate high and volatile interest rates (see ﬁgs. 8.3a and 8.4a)
in order to bring down inﬂation. 10The change in interest rate behavior was particu-
larly dramatic: Instead of smoothing the funds rate in its customary way, after the
October 1979 announcement, the Fed whipsawed the ﬁnancial markets; the funds
rose by more than 500 basis points to exceed 17% in March 1980, fell to below 10%
after real GNP declined in the second quarter, and then rose to nearly 20% in 1981.
M1 growth was noticeably lower during the 1979–1981 period than in previous
years, but there also was a signiﬁcant (and permanent) increase in the volatility of
M1 growth (ﬁg. 8.2a). 11
What are we to make of the sharp changes in Fed operating procedures that
occurred during and after 1979? The most likely explanation of these changes isTable 8.1
(continued)
Notes: Growth rates (%) are measured fourth quarter to fourth quarter. Outcome less target equals the
outcome less the midpoint of the target range. Data reﬂects deﬁnitions of aggregates current at times of
announcements. Target ranges are those announced at the beginning of the year (midyear changes
occurred in 1979, 1983, 1985, and 1990). Target and outcome for 1981 M1 growth are adjusted for shiftsinto NOW accounts.Sources: Isard and Rojas-Suarez (1986) and Fischer (1987); updates from annual ‘‘Monetary Report toCongress,’’ March or April issues of Federal Reserve Bulletin .Central Bank Behavior and Strategy 179

political rather than technical. The Fed had decided that inﬂation had reached crisis
levels and had to be controlled at almost any cost. As many authors have noted, 12
the new operating procedures and the greater (putative) attention to monetary tar-
gets were a useful smokescreen that obscured the link between the Fed’s actions and
the painful increases in interest rates. At the same time, the changes in procedure sig-
nalled to the public that they should not expect business as usual with respect to theFed’s attitude toward inﬂation.
Volcker’s policy shift achieved its disinﬂationary goals but contributed to a deep
recession in 1981–1982. Velocity instability associated with ﬁnancial innovation and
other factors also raised concerns (based on the traditional Poole, 1970, analysis)
about whether monetary targets would continue to be of any value for guiding
policy. In the fall of 1982, the Fed switched tactics again, this time to a borrowed
reserves operating procedure. Simultaneously, it adopted a decidedly easier policy,
despite the fact that money growth was above its targeted range (table 8.1). Money
targets were deemphasized after 1982. In particular, M1 was allowed to deviate quite
far from its targets and after 1986 was no longer targeted at all.
Because there is a close link between desired borrowed reserves and the funds rate,
the borrowed reserves procedure adopted in 1982 is, in practice, quite similar to
funds rate targeting. 13Thus, the third regime of post-1973 monetary policy in the
United States is a return to an emphasis on interest rate smoothing, as in the pre-
1979 monetary regime (note from ﬁg. 8.4a that after 1982, interest rate volatility
returned to pre-1979 levels). During the 1990–1991 recession, the degree to which
Fed policy has been guided by and expressed in terms of interest rate targets rather
than money or reserve growth targets has been particularly striking. For example,
the Fed’s ‘‘shock treatment’’ of December 1991 was couched solely in terms of funds
rate and discount rate reductions. 14
While the Fed concentrated relatively more on stabilizing interest rates after 1982,
it also pursued several other goals. One key objective during the latter part of the
1980s was exchange rate stabilization: The sharp appreciation of the dollar during
the Volcker regime (ﬁg. 8.5a) had contributed to a massive increase in the U.S. cur-
rent account deﬁcit. Beginning in early 1985, the Fed attempted to bring down the
dollar by driving up both M1 and M2 growth rates (ﬁg. 8.1a). By 1987, policymakers
at the Fed agreed that the dollar had fallen enough, and money growth rates were
brought back down. These actions by the Fed were supported by attempts at interna-
tional policy coordination embodied by the Plaza Accord in September 1985 and the
Louvre Accord in February 1987.
Other objectives that inﬂuenced monetary policy during the 1980s included ﬁnan-
cial market stability (particularly following the October 1987 stock market crash; see
Brimmer, 1989, Mishkin, 1991) and the maintenance of Volcker’s inﬂation gains. On
the price stability front, the Fed was particularly successful, as for the ﬁrst time since180 Chapter 8

the early 1960s, inﬂation in the latter part of the 1980s remained low and stable.
Whether the good inﬂation performance of recent years was due primarily to good
luck (e.g., falling oil prices) or agile policy is controversial.
The United Kingdom .15As has often been discussed, there are some broad parallels
between the recent histories of British and U.S. monetary policies, as there were for
general economic policies under Thatcher and Reagan.
As in the United States, the British introduced money targeting in the mid-1970s in
response to mounting inﬂation concerns. Also as in the United States, the Bank of
England used interest rates as operating instruments and was committed to interest-
rate smoothing during this period. Informal targeting of a broad aggregate, sterling
M3 (hereafter M3), began in late 1973, and formal publication of targets began in
1976 (table 8.2), following a spike in inﬂation and in conjunction with an IMF sup-
port arrangement. To help ensure that M3 targets were met, the Supplementary
Special Deposits Scheme—the infamous ‘‘corset’’—was introduced in December
1973. The corset scheme attempted to reduce M3 growth essentially by taxing a com-
ponent of M3, high-interest bank deposits.
Elementary economic analysis suggests that a scheme to reduce the growth rate of
monetary aggregate artiﬁcially through tax policy would also distort the relationship
between that aggregate and macroeconomic variables such as nominal income and
inﬂation. Thus, the reliance on the corset is evidence that, during the pre-1979 pe-
riod, the British monetary authorities were like their U.S. counterparts in not taking
their money growth targets very seriously. It is interesting that, despite the assistance
of the corset, the Bank of England had great di‰culty in meeting its M3 growth tar-
gets during this period: Not only were announced targets consistently overshot, but
the Bank of England frequently revised its targets midstream or abandoned them al-
together (table 8.2). One result of these policies was that British monetary aggregateshad greater volatility than even those in the United States (ﬁg. 8.2b). For example,
the volatility of U.S. monetary base growth (not shown in the ﬁgures) was on aver-
age well less than half that of British monetary base growth in the pre-1979 period,
and the same is true for M3 growth.
Although inﬂation fell subsequent to the 1973 oil price shock, beginning in 1978
prices in the United Kingdom began to accelerate again, with inﬂation ultimately
reaching nearly 20% by 1980. As in the United States, the perception of an inﬂation-
ary crisis led to a change in strategy in 1979. Prime Minister Thatcher’s Medium-
Term Financial Strategy (MTFS, formally introduced in the government’s second
budget in March 1980) included three main components: a gradual deceleration in
M3 growth, elimination of various controls on the economy (including the corset,exchange controls, and incomes policies), and a reduction of the PSBR (the public
sector borrowing requirement, or deﬁcit). A central goal of this program was the res-
toration of credibility for the government’s anti-inﬂationary policies; it was in orderCentral Bank Behavior and Strategy 181

Table 8.2
Money Growth Targets and Outcomes: United Kingdom
Period Aggregate Target OutcomeOutcome
less target
April 1976–April 1977 M3 9–13 1 8.0 /C03.0
April 1977–April 1978 M3 9–13 15.1 ț4.1
April 1978–April 1979 M3 8–12 2 11.4 ț1.4
October 1978–October 1979 M3 8–12 3 13.7 ț3.7
June 1979–October 1980 M3 7–11 4 17.2 ț8.2
February 1980–April 1981 M3 7–11 5 19.4 ț10.4
February 1981–April 1982 M3 6–10 12.8 ț4.8
February 1982–April 1983 M1 8–12 12.4 ț2.4
M3 8–12 11.2 ț1.2
PSL2 8–12 11.6 ț1.6
February 1983–April 1984 M1 7–11 14.0 ț5.0
M3 7–11 9.5 ț0.5
PSL2 7–11 12.6 ț3.6
February 1984–April 1985 M0 4–8 6 5.4 /C00.6
M3 6–10 11.9 ț3.9
March 1985–March 1986 M0 3–7 3.4 /C01.6
M3 5–9 7 16.7 ț9.7
March 1986–March 1987 M0 2–6 4.4 ț0.4
M3 11–15 8 19.0 ț6.0
March 1987–March 1988 M0 2–6 5.6 ț1.6
March 1988–March 1989 M0 1–5 6.1 ț3.1
March 1989–March 1990 M0 1–5 6.3 ț3.3
March 1990–March 1991 M0 1–5 2.6 /C00.4
March 1991–March 1992 M0 0–4 — —
Notes: M3 refers to sterling M3, or M3 less residents’ deposits abroad. PSL2, private sector liquidity, is a
broader aggregate than M3. Outcome less target equals the outcome less the midpoint of the target range.
1Target of 12% growth for M3 set in July 1976 superseded by 9–13% target for M3 in December 1976
‘letter of intent’ to IMF.2New target after 6 months.
3New target after 8 months.
4Original target was to April 1980. Target was extended in October 1979 for 1 year, but then new target
was set for period beginning February 1980.
5From 1980 to 1986, target ranges for M3 were also set for a 3–4-year horizon.
6Beginning in 1984, target ranges for M0 were also set for a 4-year horizon.
7Target suspended in October 1985.
8Target suspended in October 1986.
Sources: Temperton (1991), supplemented by OECD Economic Surveys , various issues.182 Chapter 8

to enhance the credibility of proposed reductions in money growth that the govern-
ment opted for reduced government deﬁcits instead of lower taxes, a `la Reagan. 16
Unfortunately, the British disinﬂationary strategy in the 1979–1982 period ran
into a technical problem similar to that experienced in the United States, namely,
that the relationship between the targeted aggregate and nominal income became
very unstable. M3 velocity fell sharply, and M3 grew at rates well above the targetranges (table 8.2, ﬁg. 8.1b), even as other indicators—the value of the pound, the
growth rates of narrower money aggregates, and the unemployment and inﬂation
rates—all began to signal that monetary policy was very tight (ﬁgs. 8.1b–8.7b). In
retrospect, the instability of M3 is not surprising, because the removal of the corset
induced banks to market high-interest deposits aggressively. Other factors, such as
the phasing out of exchange controls and an increased pace of ﬁnancial innovation,
also a¤ected the growth rate of M3. The monetary authorities tried several strategies
in response to this instability, including the setting of multiyear target ranges
(which, for the most part, were not met) and the targeting of several aggregates
simultaneously. 17
Subsequent to 1983, arguing that ﬁnancial innovation was wreaking havoc with
the relationship between broad money and income, 18the Bank of England began to
deemphasize M3 in favor of narrower aggregates, particularly M0 (the monetary
base). The target for M3 was temporarily suspended in October 1985 and ﬁnally
dropped in 1987, leaving M0 as the only money aggregate to be targeted. Generally,
the attempt to target M0 was more successful than earlier attempts to target M3:
Target ranges have been announced on a regular basis and have been gradually
reduced over time. Also, since 1984, actual M0 growth has generally fallen within
or close to the target ranges, with under- or overshootings tending to be reversed in
subsequent years.
The major exception to the assertion that M0 growth has been on target occurred
in the 1987–1988 period, during which the authorities became concerned about ap-
preciation of the pound and informally ‘‘capped’’ sterling at 3.00 DM to the pound,
resulting in more rapid money growth (see ﬁg. 8.1b and table 8.2). Some economists,
such as Belongia and Chrystal (1990), have argued that this episode was less an
attempt to manage the exchange rate per se than it was an attempt to ﬁnd a new
nominal anchor for monetary policy, given the problems experienced with monetary
aggregates. If so, in this instance the Bank of England backed the wrong horse, be-
cause following the period of the cap, inﬂation rose sharply, a development that was
predicted by rapid growth of the monetary base during the period of the cap. What-
ever interpretation one places on the ‘‘capping’’ episode, however, in October 1990—after much debate—the United Kingdom decided to accept the discipline of a ﬁxed
nominal exchange rate by joining the European Exchange Rate Mechanism (ERM).Central Bank Behavior and Strategy 183

Overall, a comparison with the United States and the other countries examined
here does not put British monetary policy in a favorable light. As ﬁgures 8.6 and
8.7 indicate, not only has British inﬂation had the highest mean and the greatest vol-
atility of any of these countries, but the unemployment rate has also been high and
variable. However, in the 1980s, British inﬂation performance did improve consider-
ably, remaining well below the 1970s level and becoming signiﬁcantly less variable.
Canada .19Recent Canadian monetary experience bears some close parallels to
that of the United States and Britain. This parallel experience is not purely a coinci-
dence, of course, as Canadian monetary policy has often—although not always—
been driven by the goal of maintaining a stable exchange rate with the United States
(ﬁg. 8.5c). As a result, interest rates (ﬁg. 8.3), interest rate volatility (ﬁg. 8.4), and in-
ﬂation (ﬁg. 8.6) have followed generally similar patterns in the two countries.
Like the other countries discussed here, Canada experienced signiﬁcant inﬂation
problems in the mid-1970s, problems that were clearly exacerbated by its attempt to
contain the appreciation of its currency after the breakdown of the Bretton Woods
system. Like the other countries, Canada responded by adopting money growth tar-
gets. In 1975, as part of a larger government initiative that included the imposition ofwage and price controls, the Bank of Canada introduced a program of ‘‘monetary
gradualism,’’ under which M1 growth would be controlled within a gradually falling
target range (table 8.3). The change in monetary strategy did not extend to a change
in operating procedures, however, which continued to emphasize an interest rate
instrument.
Monetary gradualism was no more successful in Canada than were initial attempts
at money targeting in the United States and the United Kingdom, and arguably—as
Table 8.3
Money Growth Targets and Outcomes: Canada
Announcement date Base periodM1 growth
target OutcomeOutcome
less target
November 1975 April–June 1975 10–15 9.3 /C03.2
August 1976 February–April 1976 8–12 7.7 /C02.3
October 1977 June 1977 7–11 9.3 ț0.3
September 1978 June 1978 6–10 5.1 /C02.9
December 1979 April–June 1979 5–9 5.9 /C01.1
February 1981 August–October 1980 4–8 0.4 /C05.6
November 1982 M1 target withdrawn
Notes: Outcomes are annualized growth rates (%) of seasonally adjusted M1 between the base period and
the next announcement of new targets, for example, the outcome corresponding to the November 1975 an-nouncement is the annualized growth rate of M1 between May and June 1975 and August 1976. Outcomeless target equals the outcome less the midpoint of the target range.Source: OECD Economic Surveys and Bank of Canada Review , various issues.184 Chapter 8

in the other two countries—a lack of seriousness on the part of the central bank was
a contributing factor. Announcements of new money targets were made irregularly
and employed base periods for the measurement of money growth that were as
much as 6 months earlier than the date of the announcement (table 8.3). Although
actual M1 growth was often very close to target, and the goal of reducing M1 growth
was achieved during the latter part of the decade, subsequent to the adoption ofgradualism Canada su¤ered a sharp depreciation of its currency and, like the United
States and the United Kingdom, a resurgence in inﬂation.
In defense of the Bank of Canada, many of the same problems that plagued
attempts to target money growth in other countries were present in Canada as well,
including ﬁnancial innovation (see Howitt, forthcoming), velocity instability of the
targeted aggregate, and radically di¤erent signals of policy stance from narrow and
broad money aggregates (ﬁg. 8.1c). Overlaying these standard problems were the
distortions caused by the imposition and eventual elimination of wage and price
controls.
By 1978, only 3 years after money targeting had begun, the Bank of Canada began
to distance itself from this strategy. A dominant factor was concern about the ex-change rate, which as we have noted had been depreciating (ﬁg. 8.5c). Exchange
rate worries intensiﬁed as the U.S. dollar began its rapid appreciation of the early
1980s, threatening Canada with an inﬂationary shock from import prices. The Bank
of Canada responded by tightening policy more than needed to meet the M1 targets;
indeed, M1 growth was negative in 1981 even though the target range was for
growth between 4 and 8% (ﬁg. 8.1c and table 8.3). Because of their conﬂict with ex-
change rate goals, as well as ongoing money demand instability, the M1 targets were
canceled in November 1982. Canada thus became the only country examined here to
abandon formal money growth targeting completely in the early 1980s.
The period following 1982 was one of groping. In 1984 the emphasis on the ex-
change rate (which had been largely unchanged since 1978) was lessened, so that the
Bank of Canada could attempt to assist recovery from the very deep recession that
had begun in 1981. Unemployment did fall after 1984 (ﬁg. 8.7c), and by 1988 the
Canadian ‘‘misery index’’ (the inﬂation rate plus the unemployment rate) was at its
lowest point in many years. Still, inﬂation had begun to edge up again, to some
minds threatening a possible return to the 1970s pattern.
In a rather dramatic reversal of the evolving ad hoc monetary strategy, in January
1988 Governor John Crow announced that the Bank of Canada would subsequently
pursue an objective of ‘‘price stability,’’ that is literal elimination of inﬂation. 20In
February 1991 the Bank and the Minister of Finance jointly announced a series ofdeclining inﬂation targets. Although this strategy implied that inﬂation itself, not
money growth, would be the target of monetary policy, it was indicated that M2
would be used to guide policy. (Attention is also to be paid to an index of monetaryCentral Bank Behavior and Strategy 185

conditions based on interest rates and exchange rates.) It is not completely clear to
what degree this new commitment to price stability implies abandonment of other
objectives, but it does seem that attention to those other goals has been reduced:
For example, during 1987 through 1989, the Bank of Canada permitted a much
greater increase in interest rates and appreciation of the currency than would havenormally been expected under previous regimes.
Germany .21Germany’s central bank, the Bundesbank, also responded to rising in-
ﬂation in the early 1970s by adopting a strategy of targeting money growth, with the
ﬁrst targets being announced for 1975 (see table 8.4). The monetary aggregate chosen
for targeting was central bank money (denoted as M0 in ﬁgure 8.1d), the sum of cur-
rency in circulation and bank deposits held by residents, with each category of bank
deposits weighted by its 1974 required reserve ratios. As Fischer (1987) points out,
central bank money can be interpreted as approximating the ‘‘required monetary
base,’’ and for convenience, we label it as a narrow money aggregate in ﬁgure 8.1d.Table 8.4
Money Growth Targets and Outcomes: Germany
Year Aggregate Target OutcomeOutcome
less target
1975 CBM 8.0 9.8 ț1.8
1976 CBM 8.0 9.2 ț1.2
1977 CBM 8.0 9.0 ț1.0
1978 CBM 8.0 11.5 ț3.5
1979 CBM 6.0–9.0 6.4 /C01.1
1980 CBM 5.0–8.0 4.8 /C01.7
1981 CBM 4.0–7.0 3.6 /C01.9
1982 CBM 4.0–7.0 6.1 ț0.6
1983 CBM 4.0–7.0 7.0 ț1.5
1984 CBM 4.0–6.0 4.6 /C00.4
1985 CBM 3.0–5.0 4.5 ț0.5
1986 CBM 3.5–5.5 7.7 ț3.2
1987 CBM 3.0–6.0 8.0 ț3.5
1988 M3 3.0–6.0 6.8 ț2.3
1989 M3 5.0 4.7 /C00.3
1990 M3 4.0–6.0 1 5.5 ț0.5
1991 M3 4.0–6.0 2 ——
Notes: Growth rates are measured year over year for 1975–1978 and fourth quarter to fourth quarter
thereafter. Outcome less target equals the outcome less the midpoint of the target range. CBM is central
bank money.
1The target was lowered to 3–5% in July.
2As of 1991, targets apply to all-German M3.
Source: Kahn and Jacobson (1989), updates for OECD Economic Surveys , various issues.186 Chapter 8

However, the Bundesbank has noted that it views central bank money as a broad
rather than narrow measure of money, arguing that the required reserve ratio
weights are reasonable proxies for the relative liquidities of the various components.
Monetary targets have been announced annually and are reviewed at midyear in
light of macroeconomic developments, although midyear revision of targets has
been extremely unusual. (The usual function of the midyear review is to use interiminformation to reduce the size of the target range.) The method by which the Bundes-
bank’s monetary targets are set is particularly interesting: The calculation of target
ranges is a public rather than a clandestine exercise. The setting of targets explicitly
takes into account the Bundesbank’s long-term inﬂation goal, estimated potential
output growth, and expected velocity trends, which are combined using the
quantity-theory equation to determine the desired money growth rate. In theory,
this explicit linkage of targets to goals has the important beneﬁt of allowing targets
to be adjusted when the target–goal relationship changes, without compromising the
central bank’s commitment to meeting its targets.
‘‘Short-term’’ considerations such as the unemployment rate and expected transi-
tory deviations in inﬂation or velocity are not formally included in the Bundesbank’starget-setting exercise. Nevertheless, there is some scope for shorter-term considera-
tions to a¤ect monetary policy. For example, the Bundesbank freely acknowledges
that one purpose of specifying target ranges 22rather than single numbers is to give
itself some scope for short-run discretionary activism. The size of the target range has
varied over time—it was zero in 1989—indicating changes in the amount of short-
term ﬂexibility the Bundesbank thinks it needs.
The Bundesbank has also shown that it is willing to accept money growth outside
of the target range for periods of 2–3 years. In principle, deviations of money growth
from targets are supposed to be reversed subsequently, so that short-term considera-tions do not detract from the Bundesbank’s preeminent goal of low and stable inﬂa-
tion in the long run. Table 8.4 shows that periods of money growth over target, such
as 1975–1978, have tended to be followed by periods of slower growth, as in 1979–
1981. In general, though, table 8.4 suggests that the Bundesbank has not always suc-
ceeded in fully reversing short-term deviations from the money growth targets.
Over the last two decades, the principal object of short-term discretionary policy
by the Bundesbank has been the exchange rate. In particular, money growth targets
were exceeded during 1975–1978 and again during 1986–1988 in order to dampen an
appreciating mark. The Bundesbank’s concern about the exchange rate has a number
of sources: First, under international agreements including the European Exchange
Rate Mechanism, the Plaza Accord, and the Louvre Accord, Germany has acceptedsome responsibility for stabilizing its exchange rate within agreed-upon ranges. Sec-
ond, the large size of the German export sector makes the exchange rate a politicallyCentral Bank Behavior and Strategy 187

sensitive variable. Finally, maintenance of a strong and stable mark is viewed as a
precondition for achieving inﬂation goals.
Central bank money remained the money target through 1987. In 1988, the Bun-
desbank adopted simple-sum M3 (the equal-weighted sum of currency in circulation,
demand deposits, time deposits less than 4 years, and savings deposits). The rationale
for the switch was that central bank money put too much weight on a rapidly grow-ing currency component and thus overstated monetary ease—the so-called currency
bias problem. Despite the switch in targets, Germany has not experienced nearly as
much instability in the relationship between targeted aggregates and nominal income
as have a number of the other major countries.
In achieving short-run money control, the Bundesbank has typically relied heavily
on interest rate indicators (including the call, or overnight, rate and the repurchase
rate), much in the spirit of the Federal Reserve’s use of federal funds rate targeting
as a mechanism for hitting monetary targets in the medium term. However, while the
Bundesbank has attempted to keep interest rates stable in the short run, it has not
gone so far as to set explicit targets for interest rates (Batten et al., 1990, p. 11). It is
notable that the Bundesbank has consistently achieved very low variability of bothinterest rates (ﬁg. 8.4d) and money growth rates (ﬁg. 8.2d), contrary to the simple
view that suggests a tradeo¤ between these two quantities.
German monetary policy has been quite successful in maintaining a low and stable
inﬂation rate (ﬁg. 8.7d), but, unlike Switzerland and Japan, Germany has not
avoided a serious and persistent unemployment problem (ﬁg. 8.7d). Fischer (1987)
and others have pointed to inﬂexibilities in the labor market (relative to, say, Japan)
as a potential cause of persistent German unemployment.
Most recently, the reuniﬁcation of Germany has posed some novel problems for
the Bundesbank. The exchange of West German currency for East German currencyat reuniﬁcation at rates favorable to the East has created nascent inﬂationary pres-
sures, at the same time that the tremendous uncertainties created by the reuniﬁcation
have made the forecasting of prosaic items like velocity quite tricky. In addition, the
political pressures to support strong real growth at the early, delicate stages of reuni-
ﬁcation are strong. It remains to be seen how well the Bundesbank’s traditional pol-
icy strategy can deal with this new set of circumstances.
Switzerland .23The ﬁxed-exchange-rate regime ended in Switzerland in January
1973. The Swiss National Bank began to announce money stock targets, with M1
the targeted aggregate, at the end of 1974. Like the Germans, the Swiss set money
growth targets based on explicit inﬂation goals and forecasts of potential output
and velocity growth. Announced targets were and have continued to be single-valuedrather than ranges, a practice based on the interesting rationale that ‘‘from a psycho-
logical point of view, missing a target band is worse than missing a point target’’
(Schiltknecht, 1982, p. 73).188 Chapter 8

An unusual feature of the conduct of Swiss monetary policy has been the Swiss
National Bank’s consistent use of the monetary base directly as an operating instru-
ment. Control of M1 during the early years of targeting therefore required the central
bank to predict the value of the money multiplier (the ratio of M1 to the base). Per-
haps because of the use of the monetary base as an instrument, Switzerland has gen-
erally had higher volatility in short-term interest rates than have other countries (ﬁg.8.4). However, this volatility has not carried over to long-term rates, as Switzerland
has had the lowest volatility of long-term interest rates of the six countries studied
here (again see ﬁg. 8.4). Presumably, the low volatility of long-term rates reﬂects
Switzerland’s success at keeping its inﬂation rate low and stable in the longer term.
As in other countries, the idea underlying money targeting in Switzerland was to
reduce money growth gradually in order to eradicate inﬂation over the longer term.
However, according to the Director of the Swiss National Bank: ‘‘. . . the policy of
well controlled, stable monetary growth was never viewed as a policy which should
be adhered to rigidly year after year, or even month after month, at all costs. Rather,
it was viewed as a medium- to long-term constraint, with the necessity for short-run
ﬂexibility, especially in view of exchange rate developments’’ (Schiltknecht, 1982,p. 72).
This approach to targets as a medium- to long-term constraint but not an impedi-
ment to short-term discretion is similar to the approach taken in Germany. Indeed,
in practice the Swiss have been even more successful than the Germans in reversing
deviations of money growth from target: Between 1975 and 1986, the cumulative
excess of money growth over target in Switzerland (the sum of the ‘‘outcome less tar-
get’’ column in table 8.5) was only about 1.6%.
An example of short-run monetary ‘‘ﬂexibility’’ occurred in 1978, when the Swiss
franc began to appreciate (ﬁg. 8.5e). In response, the Bank eased monetary policysigniﬁcantly: M1 growth in 1978 was above 16% (ﬁg. 8.1e and table 8.5), compared
to a target of 5%. While rather an extreme episode, the 1978 actions illustrate the
general willingness of the Swiss National Bank to subordinate money targets, at least
in the short run, to exchange rate considerations. Swiss concern about the exchange
rate reﬂects not only the extreme openness of the Swiss economy, but the fact that a
stable franc is an important component of Switzerland’s prominence as an interna-
tional ﬁnancial center.
After containment of the 1978 exchange rate emergency, the bank returned to an
(unannounced) policy of money targeting in the spring of 1979. However, because
of problems with forecasting the money multiplier, beginning in 1980 the mone-
tary base rather than M1 became the targeted aggregate (as well as the policyinstrument).
In 1980 and 1981 money growth was low and below target, in reaction to
increased inﬂation and the overshooting of money targets in the previous few years.Central Bank Behavior and Strategy 189

The period from 1982 to about 1987, though, was remarkably halcyon: Money
growth targets were routinely met (table 8.5). The short-term volatility of Swiss
money growth remained comparatively high (ﬁg. 8.2), however, implying that the
Swiss were acting quickly to o¤set high-frequency deviations of money growth from
target. Inﬂation fell to low levels (ﬁg. 8.6e), and unemployment remained insigniﬁ-
cant (ﬁg. 8.7e). 24Monetary policy was assisted considerably during the early 1980s
by the fact that the link between money growth and nominal magnitudes in Switzer-
land appeared stable, despite transient velocity ﬂuctuations.
In 1986 there was a signiﬁcant decline in the inﬂation rate (from over 3% almost to
zero) and in 1989 a sharp increase in inﬂation (from about 2% to nearly 5%), neither
of which was predicted by the behavior of the monetary base (see Yue and Fluri,
1991, for a discussion). Swiss central bankers have suggested that the problem is astructural break in the demand for base money, brought about by the introduction
of an electronic interbank payments system and a reduction in legal reserve require-
ments. In attempting to o¤set this fall in base money demand, the Swiss NationalTable 8.5
Money Growth Targets and Outcomes: Switzerland
Year Aggregate Target OutcomeOutcome
less target
1975 M1 6 4.4 /C01.1
1976 M1 6 7.7 ț1.7
1977 M1 5 5.5 ț0.5
1978 M1 5 16.2 ț11.2
1979 — — — —
1980 M0 4 1 /C00.61 /C04.6
1981 M0 4 /C00.5 /C04.5
1982 M0 3 2.6 /C00.4
1983 M0 3 3.6 ț0.6
1984 M0 3 2.5 /C00.5
1985 M0 3 2.2 /C00.8
1986 M0 2 2.0 0.01987 M0 2 3.0 ț1.0
1988 M0 3 /C03.9 /C06.9
1989 M0 2 /C04.9 /C06.9
1990 M0 2 /C02.6 /C04.6
1991 M0 1 — —
Notes: Growth rates are measured as mean of monthly year-on-year growth rates until 1988; after 1988
growth rates are measured fourth quarter to fourth quarter. M0 is the monetary base adjusted to exclude
end-of-month bulges in Swiss National Bank credit to banks.
1Average percentage increase over the November 1979 level.
Source: Rich (1987), with updates from OECD Economic Surveys , various issues.190 Chapter 8

Bank permitted negative money growth for 3 years (table 8.5). The instability in
the demand for base money has led the Swiss National Bank to deemphasize money
base targeting and, recently, to contemplate fundamental changes in its monetary
strategy.
Japan .25The increase in oil prices in late 1973 was a major shock for Japan, with
substantial adverse e¤ects on inﬂation, economic growth, and the government’s bud-
get. In response to an increase in the inﬂation rate to a level above 20% in 1974 (ﬁg.
8.6f )—a surge facilitated by money growth in 1973 in excess of 20% (ﬁg. 8.1f )—the
Bank of Japan, like the other central banks we have considered, began to pay moreattention to money growth rates. In 1978 the Bank began to announce ‘‘forecasts’’ at
the beginning of each quarter for the growth rate of M2 (changed to the growth rate
of M2 țCDs when CDs were introduced in 1979) from 1 year earlier to the current
quarter (table 8.6).
The use of the word forecast rather than target suggests that the Bank of Japan
was committed only to monitoring rather than to controlling money growth. 26How-
ever, after 1978 there did appear to be a substantive change in policy strategy, in
the direction of being more ‘‘money-focused.’’ Particularly striking was the di¤er-
ent response of monetary policy to the second oil price shock in 1979: Instead ofTable 8.6
Money Growth Targets and Outcomes: Japan
Year Aggregate Target 1 OutcomeOutcome
less target
1978 M2 12–13 12.6 ț0.1
1979 M2 țCD 11 10.3 /C00.7
1980 M2 țCD 8 7.6 /C00.4
1981 M2 țCD 10 10.4 ț0.4
1982 M2 țCD 8 8.3 ț0.3
1983 M2 țCD 7 6.8 /C00.2
1984 M2 țCD 8 7.9 /C00.1
1985 M2 țCD 8 9.0 ț1.0
1986 M2 țCD 8–9 8.3 /C00.2
1987 M2 țCD 11–12 11.8 ț0.3
1988 M2 țCD 10–11 10.6 ț0.1
1989 M2 țCD 10–11 10.6 ț0.1
1990 M2 țCD ca. 11 10.0 /C01.0
1991 M2 țCD ca. 4 — —
Notes: Growth rates are measured fourth quarter to fourth quarter. Outcome less target equals the out-
come less the midpoint of the target range.1Announced at the beginning of the fourth quarter and are referred to as forecasts rather than targets by
the Bank of Japan.Source: Fischer (1987) and Bank for International Settlements, Annual Report , various issues.Central Bank Behavior and Strategy 191

allowing extremely high money growth, as occurred in 1973, the Bank of Japan
quickly reduced M2 țCDs growth in 1979 and 1980 to quite a low level (ﬁg. 8.1f ).
The di¤erence in the inﬂation outcome in this episode was also striking, as inﬂation
increased only moderately with no adverse e¤ects on the unemployment situation.
More generally, the Bank of Japan’s forecasts and actual money growth followed a
declining trend into the mid-1980s (except in 1981; see table 8.6). Thus, in contrastto the German and Swiss practice of clearly specifying central bank intentions in
advance, the Japanese seemed to follow an ‘‘actions speak louder than words’’
approach. As we discuss further later, however, in recent years both forecasts and
actual money growth in Japan have become much more variable, weakening the pre-
sumption that the Bank of Japan practices ‘‘closet monetarism.’’
From an institutional point of view, it was no doubt fortunate that the Bank of
Japan began to focus on money at the time that it did. Traditionally, Japanese cen-
tral bank policy had emphasized the control of bank credit, which proved an e¤ective
instrument in a highly regulated ﬁnancial environment in which borrowers had few
substitutes for bank loans. However, a slow but steady process of liberalization of
ﬁnancial markets began around 1975, resulting ultimately in the introduction of newﬁnancial instruments and markets and a weaker tie between bank lending and eco-
nomic activity. 27
In a ﬁnancial environment that over time has become more and more similar to
that of the United States, the Bank of Japan’s methods of conducting monetary pol-
icy have also evolved in the direction of the U.S. example. 28Abandoning quantita-
tive credit controls, the Bank of Japan has moved gradually to a system emphasizing
open-market operations in the interbank market, 29more attention to money growth,
and the use of interbank interest rates as the primary instruments of monetary con-
trol. However, unlike the United States, Japan has always used interest rate instru-ments of some type and has never experimented with the targeting of bank reserves.
The outcome of these operating procedures is that the volatility of interest rates in
Japan has generally been low in relation to other countries (ﬁg. 8.4), while the vola-
tility of the M2 țCDs aggregate focused on by the Bank of Japan has been compa-
rable to the volatility of U.S. M2 (ﬁg. 8.2).
Also in parallel to the United States, ultimately ﬁnancial innovation and deregula-
tion in Japan began to reduce the usefulness of the broad money target: In particular,
introduction of money market certiﬁcates and large time deposits in 1985, and the
repeated reductions in the minimum denominations of these assets over 1986–1989,
led to increases in the demand for M2 (see, e.g., Yoshida and Rasche, 1990). In re-
sponse to increased money demand, and also because of concern about appreciationof the yen, the Bank of Japan signiﬁcantly increased the rate of money growth in
1987–1989 (table 8.6).192 Chapter 8

Beginning in 1989, monetary policy became oriented toward trying to arrest what
many Japanese policymakers considered to be a bubble in land and stock prices,
without causing a crash that might have disastrous ﬁnancial consequences. Asset
prices did come down as money growth slowed, but economic activity weakened
also. Another factor that has recently complicated monetary policy is a slowdown
in lending by Japanese banks associated with the increase in bank capital require-ments mandated by the Basle Accord. In responding to these developments, as we
have mentioned, the Bank of Japan has permitted a considerable increase in the vari-
ability of broad money growth since late 1990 (ﬁg. 8.2f ), and in general has engaged
in a much more ‘‘discretionary’’ style of policy-making.
8.3 Conduct of Monetary Policy in Six Countries: Some Positive Hypotheses
What do we learn from these case studies of monetary policy-making? In this section,
we discuss some positive hypotheses, so called because they seem to apply generally
across the case studies. We state these hypotheses as if they were conclusions but
remind the reader once again that they (as well as the more normative observa-tions discussed in section 8.4) are intended only as propositions worthy of further
examination.
(1)Central bankers have multiple objectives and a ‘‘crisis mentality.’’ It is a com-
monplace that central bankers care about both economic growth and inﬂation, which
may force them to confront di‰cult tradeo¤s. But the behavior of central bankers
suggests that other variables enter their objective function as well. The leading exam-
ple from the case studies is the nominal exchange rate: In all six cases examined, cen-
tral bankers modiﬁed their policies in order to arrest what they considered to be
undesirable exchange rate trends. Arguably, in some of these cases (when the UnitedKingdom ‘‘capped’’ the pound in 1987, e.g.) the exchange rate played the role of an
intermediate target, that is, the central bank’s intervention reﬂected concern not
about the exchange rate per se but about what the exchange rate was signalling
about the stance of monetary policy. However, in many of the cases, the exchange
rate clearly functioned as a goal of policy, reﬂecting central bank concerns about
the health of the traded goods sector or international commitments to meet exchange
rate targets.
Interest rate stability has also in many cases been an independent objective of pol-
icy. For example, in the 1970s the Federal Reserve chose to tolerate high rates of
money growth in order to avoid sharp increases in interest rates (a policy that was
dramatically reversed in 1979). Japan, Germany, and to some extent Great Britainhave all attempted to keep interest rate volatility low even as the economic environ-
ment and monetary policy strategies have changed (ﬁg. 8.4). Several writers (e.g.,Central Bank Behavior and Strategy 193

Goodfriend, 1987; Howitt, 1993) have suggested that central banks view interest rate
stability as important for maintaining ‘‘orderly’’ ﬁnancial markets free from excessive
speculation.
Although they have multiple objectives, over time central bankers do not devote
constant proportions of their attention to each objective. Rather, at any given time,
the lion’s share of the central bank’s attention is typically devoted to the one or twoobjectives that are furthest from desired levels. A possible explanation of this ‘‘crisis
mentality’’ is that the marginal social cost of, say, high inﬂation really does increase
sharply with the inﬂation rate. Alternatively, central bankers may feel that their inde-
pendence and perquisites are threatened more by a public perception that some
aspect of the economy is ‘‘out of control’’ than by a record of generally mediocre
performance.
The fact that central banks have multiple objectives creates obvious tensions in the
monetary policy process. For example, as Goodfriend (1987) has pointed out, the
preference of the central bank for maintaining a stable nominal interest rate may
lead to nonstationarity in money and prices. Multiplicity of objectives and the crisis
mentality can also make even the most competent and purposeful central bank ap-pear at best to be muddling through, or at worst to be lurching from one strategy to
another. As we discuss further later, the complexity of central bank objectives and
behavior may increase the value of clear communication with the public about the
goals and direction of monetary policy.
(2)The greater is the central bank’s concern about inﬂation, the stronger will be its
tendency to employ monetary aggregates as intermediate targets . All six of the
countries discussed here adopted monetary targeting in the 1970s in response to a
worldwide increase in inﬂation and persisted with money targets until disinﬂation
was achieved. 30The central banks most ‘‘hawkish’’ on inﬂation, such as those of
Germany and Switzerland, have been the most consistent in maintaining a money
targeting strategy, while more ‘‘dovish’’ monetary authorities like those of the
United Kingdom, Canada (before 1988), and the United States have been the least
consistent.
The natural ﬁrst place to look for an explanation for this aspect of central bank
behavior is Poole’s (1970) well-known theory of target choice, which argues essen-
tially that the optimal intermediate target is the one with the most stable relationship
with the goal variables. Unfortunately, Poole’s model is of limited help in this in-
stance, because it predicts that money targets will be preferred over interest rate tar-
gets during periods when money demand is relatively stable. What we observe is the
reverse: In the halcyon pre-1974 days of stable money demand, central banks were
more likely to focus on interest rate targets, while in many countries, the switch to
money targets occurred and persisted during a period of severe velocity instability.
Further, central bankers have typically reacted to unstable velocities not by reverting194 Chapter 8

to interest rate targeting but instead by changing the particular monetary aggregate
that they target—in some cases switching from a narrower to a broad aggregate (the
United States, Germany) and in others from a broader aggregate to a narrower one
(the United Kingdom, Switzerland).
Why then do central banks adopt money growth targets when faced with inﬂation-
ary crises? The next two points discuss possible reasons.
(3)One function of an intermediate target such as money growth, as perceived by cen-
tral bankers, is to act as a guidepost or compass for monetary policy . Central bank-
ers face considerable uncertainty not only with regard to the state of the economy
and the nature and timing of the monetary transmission mechanism, but also about
the stance of policy itself. In pursuing intermediate targets, the policymakers hope toimprove their measurement of their policy stance and, thus, reduce the probability of
inadvertently choosing the wrong settings for their instruments. Thus, the adoption
of money growth targets in the late 1970s by many central banks was intended to
help avoid the overexpansionary tendencies of the earlier part of the decade. In par-
ticular, it was hoped that money growth would prove a more reliable indicator of
monetary conditions than variables that had been employed earlier, such as interest
rates 31and free reserves.
The use of monetary aggregates as guideposts has been problematic in practice,
however, and for some of the same reasons suggested by Poole’s original analysis:
The relationship between individual aggregates and macroeconomic variables has
often been unstable, and di¤erent aggregates have as often as not given conﬂictinginformation, as for example in the United Kingdom in the 1979–1982 period when
narrow and broad aggregates gave very di¤erent readings of the tightness of policy.
There is still a deeper question about the use of monetary aggregates as guideposts,
however, which also follows from the logic of the Poole model: If the central bank is
searching for a guidepost for monetary policy, why conﬁne the search to one or two
economic variables? Why not instead use a forecast that optimally weights all avail-
able information about the likely e¤ects of policy on the economy? As we discuss
further below, the answer to this question may be that there is a complementarity be-
tween using a money growth target as a guidepost and using it as a signal to the pub-lic about monetary policy intentions.
(4)The second and probably more important reason that central bankers adopt money
growth targets is to signal the central bank’s goals and intentions—particularly those
concerning inﬂation—to the public . Both central bankers and the public consider
the control of inﬂation to be one of the most important objectives of monetary pol-icy. Yet of central banks’ many objectives, inﬂation is perhaps the one related to
policy actions with the longest lag. Thus, it is particularly di‰cult for the public to
evaluate the inﬂationary impact of current policies. An advantage of money targetingCentral Bank Behavior and Strategy 195

is that—because of the simple and widely understood quantity-theory prediction that
money growth and inﬂation will be proportional—money growth targets may be per-
ceived as being informative about the central bank’s goals and intentions with re-
spect to inﬂation. 32
Central bankers see several potential beneﬁts to using money growth targets to sig-
nal medium- and long-term inﬂation strategy. One potential beneﬁt is that explicittargets for money growth may aid the management of inﬂationary expectations. If
the central bank can reassure the public through a targeting procedure that it is
committed to controlling inﬂation in the longer run, it may reduce ﬁnancial market
volatility and conceivably (although we have no evidence on this point) improve
short-run policy tradeo¤s.
Another potential beneﬁt to the central bank of emphasizing money growth targets
is that this practice keeps the central bank’s inﬂation objectives ‘‘on the front burner’’
and makes the central bank more accountable to the public for keeping inﬂation low.
Theories of bureaucratic behavior might seem to imply that a bureaucracy like a cen-
tral bank will want to avoid accountability. But in fact, a central bank may want to
make itself more accountable for achieving price stability because it values the pricestability goal more than do politicians in the legislative and executive branches. 33
For example, if the central bank is able to point to money growth above target
(with its implied inﬂationary consequences), it may be able to enlist public support
in resisting political pressures for excessive short-run expansion. Elements of this
strategy can be seen in almost all the major disinﬂations of the early 1980s, in which
central bankers emphasized the importance of meeting money growth targets in or-
der to deﬂect political demands for rapid reﬂation.
The notion that central banks seek to bind their own hands is of course closely
related to Kydland and Prescott’s (1977) seminal argument for rules, with the di¤er-ence that we here emphasize an intragovernmental variant of Kydland and Prescott’s
precommitment game. However, as the next point emphasizes, in practice central
bankers reject the notion of rigid rules in favor of looser types of precommitment.
(5)Central banks never and nowhere adhere to strict, ironclad rules for monetary
growth. Central banks’ attachments to speciﬁc targets for speciﬁc monetary aggregatesis at best modest and is always hostage to new developments in the economy .A s i s
evident from the case studies and tables 8.1–8.6, all central banks deviate signiﬁ-
cantly from their monetary targets to pursue short-term objectives, and are most
explicit about their willingness to be ‘‘ﬂexible’’ and ‘‘pragmatic’’ in the short run.
Further, money growth targets and the targeted aggregates themselves may be
changed fairly often.
Clearly, central banks have never taken seriously the literal ‘‘precommitment
through rules’’ strategy implied by Kydland and Prescott’s analysis of the time-
inconsistency problems. If money growth rules are adopted at all, they are intended196 Chapter 8

to apply only in the medium and long term. Of course, as it has been said, the long
term is just a succession of short terms. Thus, for a longer-term money growth target
to be meaningful, the central bank must at some point demonstrate its willingness to
o¤set short-term deviations from the target path. 34The feasibility and value of ‘‘hy-
brid’’ strategies, containing elements of both rules and discretion, is discussed further
in the next section.
8.4 What Works? Some Normative Hypotheses and Issues for Future Research
The case studies showed that, although national experiences with monetary policy inthe last two decades are diverse, a dominant theme is the adoption of money target-
ing strategies as a response to increased inﬂation. In the last section we argued that
central bankers adopted money growth targets for two reasons: as guideposts, help-
ing them to measure policy stance; and as signals, communicating to the public the
medium-term goals of policy. Despite what was to some degree a common approach
to monetary policy, however, some central banks have fared much better than others
in meeting their ultimate policy objectives, particularly in achieving low and stableinﬂation.
Why have some central banks been more successful in their use of money growth
targets? The case studies provide some clues that may help answer this question. We
list some hypotheses suggested by the case studies that we view as being worth seri-
ous exploration in future research.
(1)Successful use of money growth targets in conducting monetary policy seems to re-
quire that the central bank does not ‘‘play games’’ with its targeting procedures .A
major reason for using money growth targets, we have seen, is to communicate with
the public. Hence, clarity, openness, and consistency in the targeting procedure arepotentially almost as important as whether the targets are met. Central bank actions
that increase the clarity of its policies include: targeting only one aggregate at a time,
announcing targets on a regular schedule for a speciﬁed horizon, being as consistent
as possible in the choice of aggregate to be targeted, and giving clear explanations of
the reason for and expected duration of deviations of money growth from target.
A particularly interesting way in which central banks can clarify their intentions is
by means of a public calculation of target ranges that makes explicit the central
bank’s goals and its assumptions about how the target is tied to those goals. In prin-
ciple, this explicit linkage of targets to goals might have the important beneﬁt of
allowing the central bank to adjust its targets when the target–goal relationship
changes, without compromising its credibility.
Generally, Germany and Switzerland did well on the above criteria over the last
two decades, while the United States, the United Kingdom, and Canada did lessCentral Bank Behavior and Strategy 197

well. The most egregious game-player was the Bank of England, with its multiple tar-
geted aggregates, extreme base drift, erratic changes in targets and target horizons,
and its use of artiﬁcial means (the corset) to bring down the growth of a targeted ag-
gregate. The U.S. Fed and the Bank of Canada also did not take their targets very
seriously, at least at ﬁrst, as evidenced by the Fed’s multiple targets and base drift
and the Bank of Canada’s practice of announcing targets irregularly for horizonsthat were not clearly speciﬁed. 35Improved inﬂation performance in a number of the
countries studied here coincided with the adoption of more serious and straightfor-
ward targeting procedures. The clearest example is Britain, which achieved more sta-
ble inﬂation after it abandoned the corset and multiple targets to focus on a regularly
announced target for a single aggregate.
Japan is an interesting intermediate case, in that it has had a very successful mon-
etary policy despite the opacity of its targeting (or nontargeting) procedure. 36On
the other hand, Japan is the only country to have focused on a single monetary ag-
gregate (M2 țCDs) over the entire period; it has announced its money growth
‘‘forecasts’’ on a consistent and regular basis; and it achieved a relatively steady
slowdown of money growth between the mid-1970s and mid-1980s, despite theoccurrence of a second oil shock in 1979. Thus—at least prior to its recent switch to
a more discretionary mode—the Bank of Japan created a degree of predictability
about its medium-term policies.
From the perspective of the literature on central bank credibility, it is not surpris-
ing that game-playing in targeting procedures—which leads the public to believe the
central bank is not serious—is counterproductive. A straightforward approach to
conducting monetary policy appears to be quite useful for increasing the central
bank’s credibility and improving policy outcomes.
(2)Short-run adherence to money growth targets may not be necessary for the success-
ful use of a money targeting strategy as long as there is some commitment by the cen-
tral bank to reverse deviations of money growth from target over the longer term .A s
the example of Switzerland most clearly illustrates, a money targeting strategy appar-
ently can be used successfully even if money growth rates have large ﬂuctuations and
are frequently outside of target ranges. However, the success of Swiss monetarypolicy in keeping inﬂation low seems to have required a commitment by the Swiss
National Bank to compensate for high rates of money growth in one period by sub-
sequent o¤setting low rates of money growth in future periods. In other words, it
looks as if the Swiss have successfully used a hybrid strategy, in which rules are
used to guide policy in the long term but not in the short term. The German and
Japanese central banks have similarly demonstrated their willingness to make up for
periods of excessive money growth by subsequent periods of slow money growth,
although to a lesser extent than the Swiss. Again the worst record belongs to the Brit-
ish, who consistently missed targets in the same direction.198 Chapter 8

A cynic might ask, ‘‘What is the di¤erence between a policy of reversing deviations
from target and the highly criticized ‘stop–go’ policies of the 1960s and early 1970s,
which also involved alternating periods of low and high money growth?’’ The di¤er-
ence, which is admittedly subtle, is that the policy of reversing deviations from target
takes place in a larger framework, one that provides a basis for expecting that short-
term expansions or reductions in money growth will be subsequently o¤set. Incontrast, although the earlier regime sometimes involved reversals ex post (stop–go
policies), there was no basis for people to expect ex ante that such reversals would
occur. Thus—as again is consistent with the literature on credibility—it is the nature
of the expectation engendered by a policy that appears to be critical to its success.
Complementary to a strategy of reversing short-term deviations from target is a
policy of adjusting targets when their relationship with goal variables changes, as is
practiced (in principle at least) by Germany and Switzerland. It would not be desir-
able to o¤set a deviation in money growth arising from a permanent shock to veloc-
ity, for example. Under the German–Swiss method of setting targets, a permanent
shock to velocity would result in a change in the money growth target. In an uncon-
ditional money targeting scheme, by contrast, the central bank could accommodatethe velocity shock only by sacriﬁcing its commitment to the target.
(3)The outcomes of monetary policy do not appear to be dependent on the details of
the operating procedure or the choice of instruments . A wide variety of operating
procedures has been observed across the six countries studied here, but there is no
evident correlation between the type of procedure and the e¤ectiveness of monetarypolicy. For example, the most common procedure—using the interbank interest rate
as an instrument for achieving medium-term targets for money growth—seemed to
work poorly for the United States in the 1970s but has been used quite successfully
by Japan and Germany.
In addition, as a comparison of operating procedures between Switzerland and
Germany indicates, focus on a monetary aggregate as an operating instrument does
not guarantee a more successful adherence to monetary targets. Indeed, Switzerland
(which has used the monetary base as its operating instrument) has had among the
most variable rates of money growth, while Germany (which employs an interbankinterest rate as its instrument) has had among the lowest money growth variability
(ﬁg. 8.2). It is also interesting that, although the Swiss operating procedure has
resulted in high volatility of short-term interest rates, Swiss long-term rates have
shown less volatility than in any of the other countries studied here (ﬁg. 8.4). Because
it is the volatility of long-term interest rates that would seem to be the more relevant
to the stability of the ﬁnancial system, the Swiss example suggests that the use of the
monetary base as an operating instrument need not create problems even with re-
spect to the goal of interest rate smoothing.Central Bank Behavior and Strategy 199

This irrelevance of the operating procedure is not surprising from a theoretical
viewpoint, because any of a number of procedures can be used to achieve any given
set of values for the central bank’s targets and goals—and it is the latter that should
matter for the macroeconomy. If operating procedures are macroeconomically unim-
portant, why then do central banks pay so much attention to them? The ‘‘smoke-
screen’’ argument may be relevant here. For example, by focusing on the change inoperating procedure in 1979, Fed Chairman Volcker partly diverted attention from a
more fundamental change in policy. Also, the Swiss example notwithstanding, the
details of operating procedures may have important e¤ects on certain segments of
ﬁnancial markets (banks, bond traders) which the central bank considers to be an
important part of its clientele.
Although these observations about what works well in promoting successful mon-
etary policy are suggestive, further research on several problematic points is needed.
A ﬁrst troublesome issue turns on the nature of the empirical relationship between
money and other economic variables. Our review of central banks’ experience sug-
gests that money growth targeting, if treated as a ﬂexible constraint on medium-
term policy, can be a useful tool. However, even the best-handled money targetingstrategy requires that there be some predictable relationship between money growth
and the goal variables of policy; it has been argued (most persuasively by Friedman
and Kuttner, 1990) that the relationship between money and the economy is empiri-
cally so unstable that monetary aggregates are of essentially no value in guiding
monetary policy. Isn’t this instability fatal to the case for any type of money target-
ing?
This issue is of ﬁrst-order importance and needs further investigation in a cross-
national context. Several responses can be made at this point, however:
First, it is possible that the velocity instability that has plagued the monetary pol-
icy of countries such as the United States and the United Kingdom is itself partly
endogenous, a result of erratic monetary policies that have created highly variable
inﬂation and interest rates. Our case studies show that countries with more stable
monetary policies, while not immune to velocity instability, do su¤er from it to a
smaller degree. In particular, Japan’s ability to provide monetary stability despite
major changes in its ﬁnancial institutions is striking. Thus, longer-run money growth
targeting might also lead to a more stable relationship of money to other variables.
Second, as we have already discussed, there are reasons to believe that the
German–Swiss technique of adjusting money growth targets for expected changes in
velocity is preferable to unconditional money growth targeting. If adjustments for
expected velocity changes are made, then stability of velocity is not a prerequisitefor successful policy, only some degree of conditional predictability of velocity. Of
course, it may be that even conditional prediction is not possible; empirical work
should be directed toward ﬁnding out.200 Chapter 8

A third response that can be made to the Friedman–Kuttner objection is that it
does appear to be useful to central bankers to have some variable or variables to sig-
nal the medium-term stance of policy; for reasons of both theory and simplicity,
money growth is a natural candidate. However, if velocity unpredictability disquali-
ﬁes money as an appropriate target—as might have been the case in the United
States and Britain during 1979–1982, for example—then one would want to consideralternative anchors for policy, such as the exchange rate, nominal GNP, or inﬂation
forecasts. Unfortunately, as a large literature discusses, the obvious alternatives to
money growth also have shortcomings, including unstable relationships with the
economy and inadequate controllability and observability.
Besides the question of stability of the money-output link, another broad unre-
solved issue concerns the degree to which successful monetary policies are the result
of a more favorable political environment, rather than superior policy techniques. To
ask the question more concretely: Is the superiority of German or Swiss monetary
policy over, say, British policy really due to better and more coherent policies by
the Bundesbank and Swiss National Bank? Or is the better German and Swiss per-
formance a necessary consequence of institutional factors (such as greater centralbank independence) and greater political support for low inﬂation? If the latter is
true, then the features of policy that we have observed to be associated with more
successful outcomes may in fact be either endogenous or irrelevant.
Despite the obvious importance of political and institutional factors, it still seems
plausible that, given their environments, central banks have considerable latitude to
deliver successful or unsuccessful monetary policies. Some evidence for this proposi-
tion is that the e¤ectiveness of monetary policy within given countries has changed
substantially over time. British and U.S. monetary policies seem noticeably more
successful in the 1980s than in the 1970s. Japan made the transition from high anderratic inﬂation in the mid-1970s to a low and stable inﬂation rate (despite the fact
that the Bank of Japan is probably less politically independent than, say, the Bank
of Canada). Political conditions (e.g., the public’s aversion to inﬂation) can also
change over time, but such changes are likely to be more gradual than the observed
changes in policy outcomes. Thus, while the political dimension needs to be explored
further, it remains likely that how the central bank chooses to handle monetary pol-
icy is also a major factor determining macroeconomic outcomes.
Notes
Bernanke acknowledges research support from the National Science Foundation, and Mishkin acknowl-
edges the support of the Faculty Research Fund of the Graduate School of Business, Columbia University.We thank Mark Gertler, Bruce Kasman, and participants in seminars at NYU, Columbia, Princeton, Uni-versity of Pennsylvania, Miami University, University of Kansas, University of Michigan, University ofIllinois, and the NBER Macro Annual Conference for useful comments. The research is part of NBER’sCentral Bank Behavior and Strategy 201

research programs in Monetary Economics and Economic Fluctuations. Any opinions expressed are those
of the authors, not those of the NBER.
1. The requirement of simplicity is essential. Any monetary strategy at all could in principle be speciﬁed as
a su‰ciently complex contingent rule.
2. In what sense is discretion a strategy, rather than the absence of a strategy? If we interpret discretion as
the best time-consistent (no-precommitment) policy, then it is a strategy in the formal sense, because inprinciple, one could calculate the policy action to be taken in every future contingency. In practice, ofcourse, such a calculation would be di‰cult or impossible to carry out, so that the strategy implied by dis-cretion is much less transparent than the strategy implied by rules.
3. On this basis we exclude France and Italy, whose exchange rates are tied to the deutschemark through
the Exchange Rate Mechanism (ERM). (The U.K. did not join the ERM until 1990.) Of course, attemptsto stabilize nominal exchange rates have a¤ected monetary policy at various times in all of these countries;as we discuss later, Canada in particular has often subordinated its monetary policy to exchange rate
objectives.
4. Excellent discussions of the ‘‘microstructure’’ of monetary institutions and policy operations can be
found in Kneeshaw and Van den Bergh (1989), Batten et al. (1990), and Kasman (1991).
5. See the notes to the ﬁgures for details and sources.
6. Huizinga and Mishkin (1986) have pointed out potential problems with moving-average measures of
volatility. Thus we have also calculated volatility measures using a procedure suggested by Pagan (1984),
which e¤ectively assumes an autoregressive conditional heteroscedasticity (ARCH) speciﬁcation for thevariability of money growth. The results using this procedure yield similar conclusions to those providedby ﬁgures 8.2 and 8.4.
7. Numerous sources discuss recent monetary policy and the policy process in the United States. See, e.g.,
Lombra (forthcoming), Karamouzis and Lombra (1989), Friedman (1988), Poole (1988), and Heller(1988). For a longer-term overview, see Meulendyke (1990). In this and all subsequent case studies wealso made use of the OECD’s Economic Surveys .
8. Bernanke and Blinder (forthcoming) present evidence for the veiw that, during this period, changes in
the funds rate (or the spread between the funds rate and other rates) were the best signal of a changing
stance of monetary policy. Cook and Hahn (1989) provide a record of funds rate target changes and
show that, during the 1975–1979 period, open-market interest rates responded sensitively to changes inthe Federal Reserve’s target for the funds rate.
9. Walsh (1986) defends base drift as the correct response to nonstationary shocks to money demand. It
seems to us that this case requires that the central bank clearly identify—and explain to the public—thesource of these nonstationary shocks, otherwise base drift will be perceived as a ploy. The fact that inﬂa-tion rose signiﬁcantly in the late 1970s is evidence against the view that the Fed was optimally o¤settingnonstationary money demand shocks.
10. Fed reaction functions estimated by McNees (1986) and by Karamouzis and Lombra (1989) show that
the Fed placed a greater weight on deviations of the money supply from target during 1979–1982, relative
to earlier and later periods. Cook (1989), in an excellent discussion of 1979–1982 policy, argues that high-
interest rates were not an accidental byproduct of the nonborrowed reserves procedure but that non-borrowed reserves targets were intentionally adjusted so as to produce high interest rates.
11. Added complexity in the use of M1 as a policy guide was created by a redeﬁnition of M1, to include
other checkable deposits such as NOW accounts but to exclude foreign-held deposits, in 1980.
12. For example, see Greider (1987), Mussa (1993), and Mishkin (1992).13. The demand for borrowed reserves is usually taken to be an increasing function of the spread between
the federal funds rate and the discount rate, reﬂecting the equilibrium condition that banks must be indif-ferent between obtaining funds from the federal funds market and from the discount window. If this de-mand function is stable, then targeting borrowed reserves is equivalent to targeting the excess of the fundsrate over the discount rate. See Thornton (1988). Thornton also presents evidence that, on those occasionswhen the demand for borrowed reserves appeared to shift, the Fed typically shifted its borrowed reserve
target so as to stabilize the funds rate.
14. A principal reason for the deemphasis of money growth was the perception that the ‘‘credit crunch’’ in
banking had interfered with the normal relationship between aggregates such as M2 and nominal GNP;202 Chapter 8

see Bernanke and Lown (1991) for a discussion of the credit crunch and its implications for monetary
policy.
15. Good recent descriptions of U.K. monetary policy are to be found in Fischer (1987), Minford (1993),
and Temperton (1991).
16. Another di¤erence with the U.S. approach was that the British did not signiﬁcantly reduce their com-
mitment to interest rate smoothing with the change in strategy in 1979 (ﬁg. 8.4b). This conﬁrms the earlierpoint that there is no necessary connection between the operating procedure and the general stance ofmonetary policy.
17. Besides M0 and M3, the Bank of England also targeted a broad measure of private sector liquidity,
PLS2; see table 8.2.
18. Leigh-Pemberton (1986).19. Principal sources for this section are Howitt (1993), the OECD Economic Surveys , and various issues
of the Bank of Canada Review .
20. As in a similar recent debate in the United States, advocates of ‘‘zero inﬂation’’ suggest that, because
of di‰culties in adjusting for quality change and other index number problems, zero inﬂation may be inter-preted as a small positive rate of measured inﬂation.
21. This section draws on Fischer (1987), Kahn and Jacobson (1989), von Hagen (1989), and Neumann
and von Hagen (1993).
22. In 1975–1978 targets were expressed as single numbers. Since 1979 targets have been set as ranges of
varying size (see table 8.4).
23. Historical discussions of Swiss monetary policy may be found in Schiltknecht (1982), Beguelin and
Rich (1985), Rich (1987), and Yue and Fluri (1991).
24. However, the Swiss reliance on ‘‘guest workers,’’ who are repatriated when labor market conditions
worsen, makes Swiss unemployment data more di‰cult to interpret.
25. Among the many useful general sources on Japanese monetary policy are Cargill and Hutchison
(1987), Dotsey (1986), Hutchison (1988), Batten et al. (1990), Kasman and Rodrigues (1991), and Ueda(1991).
26. Much has been written on whether and to what degree the Bank of Japan implicitly targets money
growth. See, e.g., Hutchison (1986), Ito (1989), and Ueda (1991).
27. Kasman and Rodrigues (1991) provide an excellent discussion of Japanese ﬁnancial liberalization and
its e¤ects on monetary policy.
28. The similarity of Japanese and American central bank operating procedures is discussed by Dotsey
(1986).
29. Open-market operations are supplemented by discount window lending, as in the United States.
Unlike the United States, in Japan open-market operations are conducted in a number of other ﬁnancial
markets, including the CD market and (recently) the commercial paper market.
30. This statement requires that we interpret the Japanese ‘‘forecasts’’ as indicating a targeting strategy. It
should also be noted that several central banks (notably the United States and United Kingdom) initiallyadopted money targets only under some external pressure; in both the U.S. and British cases, however, theseriousness with which money targets were treated increased markedly when the second oil shock worsenedthe inﬂation problem.
31. One might construct an argument on Poole-like grounds that nominal interest rates are a bad target
during periods of unstable inﬂation, because high nominal interest rates could indicate either too tight ortoo easy money.
32. The empirical fact of velocity instability implies, of course, that the relationship between money
growth and inﬂation is really not so simple. We return to this issue in section 8.4.
33. Di¤erences in the horizons of politicians and central bankers are su‰cient to create this di¤erence in
preferences. For example, as suggested by the work of Rogo¤ and Sibert (1988), in order to signal their eco-
nomic competence, politicians may have an incentive to create an inﬂationary boom prior to an election.
If the central banker is not up for re-election and fears that the central bank will be blamed for long-run increases in inﬂation, he will resist political demands for preelection increases in money growth. In aCentral Bank Behavior and Strategy 203

Rogo¤–Sibert-style game, all the central banker needs to do to di¤use the pressure from the politicians is to
give the public full information about monetary policy—for example, announce the money growth targets
consistent with noninﬂationary growth—thereby ensuring that the politicians receive no credit for outputincreases arising from excessive monetary expansion.
34. The basic Kydland–Prescott (1977) analysis suggests that central bank promises to meet money
growth targets in the long run but not the short run would never be credible. However, this conclusion isdependent on the assumption that the central bank values unemployment below the natural rate. If thecentral bank does not view its mandate as reducing unemployment, or is content with unemployment atthe natural rate, then it may be possible to make credible promises about future money growth. Further,
the central bank may be able to develop a reputation for meeting its medium-term targets; see Rogo¤
(1987) for a comprehensive discussion of reputation and central bank credibility.
35. We should be careful of attributing the relatively less good performance of Canadian monetary policy
solely to such game-playing, however; as we have noted, the degree to which Canadian monetary policy isindependent from U.S. policy is problematic.
36. At least it is opaque to U.S. academics. Perhaps it is clearer to Japanese business and ﬁnancial leaders.
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9Inflation Targeting: A New Framework for Monetary Policy?
Ben Bernanke and Frederic S. Mishkin
The world’s central bankers and their sta¤s meet regularly, in venues from Basle
to Washington, to share ideas and discuss common problems. Perhaps these fre-
quent meetings help explain why changes in the tactics and strategy of monetary
policymaking—such as the adoption of money growth targets in the 1970s, the inten-
siﬁcation of e¤orts to reduce inﬂation in the 1980s, and the recent push for increased
institutional independence for central banks—tend to occur in many countries more
or less simultaneously. Whatever their source, major changes in the theory and prac-tice of central banking are of great importance, for both individual countries and the
international economy. In this chapter, we discuss a new strategy for monetary pol-
icy known as ‘‘inﬂation targeting,’’ which has sparked much interest and debate
among central bankers and monetary economists in recent years. This approach is
characterized, as the name suggests, by the announcement of o‰cial target ranges
for the inﬂation rate at one or more horizons, and by explicit acknowledgment that
low and stable inﬂation is the overriding goal of monetary policy. Other important
features of inﬂation targeting include increased communication with the public about
the plans and objectives of the monetary policymakers, and, in many cases, increasedaccountability of the central bank for attaining those objectives.
Inﬂation targeting in various forms has been adopted in recent years by a number
of industrialized countries, including Canada, the United Kingdom, New Zealand,
Sweden, Australia, Finland, Spain and Israel. 1Table 9.1 o¤ers some details about
the speciﬁc plans in each country. There are also important elements of inﬂation tar-
geting, as we discuss below, in the long-standing and well-regarded monetary policy
approaches of Germany and Switzerland. In the United States, inﬂation targeting
has been advocated by some inﬂuential policymakers, and Senator Connie Mack
(R-Fla.) has introduced a bill that, if passed, would establish price stability as
the primary goal of monetary policy [S.R. 1266, 104th Cong. 1st sess.]. Finally, the
Maastricht treaty mandates price stability as the primary objective of the EuropeanCentral Bank, and it seems likely—if European monetary union in fact occurs—that

the ECB would incorporate major elements of the inﬂation targeting approach in its
procedures (Issing, 1996).
We begin our discussion of inﬂation targeting with some details of how this
approach has been implemented in practice. We focus on the practice of inﬂation tar-geting, rather than the theory, because we believe that the rhetoric associated with
inﬂation targeting is often misleading. In particular, we will argue that actual experi-
ence with this approach shows that inﬂation targeting does not represent an ironclad
policy rule, as some writers on the subject and even some advocates of this approach
seem to assume. Instead, inﬂation targeting is better understood as a policy frame-
work , whose major advantage is increased transparency and coherence of policy, and
in which fairly ﬂexible, even ‘‘discretionary’’ monetary policy actions can be accom-
modated. 2We next discuss in more detail why viewing inﬂation targeting as a frame-
work, rather than a rule, blunts some of the arguments that have been made againstit and in general enhances the appeal of this approach. This is not to say that valid
questions do not remain about this strategy for monetary policy; in the ﬁnal portionTable 9.1
Operational Aspects of Inﬂation Targets
Country
(date ofadoption) Target Series DeﬁnitionTarget Level
(percentage annualinﬂation) Time Horizon
Australia (1993) Underlying CPI (excluding fruit
and vegetables, petrol, interest
costs, public sector prices and
other volatile prices)2–3 Ongoing
Canada
(February 1991)Core CPI (excluding food, energy
and ﬁrst-round e¤ects of indirecttaxes)1–3 18 months
Finland
(February 1993)Underlying CPI (excluding
government subsidies, indirecttaxes, housing prices and mortgageinterest payments)about 2 Ongoing
Israel
(December 1991)CPI 8–11 1 year
New Zealand
(March 1990)Underlying CPI (excluding
changes in indirect taxes orgovernment changes, signiﬁcant
changes in import or export prices,
interest costs and natural disasters)0–2 (until November
1996; 0–3 thereafter)1 year
Spain
(January 1995)CPI (excluding ﬁrst-round e¤ects
of indirect tax changes)below 3 Through 1997
Sweden
(January 1993)CPI 2 G1 Ongoing
United Kingdom
(October 1992)RPIX (RPI excluding mortgage
interest payments)lower half of 1–4 until
spring 1997; 2.5 or lessthereafterUntil the end of
this Parliament208 Chapter 9

of the chapter we discuss some important additional issues and draw conclusions
about the usefulness of the inﬂation targeting framework.
9.1 Inflation Targeting in Practice
Although every country that has adopted inﬂation targeting has customized theapproach in various ways, certain empirical generalizations about this strategy can
be made.
The hallmark of inﬂation targeting is the announcement by the government, the
central bank, or some combination of the two that in the future the central bank will
strive to hold inﬂation at or near some numerically speciﬁed level. As can be seen in
table 9.1, inﬂation targets are more often than not speciﬁed as ranges—for example,
1–3 percent—rather than single numbers, and they are typically established for mul-
tiple horizons ranging from one to four years. However, there are exceptions to both
observations; indeed, Germany, with the longest experience with inﬂation-focused
monetary policy, speciﬁes its implicit inﬂation target as a point and only for a one-
year horizon. Initial announcements of inﬂation targeting generally allow for agradual transition from the current level of inﬂation to a desired steady-state level,
usually the level deemed consistent with price stability. ‘‘Price stability’’ never in
practice means literally zero inﬂation, however, but usually something closer to a 2
percent annual rate of price change, for reasons we discuss later.
There is a lively debate over whether targeting should be of the inﬂation rate per
se or of the price level. Of course, a targeted price level need not remain constant
indeﬁnitely, but could be allowed to drift upward in a predetermined way over time
(Goodhart and Vinals, 1994; Svensson, 1996). The relative disadvantage of targeting
the inﬂation rate is that unanticipated shocks to the price level may be treated asbygones and never o¤set; as a result, forecasts of the price level at long horizons
might have a large variance under inﬂation targeting, which presumably impedes
private-sector planning. 3On the other hand, strict price-level targeting requires that
overshoots or undershoots of the target be fully made up, which reduces the variance
of long-run forecasts of prices but could impart signiﬁcantly more volatility into
monetary policy in the short run. 4In practice, central banks tend to compensate par-
tially for target misses, particularly at shorter horizons.
Associated with the announcement of inﬂation targets there is usually some state-
ment to the e¤ect that control of inﬂation is the ‘‘primary’’ or ‘‘overriding’’ goal of
monetary policy and that the central bank will be held accountable for meeting the
inﬂation targets. For example, Section 8 of the Reserve Bank of New Zealand Act of1989 assigns the central bank the statutory responsibility ‘‘to formulate and imple-
ment monetary policy directed to the economic objective of achieving and maintain-
ing stability in the general level of prices,’’ with no mention of competing goals.Inflation Targeting: A New Framework? 209

Section 9 of the act requires the Minister of Finance and the Governor of the Re-
serve Bank to negotiate and make public a Policy Targets Agreement (PTA), setting
out speciﬁc inﬂation targets. In other countries, such as Switzerland, Canada and the
United Kingdom, the inﬂation goal is embodied in public statements by the central
bank rather than mandated by law.
The rationale for treating inﬂation as the primary goal of monetary policy is
clearly strongest when medium- to long-term horizons are considered, as most econ-
omists agree that monetary policy can a¤ect real quantities, such as output and em-
ployment, only in the short run. Of course, some economists of new classical or
monetarist persuasions might claim that inﬂation should be the sole concern of mon-
etary policy in the short run as well, arguing that using monetary policy for short-run
stabilization of the real economy is undesirable, infeasible, or both. However, in
practice no central bank has of yet completely forsworn the use of monetary policy
for short-run stabilization, and so the phraseology ‘‘primary’’ or ‘‘overriding’’ must
be taken to refer to the longer term.
The degree to which the central bank is held formally accountable for inﬂation
outcomes varies considerably. The New Zealand law links the tenure of the governorof the Reserve Bank to the achieving of the inﬂation targets, and thus comes closest
to providing an explicit ‘‘incentive contract,’’ as proposed by Persson and Tabellini
(1993) and Walsh (1995). 5In other countries, no explicit sanctions on the central
bank for missing the target are given; presumably, however, missing the target badly
would impose implicit institutional or personal costs in terms of lost reputation or
prestige. It is rather early in many of the inﬂation-targeting experiments to judge the
extent to which the prospective penalties for missing announced targets will constrain
central bank behavior.
Despite the language referring to inﬂation control as the primary objective of mon-
etary policy, as we have said, inﬂation-targeting central banks always make room for
short-run stabilization objectives, particularly with respect to output and exchange
rates. 6This accommodation of short-run stabilization goals is accomplished through
several means. First, the price index on which the o‰cial inﬂation targets are based is
often deﬁned to exclude or down-weight the e¤ects of ‘‘supply shocks;’’ for example,
the o‰cially targeted price index may exclude some combination of food and energy
prices, indirect tax changes, terms-of-trade shocks, and the direct e¤ects of interest
rate changes on the index (for example, through imputed rental costs). Second, as al-
ready noted, inﬂation targets are typically speciﬁed as a range; the use of ranges gen-
erally reﬂect not only uncertainty about the link between policy levers and inﬂation
outcomes but is also intended to allow the central bank some ﬂexibility in the shortrun. Third, short-term inﬂation targets can and have been adjusted to accommodate
supply shocks or other exogenous changes in the inﬂation rate outside the central
bank’s control. A model here is the Deutsche Bundesbank’s practice of stating its210 Chapter 9

short-term (one-year) inﬂation projection as the level of ‘‘unavoidable inﬂation.’’
In the aftermath of the 1979 oil shock, for example, the Bundesbank announced the
‘‘unavoidable’’ inﬂation rate to be 4 percent, then moved its target gradually down to
2 percent over a six-year period. In other cases, the central bank or government
makes explicit an ‘‘escape clause,’’ which permits the inﬂation target to be suspended
or modiﬁed in the face of certain adverse economic developments.
In making inﬂation, a goal variable, the focus of monetary policy, the inﬂation-
targeting strategy in most cases signiﬁcantly reduces the role of formal intermediate
targets, such as the exchange rate or money growth. To the extent that intermediate
targets are used, it is emphasized that the inﬂation goal takes precedence in case of
conﬂict. Unconditional commitment to an intermediate target is of course inconsis-
tent with inﬂation targeting (except in the unusual case that the intermediate target
e¤ectively summarizes all current information about inﬂation at the forecast hori-
zon). The fact that in most countries the relation between intermediate targets, such
as money growth, and the central bank’s goal variables has proven to be relatively
unreliable—the so-called ‘‘velocity instability’’ problem—is a major motivation for
dropping formal intermediate targets and instead attempting to target the goal vari-able directly.
On the other hand, since targeting inﬂation directly requires that the central bank
form forecasts of the likely path of prices, close attention is typically paid to a variety
of indicators that have shown predictive power for inﬂation in the past. For example,
as an aid to inﬂation forecasting, monetary policymakers in Canada and Sweden
make use of a ‘‘monetary conditions index,’’ a weighted combination of the exchange
rate and the short-term interest rate, in conjunction with other standard indicators
such as money and credit aggregates, commodity prices, capacity utilization and
wage developments. 7
In most inﬂation-targeting regimes, the central bank publishes regular, detailed
assessments of the inﬂation situation, including current forecasts of inﬂation and dis-
cussions of the policy response that is needed to keep inﬂation on track. A good ex-
ample is the Bank of England’s Inﬂation Report , published quarterly, which contains
detailed analyses of factors likely to a¤ect the inﬂation rate as well as probabilistic
forecasts of inﬂation, assuming no change in interest rates. The central banks of Can-
ada and Sweden release similar documents, and the Reserve Bank of New Zealand is
required to issue a policy statement at least every six months. As we discuss further
below, the use of such reports reﬂects a key objective of inﬂation targeting, which is
improved communication with the public about monetary policy, its goals and, in
particular, the long-run implications of current policy actions.
The adoption of inﬂation targeting is often linked with changes in the laws or ad-
ministrative arrangements associated with the central bank. Typically, reforms are in
the direction of increased independence for the central bank, particularly in respectInflation Targeting: A New Framework? 211

to its choice of instrument settings. 8This seems to be a logical consequence of mak-
ing price stability the overriding goal of policy, since the central bank is the best
place to make the technical decisions necessary to achieve price stability and to
make judgments about whether the pursuit of other objectives is consistent with this
goal. Exceptions to this observation are the United Kingdom and, to a lesser extent,
Canada, where despite the commitment to inﬂation targeting, the government, ratherthan the central bank, retains the ﬁnal control over monetary policy. However, even
in the British case the adoption of inﬂation targeting seems to have increased the rel-
ative inﬂuence of the central bank, as the Inﬂation Report and the timely publication
of the minutes of the monthly meeting between the Governor and the Chancellor of
the Exchequer provide an independent forum for the bank to express its views; in
e¤ect, the government must rationalize for the public any deviations of its policies
from those recommended by the bank.
Most or all of the characteristics of inﬂation targeting described in this section
apply to countries adopting this approach within the last eight years or so; as noted
in the introduction, these include Canada, the United Kingdom, New Zealand,
Sweden, Australia, Finland, Spain and Israel. Germany and Switzerland, whichhave conducted inﬂation-focused monetary policies since the mid-1970s, are better
viewed as ‘‘hybrid’’ cases, which meet some but not all of the above criteria. These
two countries di¤er from the ‘‘pure’’ inﬂation targeters primarily in their greater
focus on money growth as an intermediate target, and indeed, the Bundesbank has
emphasized the superiority (in their view) of money targeting as a means of insuring
monetary discipline and transparency (for example, Deutsche Bundesbank, 1995, pp.
67–8). In fact, many observers (including ourselves) would argue that the distinction
between inﬂation and money targeting is overstated and that monetary policies in
both countries are driven in the medium and long term primarily by inﬂation goals.For example, the Bundesbank’s money growth targets are derived, using the quantity
equation, to be consistent with an annual inﬂation target, given projections of the
growth of potential output and of possible changes in the velocity of money. This in-
ﬂation target, in turn, has been brought down steadily over time and has remained at
2 percent—the level deemed consistent by the Bundesbank with price stability—since
1986. Further, the Bundesbank has shown itself quite willing to miss its money tar-
gets when pursuing these targets threatens to conﬂict with the control of inﬂation
(von Hagen, 1995; Bernanke and Mihov, 1997).
All in all, the philosophy guiding German and Swiss monetary policies seems
relatively consistent with the one motivating the self-declared inﬂation targeters.
The main practical di¤erence between the two sets of countries is that the Germansand Swiss believe that the velocity of money has been relatively more stable in their
countries, and so they view money-growth targeting as a useful tool for implement-
ing their inﬂation objectives. It is also true that Germany and Switzerland have been212 Chapter 9

less explicit in stating their inﬂation targets; neither central bank publishes a regular
inﬂation report per se. But this distinction seems relatively unimportant; inﬂation
developments receive prominent attention in the regular publications of both banks.
Moreover, there may be less need for public declarations given the long-standing
commitment of the Bundesbank and Swiss National Bank—and the popular support
for that commitment—to price stability. The examples of Germany and Switzerlandare important because, unlike the other countries mentioned, these two countries have
been following their monetary policy strategies fairly consistently for more than two
decades, rather than for only a few years; thus, their experiences may provide
researchers attempting to assess the value of inﬂation-focused monetary policy with
useful information.
9.2 A Framework, Not a Rule
The motivations for an inﬂation-targeting approach have been varied. In a number
of cases, such as those of the United Kingdom and Sweden, the collapse of an ex-
change rate peg led the monetary authorities to search for an alternative ‘‘nominalanchor’’ for monetary policy, a way of reassuring the public that monetary policy
would remain disciplined. The demise of a ﬁxed-exchange-rate regime similarly moti-
vated the adoption of a money-focused approach by Germany in the mid-1970s.
Some countries, such as Canada, came to inﬂation targeting after unsuccessful
attempts to use a money-targeting approach. For example, in the case of Canada,
by 1980 inﬂation was as high as it was in 1975 (10 percent per year) despite adher-
ence to monetary targets that led to lower money growth rates (Howitt, 1993). In
other cases, countries that by tight monetary policies had succeeded in reducing their
core rate of inﬂation adopted inﬂation targeting as an institutional means of lockingin their inﬂation gains.
Developments in macroeconomic theory also played some role in the growing
popularity of the inﬂation targeting approach. These familiar developments included
reduced conﬁdence in activist, countercyclical monetary policy; the widespread ac-
ceptance of the view that there is no long-run tradeo¤ between output (or unemploy-
ment) and inﬂation, so that monetary policy a¤ects only prices in the long run;
theoretical arguments for the value of precommitment and credibility in monetary
policy (Kydland and Prescott, 1977; Calvo, 1978; Barro and Gordon, 1983); and an
increasing acceptance of the proposition that low inﬂation promotes long-run eco-
nomic growth and e‰ciency.
Unfortunately, the interpretation of inﬂation targeting in terms of some long-
standing debates in monetary economics has also been the source of confusion.
For many years the principal debate about the best approach for monetary policy
was framed as an opposition between two polar strategies, termed ‘‘rules’’ andInflation Targeting: A New Framework? 213

‘‘discretion.’’ Advocates of rules—such as the ﬁxed rule for money growth proposed
by Milton Friedman, or a gold standard—argued that ‘‘tying the hands’’ of policy-
makers will prevent the monetary authorities from implementing counterproductive
attempts at short-run stabilization and will thus eliminate the inﬂationary bias inher-
ent in discretionary monetary policy. Supporters of discretionary policymaking—
under which the central bank is left free to ‘‘do the right thing’’ as economic condi-tions evolve—stress the inability of ironclad rules to deal with unforeseen shocks or
changes in the structure of the economy.
For various reasons, including the rhetoric of some of its proponents, inﬂation tar-
geting is sometimes interpreted as falling on the ‘‘rule’’ side of this traditional dichot-
omy (for example, Friedman and Kuttner, 1996). We view this characterization of
inﬂation targeting as a mistake; indeed, we would go farther and say that the tradi-
tional dichotomy of monetary policy strategies into rules and discretion is itself mis-
leading. In particular, some useful policy strategies are ‘‘rule-like,’’ in that by their
forward-looking nature they constrain central banks from systematically engaging
in policies with undesirable long-run consequences; but which also allow some discre-
tion for dealing with unforeseen or unusual circumstances. These hybrid or interme-diate approaches may be said to subject the central bank to ‘‘constrained discretion.’’
We argue below that inﬂation targeting should be viewed in this way, rather than as
a rigid policy rule.
If inﬂation targeting is interpreted as a rule in the classic Friedman sense, then it
would have to be conceded that this approach is vulnerable to some important
criticisms. First, the idea that monetary policy has (essentially) no legitimate goals
besides inﬂation would ﬁnd little support among central bankers, the public and
most monetary economists. Second, given that central banks do care about output,
employment, exchange rates and other variables besides inﬂation, treating inﬂationtargeting as a literal rule could lead to very poor economic outcomes. As Friedman
and Kuttner (1996) emphasize, much in the same way that money-growth targeting
in the United States was done in by unpredicted shocks to the velocity of money, so
an exclusive emphasis on inﬂation goals could lead to a highly unstable real economy
should there be signiﬁcant supply shocks, such as large changes in the price of oil.
Finally, critics of inﬂation targeting as a rule might well ask what is gained by the
loss of ﬂexibility entailed by precommitting monetary policy in this way. The aca-
demic literature on rules argues that tying the hands of policymakers will reduce the
inﬂation bias of discretionary policy and perhaps allow for less costly disinﬂations, as
increased credibility leads inﬂation expectations to moderate more quickly. However,
critics of inﬂation targeting could point out that, although inﬂation-targeting coun-tries have generally achieved and maintained low rates of inﬂation, little evidence
supports the view that these reduced rates of inﬂation have been obtained at a lower
sacriﬁce of output and employment than disinﬂations pursued under alternative214 Chapter 9

regimes (at least so far). Even the Deutsche Bundesbank and the Swiss National
Bank, whose pursuit of low inﬂation over the last two decades has presumably given
the maximum credibility, have been able to achieve inﬂation reductions only at high
costs in lost output and employment (Debelle and Fischer, 1994; Posen, 1995). Nor
is there evidence that the introduction of inﬂation targets materially a¤ects private-
sector expectations of inﬂation, as revealed either by surveys or by the level of long-term nominal interest rates. Inﬂation expectations have come down, in most cases,
only as inﬂation-targeting central banks have demonstrated that they can deliver
low inﬂation (Posen and Laubach, 1996).
These objections are certainly important, as far as they go. However, again, they
derive much of their force from the assumption that inﬂation targeting is to be
viewed as an ironclad rule. As we have said, we believe that interpreting inﬂation tar-
geting as a type of monetary policy rule is a fundamental mischaracterization of this
approach as it is actually practiced by contemporary central banks . First, at a techni-
cal level, inﬂation targeting does not qualify as a policy rule in that it does not pro-
vide simple and mechanical operational instructions to the central bank. Rather, the
inﬂation targeting approach enjoins the central bank to use its structural and judg-mental models of the economy, in conjunction with all relevant information, to de-
termine the policy action most likely to achieve the inﬂation target, and then to take
that action. Unlike simple policy rules, inﬂation targeting never requires that the cen-
tral bank ignore information that bears on its achieving its objectives. Second, and
more importantly, inﬂation targeting as it is actually practiced contains a consider-
able degree of what most economists would deﬁne as policy discretion. Within the
general constraints imposed by their medium- to long-term inﬂation targets, central
bankers have in practice left themselves considerable scope to respond to current un-
employment conditions, exchange rates and other short-run developments.
The 1989 reform of the Reserve Bank of New Zealand, for example, is often held
up as an example of the rule-making impulse. It is important to note that New Zea-
land is the most extreme of all the inﬂation-targeting countries in its use of formal
institutional constraints on policy. Even so, the New Zealand law does provide the
central bank some discretion and ﬂexibility; for example, the target inﬂation series
excludes movements in commodity prices; the target may be readjusted if necessary
in the judgment of the bank in response to supply or terms-of-trade shocks; the inﬂa-
tion target is speciﬁed as a 3 percentage point range rather than as a single number;
and there is an explicit escape clause that permits amending the target in the face of
unexpected developments. In practice, inﬂation targeting in New Zealand has been
implemented even more ﬂexibly. Inﬂation was brought down to its current low levelonly gradually; and when inﬂation moved brieﬂy above the target range in 1996, the
Parliament did not seriously consider its option of replacing the governor of the cen-
tral bank.Inflation Targeting: A New Framework? 215

If inﬂation targeting is not a rule in the way this term is usually understood, then
what is it, and what good is it? We believe that it is most fruitful to think of inﬂation
targeting not as a rule, but as a framework for monetary policy within which ‘‘con-
strained discretion’’ can be exercised. This framework has the potential to serve two
important functions: improving communication between policymakers and the pub-
lic, and providing increased discipline and accountability for monetary policy.
In terms of communication, the announcement of inﬂation targets clariﬁes the
central bank’s intentions for the markets and for the general public, reducing
uncertainty about the future course of inﬂation. (Of course, this assumes that the
announcements are believable and believed; more on this later.) Arguably, many of
the costs of inﬂation arise from its uncertainty or variability more than from its level.
Uncertain inﬂation complicates long-term saving and investment decisions, exacer-
bates relative price volatility, and increases the riskiness of nominal ﬁnancial and
wage contracts. Uncertainty about central bank intentions may also induce volatility
in ﬁnancial markets—a common phenomenon in the United States, where stock
market analysts parse every sentence uttered by the Fed chairman in search of hid-
den meanings. Inﬂation targets o¤er transparency of policy; they make explicit thecentral bank’s policy intentions in a way that should improve private-sector plan-
ning, enhance the possibility of public debate about the direction of monetary policy,
and increase central bank accountability. Transparency has been claimed as a posi-
tive feature of other policy strategies, such as money-growth targeting, but we doubt
that concepts like the growth rates of particular money aggregates are nearly so
understandable to the general public as is the predicted rate of change of consumer
prices.
To see the practical advantage of policy transparency, consider the familiar
scenario in which an upcoming election or a slow economic recovery induces thegovernment to pressure the central bank to apply some short-run stimulus. In an
inﬂation-targeting regime, the central bank would be able—indeed, would be re-
quired—to make explicit that the short-run beneﬁts of this policy (faster real growth)
may well be purchased at the price of medium- and long-term inﬂation. These projec-
tions could then be debated by politicians, press and public, but at least the issue of
long-run inﬂation e¤ects would be on the table, serving as an explicit counterweight
to the short-run beneﬁts of monetary expansion. Making the linkage of short-term
policies and long-term consequences explicit would clarify for the public what mone-
tary policy can and cannot do.
Aggregate supply shocks, such as oil price shocks, present a thornier policy prob-
lem. If a severe supply shock hits the economy, keeping medium-term inﬂation closeto the long-run target could well be very costly in terms of lost output. However, in
practice, a well-implemented inﬂation-targeting regime need not strongly constrain
the ability of the monetary authorities to respond to a supply shock. Remember, the216 Chapter 9

inﬂation target itself can be and typically is deﬁned to exclude at least the ﬁrst-round
e¤ects of some important supply shocks, such as changes in the prices of food and
energy or in value-added taxes; the use of target ranges for inﬂation gives additional
ﬂexibility. Escape clauses, which permit the central bank to change its medium-term
targets in response to major developments, are another possibility. We have seen, for
example, that the Bundesbank’s one-year inﬂation targets were often deﬁned by itsview of how much inﬂation was ‘‘unavoidable,’’ rather than by its long-run objective
of price stability. Thus, intermediate-run inﬂation targets can be used to deﬁne a
transition path by which the temporary inﬂation induced by a supply shock is elimi-
nated gradually over time. Relative to a purely discretionary approach, the inﬂation-
targeting framework should give the central bank a better chance of convincing the
public that the consequences of the supply shock are only a one-time rise in the price
level, rather than a permanent increase in inﬂation. A relevant example occurred in
Canada in 1991, shortly after their implementation of inﬂation targeting, when a
sharp increase in indirect taxes caused a blip in the price level but had no apparent
e¤ect on the underlying inﬂation rate.
The idea that inﬂation targeting requires an accounting of the long-run implica-
tions of short-run ‘‘discretionary’’ actions is also central to the argument that inﬂa-
tion targeting helps to discipline monetary policy. In practice, exactly who needs
disciplining may di¤er from country to country, depending on politics, institutional
arrangements and personalities. In the macroeconomic literature on central bank
credibility, it is the central bank that needs discipline, because it is assumed to desire
an unemployment rate lower than the natural rate. This desire leads the monetary
authority to try to ‘‘fool’’ the public with surprise inﬂation, inducing producers
(who confuse nominal and real price increases) to increase output and employment
above the natural rate. If the public has rational expectations, however, it will antic-ipate the central bank’s actions, and producers will not be fooled, so that in equilib-
rium the economy will su¤er higher-than-optimal inﬂation with no beneﬁts in terms
of lower unemployment. 9
If a story along these lines describes the actual situation in a given economy, then
an inﬂation-targeting framework will not directly prevent the counterproductive
attempts of the central bank to engage in excessive short-run stimulus. In this respect,
inﬂation targeting is inferior to an ironclad rule, if such could be implemented. How-
ever, in contrast to the purely discretionary situation with no explicit targets, under
inﬂation targeting the central bank would be forced to calculate and to publicize the
implications of its short-run actions for expected inﬂation in the long run (and again,
these projections would be subject to scrutiny and debate). To the extent that the cen-tral bank governors dislike admitting publicly that they are o¤ track with respect to
their long-run inﬂation targets, the existence of this framework would provide an ad-
ditional incentive for the central bank to limit its short-run opportunism.Inflation Targeting: A New Framework? 217

Although the theoretical literature typically posits the central bank as the entity
who chooses to inﬂate opportunistically, we suspect that in most cases the executive
and legislative branches of the government have the greater incentive to engage in
such behavior, often because of approaching elections. Central bankers, in contrast,
tend to view themselves as defenders of the currency. This view may be the result of
intentional appointments of ‘‘tough’’ central bankers (for reasons described by Rog-o¤, 1985), or it may just be that self-selection and socialization act to make central
bankers relatively hawkish on inﬂation. But in either case, the existence of longer-
term inﬂation targets can prove a useful device by which the central bank can protect
itself politically from overexpansionist pressures. In particular, by making explicit the
long-run, as well as the short-run, implications of overexpansionist policies, the cen-
tral bank may be better able to get the support it needs to resist such policies. Our
impression is that the Bank of England, for example, has on occasion used numerical
inﬂation targets in precisely this way.
9.3 Further Issues with Inflation Targeting
If viewed as a framework rather than as a rule, inﬂation targeting can confer someimportant advantages. It provides a nominal anchor for policy and the economy.
By communicating the central bank’s objectives and views, it increases the transpar-
ency of monetary policy. It has the potential to provide increased discipline and ac-
countability for policymakers. Importantly, it may be able to achieve all this without
entirely giving up the beneﬁts of discretionary policies in the short run. These opti-
mistic conclusions notwithstanding, important questions and controversies remain
around inﬂation targeting, even when interpreted in the way that we prefer. Let us
consider a few of these.
9.3.1 Which Inflation Measure? What Target Value?
A critical aspect of the design of an inﬂation-targeting regime is the deﬁnition of the
price series to be used in the inﬂation target. The series needs to be considered accu-
rate, timely and readily understood by the public, but may also need to allow for in-
dividual price shocks or one-time shifts that do not a¤ect trend inﬂation, which is
what monetary policy should inﬂuence. As table 9.1 indicates, all inﬂation-targeting
countries have chosen some variant of the consumer price index (CPI) as their target
series. However, this choice is not typically the ‘‘headline’’ CPI ﬁgure, but an index
that excludes some components or focuses on ‘‘core’’ inﬂation; clearly, it is incum-
bent on the central bank to explain its choice of index and to help the public under-stand its relation to the headline index.
In all inﬂation-targeting regimes, the inﬂation objective has been set at a low num-
ber, 4 percent or less. Is this the ideal range for the inﬂation target? Or would a some-218 Chapter 9

what higher range for inﬂation, which might involve lower initial output cost to at-
tain, be acceptable?
Obtaining direct empirical conﬁrmation of a link between inﬂation and economic
performance is very di‰cult. Inﬂation is, after all, an endogenous variable; and so we
rarely if ever see variation in inﬂation that is not associated with some third factor,
such as supply shocks or political instability, which would plausibly a¤ect other ele-ments of economic performance as well. 10As a result, economists’ views on the sub-
ject have been based largely on prior arguments, intuition and indirect evidence.
That conceded, it is nevertheless clear that the professional consensus, which at one
time did not ascribe substantial costs to moderate inﬂation, has over the past few
decades begun to take the costs of inﬂation more seriously. For example, Feldstein
(1996) has emphasized the importance of inﬂation-induced ine‰ciencies, via the tax
code, on capital formation. Fischer (1993) and others have provided some evidence
that macroeconomic stability, including control of inﬂation, is an important precon-
dition for economic growth. Shiller’s (1996) opinion surveys of public attitudes about
inﬂation, while conﬁrming economists’ suspicions that the public is confused about
even the deﬁnition of inﬂation, also show that people believe inﬂation to be highlyuneven in its distributional impacts and hence corrosive of the social compact. A
strengthening preference for low inﬂation is quite visible in policy circles, perhaps
most strikingly in the tough limits on inﬂation imposed by the Maastricht treaty on
countries that want to join the European currency union.
Given the growing consensus that the long-term goal of monetary policy should be
a low inﬂation rate, there remains the question of how low it should be. It seems
clear that an inﬂation target of zero or near zero is not desirable, for several reasons.
First, much recent research suggests that o‰cial CPI inﬂation rates tend to overstate
the true rate of inﬂation, due to various problems such as substitution bias in theﬁxed-weight index and failure to account adequately for quality change. Studies for
the United States have estimated this overstatement of inﬂation to be in the range of
0.5 to 2.0 percentage points per year. 11Thus, as a practical matter, even if the central
bank chooses to pursue a zero rate of true inﬂation, the target for the measured inﬂa-
tion rate should be greater than zero.
Putting aside measurement issues, there are other risks of setting the inﬂation tar-
get too low. In a much discussed recent article, Akerlof, Dickens and Perry (1996)
point out that if nominal wages are rigid downward (a possibility that they argue is
consistent with the evidence), then reductions in real wages can occur only through
inﬂation in the general price level. Very low inﬂation therefore e¤ectively reduces
real-wage ﬂexibility and hence may worsen the allocative e‰ciency of the labor mar-ket; indeed, the authors perform simulations suggesting that inﬂation rates near zero
would permanently increase the natural rate of unemployment. 12Another danger of
setting the inﬂation target too low is that there is a greater chance that the economyInflation Targeting: A New Framework? 219

will be tipped into deﬂation, with the true price level actually falling—as may have
happened during the recent recession in Japan. As pointed out in the literature on ﬁ-
nancial crises, persistent deﬂation—particularly if unanticipated—can create serious
problems for the ﬁnancial system, interfering with its normal functioning and precip-
itating an economic contraction (Bernanke and James, 1991; Mishkin, 1991).
These risks suggest that the inﬂation target, even when corrected for measurement
error, should be set above zero, as has been the practice of all inﬂation-targeting
countries to date. Indeed, a potentially important advantage of inﬂation targeting is
that it provides not only a ceiling for the inﬂation rate, but also a ﬂoor. Inﬂation tar-
geting thus acts to attenuate the e¤ects of negative, as well as positive, shocks to ag-
gregate demand. An interesting historical example is that of Sweden in the 1930s,
which adopted a ‘‘norm of price stabilization’’ after leaving the gold standard in
1931. As a result, Sweden did not undergo the devastating deﬂation experienced by
other countries during the Great Depression (Jonung, 1979).
9.3.2 Is Inflation Sufficiently Predictable and Controllable to Be ‘‘Targeted’’?
It has been noted by several authors that inﬂation is very di‰cult to predict accu-
rately, particularly at both very short and very long horizons (Cecchetti, 1995). This
lack of predictability poses two important problems for the inﬂation targeting strat-
egy. The ﬁrst is strictly operational: given the long lags between monetary policy
actions and the inﬂation response, low predictability suggests that accurate targeting
of inﬂation could be extremely di‰cult. The second issue has to do with the central
bank’s credibility: if inﬂation is largely unpredictable, and hence not ﬁnely control-
lable, then it will be di‰cult to judge whether the central bank has made its best ef-
fort to hit the inﬂation targets. For example, the central bank could always argue
that wide misses were the result of bad luck, not bad faith; since central bank fore-casts of inﬂation contain substantial judgmental components, such claims would be
di‰cult to disprove. This possible escape hatch for the central bank weakens the ar-
gument that inﬂation targeting increases accountability of monetary policy and sug-
gests that building up credibility for its inﬂation-targeting framework could be a long
and arduous process.
While we agree that inﬂation targeting is less e¤ective, the less predictable or con-
trollable is the inﬂation rate, several observations should be made. First, statistical
measures of predictability are themselves likely to be sensitive to the monetary policy
regime in place. Inﬂation was no doubt di‰cult to predict during the 1970s, when
monetary policymakers tried to deal with oil price shocks and other stagﬂationary
pressures without a coherent, clearly articulated framework. In contrast, the stabilityof the inﬂation rate in the United States and other industrialized countries since the
mid-1980s, a period during which the maintenance of low and steady inﬂation has220 Chapter 9

received much greater weight in central bank decision making, suggests that inﬂation
will be easier to predict in the future.
Second, the relative unpredictability of goal variables is not in itself an argument
for the use of intermediate targets in the conduct of monetary policy. As Svensson
(1997a) points out, from an optimal control perspective, the best possible intermedi-
ate target is the current forecast of the goal variable itself—in this context, inﬂation.Using an intermediate target such as money growth is acceptable in an optimal con-
trol framework only if the intermediate target contains all information relevant to
forecasting the goal variable; in this extreme case, using the intermediate target is
equivalent to targeting the forecast of the goal variable. However, if any variable
other than the intermediate target contains marginal information about the future
values of the goal variable, then targeting the inﬂation forecast strictly dominates
using any single intermediate target. Thus, from a strictly operational point of
view, while it is unfortunate if the goal variable is hard to predict or to control, no
improvement is available by using an intermediate target. 13
When the credibility of the central bank is at issue, the problem of whether to tar-
get inﬂation directly or to rely on an intermediate target becomes more complex. BySvensson’s argument, use of the intermediate target must increase the variance of the
goal variable, which is a cost of the intermediate targeting approach; the beneﬁt,
however, is that by hitting its announced target for the intermediate variable, the
central bank can demonstrate the seriousness of its intentions to the public more
quickly and reliably (Cukierman, 1995; Laubach, 1996). If credibility building is an
important objective of the central bank, and if there exists an intermediate target
variable—such as a monetary aggregate—that is well controlled by the central
bank, observed and understood by the public and the ﬁnancial markets, and strongly
and reliably related to the ultimate goal variable, then targeting the intermediatevariable may be the preferred strategy. All of these are big ‘‘ifs,’’ particularly the
last one. However, this analysis may help to explain the continued use of money-
growth targets by Germany and Switzerland, where ﬁnancial institutions and hence
velocity have evolved rather slowly, while countries such as the United Kingdom,
with a history of unstable velocity, have opted for targeting inﬂation directly.
9.3.3 Is Inflation the Right Goal Variable for Monetary Policy?
The consensus that monetary policy is neutral in the long run restricts the set of fea-sible long-run goal variables for monetary policy, but inﬂation is not the only possi-
bility. Notably, a number of economists have proposed that central banks should
target the growth rate of nominal GDP rather than inﬂation (Taylor, 1985; Hall andMankiw, 1994). Nominal GDP growth, which can be thought of as ‘‘velocity-
corrected’’ money growth (that is, if velocity were constant, nominal GDP growthInflation Targeting: A New Framework? 221

and money growth would be equal, by deﬁnition), has the advantage that it does put
some weight on output as well as prices. Under a nominal GDP target, a decline in
projected real output growth would automatically imply an increase in the central
bank’s inﬂation target, which would tend to be stabilizing. 14Also, Cecchetti (1995)
has presented simulations that suggest that policies directed to stabilizing nominal
GDP growth may be more likely to produce good economic outcomes, given the dif-ﬁculty of predicting and controlling inﬂation.
Nominal GDP targeting is a reasonable alternative to inﬂation targeting, and one
that is generally consistent with the overall strategy for monetary policy discussed in
this article. However, we have three reasons for mildly preferring inﬂation targets to
nominal GDP targets. First, information on prices is more timely and frequently
received than data on nominal GDP (and could be made even more so), a practical
consideration that o¤sets some of the theoretical appeal of the nominal GDP target.
Although collection of data on nominal GDP could also be improved, measurement
of nominal GDP involves data on current quantities as well as current prices and
thus is probably intrinsically more di‰cult to accomplish in a timely fashion. Second,
given the various escape clauses and provisions for short-run ﬂexibility built intothe inﬂation-targeting approach, we doubt that there is much practical di¤erence
in the degree to which inﬂation targeting and nominal GDP targeting would allow
accommodation of short-run stabilization objectives. Finally, and perhaps most im-
portant, it seems likely that the concept of inﬂation is better understood by the public
than is the concept of nominal GDP, which could easily be confused with real GDP.
If this is so, the objectives of communication and transparency would be better
served by the use of an inﬂation target. As a matter of revealed preference, all central
banks that have thus far adopted this general framework have chosen to target inﬂa-
tion rather than nominal GDP.
9.3.4 If It’s Not Broke, Why Fix It?
Friedman and Kuttner (1996) decry the tendency of economists to want to impose
restrictions and rules on central bank policymaking. They survey the problems with
policy rules in the past, notably the failure of money-growth targeting to become a
reliable policy framework in the United States, and they correctly point out that
U.S. monetary policy has performed quite well in the recent past without the beneﬁt
of a formal rule or framework. Why, they ask, should we change something that is
working well, especially given our inability to know what types of challenges will
confront monetary policy in the future?
We would respond that a major reason for the success of the Volcker-Greenspan
Fed is that it has employed a policymaking philosophy, or framework, which is de
facto very similar to inﬂation targeting. In particular, the Fed has expressed a strong
policy preference for low, steady inﬂation, and debates about short-run stabilization222 Chapter 9

policies have prominently featured consideration of the long-term inﬂation implica-
tions of current Fed actions.
To take the next step and to formalize this framework would have several
advantages. It would increase the transparency of the Fed’s decision-making process,
allowing more public debate and discussion of the Fed’s strategy and tactics and,
perhaps, reducing the ﬁnancial and economic uncertainty associated with the Fed’scurrent procedures. It would create an institutional commitment to the current
approach that would be less dependent on a single individual’s philosophy and might
thus be expected to survive when, inevitably, new leadership takes over at the Fed.
Finally, inﬂation targeting will be easiest to implement in a situation, like the current
one, in which inﬂation is already low and the basic approach has been made familiar
to the public and the markets. By adopting this approach now when it is relatively
easy politically, we could ensure that the new procedures will be in place to provide
guidance when the next di‰cult decisions about monetary policy have to be made.
9.4 Conclusion
It is too early to o¤er a ﬁnal judgment on whether inﬂation targeting will prove to bea fad or a trend. However, our preliminary assessment is that this approach—when
construed as a framework for making monetary policy, rather than as a rigid rule—
has a number of advantages, including more transparent and coherent policymaking,
increased accountability, and greater attention to long-run considerations in day-to-
day policy debates and decisions.
Acknowledgments
We thank Alan Blinder, Brad De Long, Mervyn King, Don Kohn, Alan Krueger,Bennett McCallum, Michael Peytrignet, Adam Posen, Georg Rich, Julio Rotemberg,
Lars Svensson and Timothy Taylor for their helpful comments. Any opinions ex-
pressed are those of the authors and not those of Princeton University, Columbia
University, the National Bureau of Economic Research, the Federal Reserve Bank
of New York, or the Federal Reserve System.
Notes
1. Detailed analyses of experiences with inﬂation targeting can be found in Goodhart and Vinals (1994),
Leiderman and Svensson (1995), Haldane (1995) and McCallum (1996), among others.
2. King (1996) adopts a similar view.3. Technically, ensuring only that the inﬂation rate is stationary may leave a unit root in the price level, so
that the forecast variance of the price level grows without bound. This problem is analogous to the issue of‘‘base drift’’ in the literature on money-growth targeting.Inflation Targeting: A New Framework? 223

4. However, Svensson (1996) gives examples in which price-level targeting actually reduces the volatility of
output.
5. Svensson (1997b) relates inﬂation targeting to the contracting approach.
6. Another short-run objective that is almost always retained by inﬂation-targeting central banks is the
maintenance of ﬁnancial stability. For example, see Mishkin (1997).
7. Users of the monetary conditions index would probably argue that treating the MCI simply as a fore-
casting variable is oversimple; they tend to view the MCI more speciﬁcally as a measure of how overall
monetary conditions are a¤ecting aggregate demand and thus as a potential guide to policy actions. SeeFreedman (1994) for further discussion.
8. Debelle and Fischer (1994) make the useful distinction between goal independence and instrument inde-
pendence for the central bank. Goal independence implies the unilateral ability of the central bank to set itsinﬂation targets and other goals, while instrument independence means that, although goals may be set bythe government or by the government in consultation with the central bank, the central bank is solely re-sponsible for choosing the instrument settings (for example, the level of short-term interest rates) necessary
to achieve those goals. Instrument independence would seem to be the form of independence that maxi-
mizes central bank accountability and minimizes opportunistic political interference, while still leavingthe ultimate goals of policy to be determined by democratic processes.
9. McCallum (1997) argues that the central bank can simply choose not to behave myopically, and the
public’s expectations will come to reﬂect this more farsighted behavior. He also points out, however, thatto the extent time-inconsistency is a problem, it will a¤ect the government as well as the central bank; weagree, as we discuss below.
10. Studies that attempt to overcome these problems include Lebow, Roberts and Stockton (1992) and
Barro (1995).
11. This bias was the subject of an o‰cial report to the Senate Finance Committee, the so-called Boskin
report (Boskin et al., 1996). See also Moulton (1996) and Shapiro and Wilcox (1997).
12. The force of this argument should not be overstated. First, the inﬂation rates which Akerlof, Dickens
and Perry (1996) argue would signiﬁcantly a¤ect the natural rate of unemployment are really quite low, forexample, measured rates (as opposed to ‘‘true’’ rates) of inﬂation of 2 percent per annum or less. Second,
their simulation studies do not take into account forces that may work in the opposite direction: for exam-
ple, Groshen and Schweitzer (1996) point out that high and variable inﬂation rates may increase the‘‘noise’’ in relative wages, reducing the e‰ciency of the process by which workers are allocated acrossindustries and occupations; thus higher inﬂation can represent sand as well as grease in the wheels of thelabor market.
13. In characterizing the forecast of inﬂation as the intermediate target, Svensson (1997a) is careful to de-
ﬁne ‘‘forecast’’ to mean the forecast derived internally by the central bank using its structural model of theeconomy. An intriguing alternative would be to try to ‘‘target’’ private-sector forecasts of inﬂation, that is,
set short-run policy instruments so that private-sector forecasts of inﬂation equal the announced target.
Unfortunately, as shown by Woodford (1994) and Bernanke and Woodford (1996), such a policy is usuallynot consistent with the existence of a unique rational expectations equilibrium. However, Bernanke andWoodford also show that, while targeting private-sector forecasts is not a good idea, private-sector fore-casts can typically be combined with the central bank’s own information to improve the e‰ciency of itsoperating procedure. Further, private-sector forecasts that the public observes to be close to the centralbank’s o‰cial targets may help to provide some validation of the bank’s internal procedures for forecast-
ing and controlling inﬂation.
14. Hall and Mankiw (1994) point out, however, that the equal weighting of real output growth and inﬂa-
tion implied by a nominal GDP targeting is not necessarily the optimal one; in general, the relative weight
put on the two goal variables should reﬂect social preferences.
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for NBER, 1994, pp. 95–116.226 Chapter 9

10International Experiences with Different Monetary Policy Regimes
Frederic S. Mishkin
10.1 Introduction
In recent years a growing consensus has emerged for price stability as the overriding,
long-run goal of monetary policy. However, despite this consensus, the followingquestion still remains: how should monetary policy be conducted to achieve the price
stability goal? To shed light on this question, this chapter examines the experience
with di¤erent monetary policy regimes currently in use in a number of countries.
A central feature of all of these monetary regimes is the use of a nominal anchor in
some form, so ﬁrst we will examine what role a nominal anchor plays in promoting
price stability. Then we will examine four basic types of monetary policy regimes: (1)
exchange-rate targeting, (2) monetary targeting, (3) inﬂation targeting, and (4) mon-
etary policy with an implicit but not an explicit nominal anchor. The basic theme
that comes out of this analysis is that the success of di¤erent monetary regimesdepends on their ability to constrain discretionary policymaking so that long-run
price stability is more likely to result.
10.2 The Role of a Nominal Anchor
A nominal anchor is a constraint on the value of domestic money, and in some form
it is a necessary element in successful monetary policy regimes. Why is a nominal an-
chor needed? First, from a purely technical viewpoint, a nominal anchor provides
conditions that make the price level uniquely determined, which is obviously neces-
sary for price stability. It helps do this by tying down inﬂation expectations directly
through its constraint on the value of domestic money.
However, a nominal anchor can be thought of more broadly as a constraint on
discretionary policy that helps weaken the time-inconsistency problem so that in the
long run, price stability is more likely to be achieved. The time-inconsistency prob-
lem arises because discretionary policy at each point in time can lead to poor long
run outcomes. In the case of monetary policy, expansionary monetary policy will

produce higher growth and employment in the short run, and so policymakers have
incentives to pursue this policy even though it ends up producing higher inﬂation,
but not higher growth or employment, in the long run. However, it is important
to recognize that the time-inconsistency problem may not reside in the central
bank because, as McCallum (1995) points out, a central bank can avoid the time-
inconsistency problem by simply recognizing the problem that forward-lookingexpectations in the wage- and price-setting process creates for a strategy of pursuing
expansionary monetary policy. The central bank can just decide not to play that
game. However, even so, there will still be pressures on the central bank to pursue
overly expansionary monetary policy by the politicians. Thus even if the source of
time inconsistency is not within central banks, a nominal anchor which limits politi-
cal pressures to pursue overly expansionary, monetary policies has an important role
to play in the achievement of price stability.
10.3 Exchange-Rate Targeting
Targeting the exchange rate is a monetary policy regime with a long history. It cantake the form of ﬁxing the value of the domestic currency to a commodity such as
gold, the key feature of the gold standard. More recently, ﬁxed exchange-rate
regimes have involved ﬁxing the value of the domestic currency to that of a large,
low-inﬂation country. Another alternative is adoption of a crawling target or peg
in which a currency is allowed to depreciate at a steady rate so that the inﬂation
rate in the pegging country can be higher than that of the anchor country.
Exchange-rate targeting has several advantages. First, the nominal anchor of
an exchange-rate target ﬁxes the inﬂation rate for internationally traded goods, and
thus directly contributes to keeping inﬂation under control. Second, if the exchange-rate target is credible, it anchors inﬂation expectations to the inﬂation rate in the
anchor country to whose currency it is pegged. Third, with a strong commitment
mechanism, an exchange-rate target provides an automatic rule for the conduct of
monetary policy that helps mitigate the time-inconsistency problem. It forces a tight-
ening of monetary policy when there is a tendency for the domestic currency to de-
preciate or a loosening of policy when there is a tendency for the domestic currency
to appreciate, so that discretionary, time-inconsistent, monetary policy is less of an
option. Fourth, an exchange-rate target has the advantage of simplicity and clarity,
which make it easily understood by the public. A ‘‘sound currency’’ is an easy-to-
understand rallying cry for monetary policy. This has been important in France, for
example, where an appeal to the ‘‘franc fort’’ is often used to justify tight monetarypolicy.
Given its advantages, it is not surprising that exchange-rate targeting has been
used successfully to control inﬂation in industrialized countries. Both France and228 Chapter 10

the United Kingdom, for example, successfully used exchange-rate targeting to lower
inﬂation by tying the value of their currencies to the German mark. In 1987, when
France ﬁrst pegged their exchange rate to the mark, its inﬂation rate was 3%, two
percentage points above the German inﬂation rate. By 1992 its inﬂation rate had
fallen to 2%, a level that can be argued is consistent with price stability, and was
even below that in Germany. By 1996, the French and German inﬂation rates hadconverged, to a number slightly below 2%. Similarly, after pegging to the German
mark in 1990, the United Kingdom was able to lower its inﬂation rate from 10% to
3% by 1992, when it was forced to abandon the exchange rate mechanism (ERM).
Exchange-rate targeting has also been an e¤ective means of reducing inﬂation
quickly in emerging market countries. An important recent example has been Argen-
tina, which in 1991 established a currency board arrangement, requiring the central
bank to exchange US dollars for new pesos at a ﬁxed exchange rate of 1:1. A cur-
rency board is just one form of a ﬁxed-exchange rate regime with an important dif-
ference. The currency board makes a much stronger and transparent commitment to
an exchange-rate target than the typical ﬁxed-ﬁxed exchange rate regime because it
requires that the monetary authority stands ready to exchange the domestic currencyfor foreign currency at the speciﬁed ﬁxed exchange rate whenever the public requests
it. In order to credibly meet these requests, a currency board typically has more
than 100% foreign reserves backing the domestic currency and allows the monetary
authorities absolutely no discretion. The early years of Argentina’s currency board
looked stunningly successful. Inﬂation which had been running at over a one-
thousand percent annual rate in 1989 and 1990 fell to under 5% by the end of 1994,
and economic growth was rapid, averaging almost 8% at an annual rate from 1991
to 1994.
Despite the inherent advantages of exchange-rate targeting, it is not without its
serious problems, as the international experience demonstrates. There are several se-
rious criticisms of exchange-rate targeting, which have been articulated brilliantly in
Obstfeld and Rogo¤ (1995). First is that, with open capital markets, an exchange-
rate target results in the loss of independent monetary policy, since the targeting
country loses the ability to use monetary policy to respond to domestic shocks that
are independent of those hitting the anchor country. Furthermore, an exchange-rate
target means that shocks to the anchor country are directly transmitted to the target-
ing country because changes in interest rates in the anchor country lead to a corre-
sponding change in interest rates in the targeting country.
A striking example of these problems occurred when Germany reuniﬁed in 1990.
Concerns about inﬂationary pressures arising from reuniﬁcation and the massiveﬁscal expansion required to rebuild East Germany led to rises in German long-term
interest rates until February 1991 and to rises in short-term rates until December
1991. This shock to the anchor country in the exchange rate mechanism (ERM)International Experiences with Different Regimes 229

was transmitted directly to the other countries in the ERM whose currencies
were pegged to the mark because their interest rates now rose in tandem with those
in Germany. The result was that continuing adherence to the exchange-rate target
produced a signiﬁcant slowing of economic growth and rising unemployment, which
is exactly what France experienced when it remained in the ERM and adhered to the
exchange-rate peg.
An exchange-rate target has the additional disadvantage that it removes the signal
that the foreign exchange market provides about the stance of monetary policy on a
daily basis. Under an exchange-rate-target regime, central banks often pursue overly
expansionary policies that are not discovered until too late, when a successful specu-
lative attack has gotten underway. The problem of lack of accountability of the
central bank under an exchange-rate-target regime is particularly acute in emerging
market countries where the balance sheets and actions of the central banks are not as
transparent as in developed countries. This can make it harder to ascertain the cen-
tral bank’s policy actions, as occurred in Thailand before the July currency crisis.
Although, an exchange-rate peg appears to provide rules for central bank behavior
that ameliorate the time-inconsistency problem, it can actually make the time-inconsistency problem more severe because it may make central bank actions less
transparent and less accountable. Indeed, an exchange-rate depreciation when the ex-
change rate is not pegged can provide an early warning signal that monetary policy is
overly expansionary, and fear of depreciation can make overly expansionary, time-
inconsistent, monetary policy less likely.
A third problem with exchange-rate targets is that they leave countries open to
speculative attacks on their currencies. Indeed, one aftermath of German reuniﬁca-
tion was the foreign exchange crisis of September 1992. As we have seen, the tight
monetary policy in Germany resulting from German reuniﬁcation meant that thecountries in the ERM were subjected to a negative demand shock that led to a de-
cline in economic growth and a rise in unemployment. It was certainly feasible for
the governments of these countries to keep their exchange rates ﬁxed relative to the
mark in these circumstances, but speculators began to question whether these coun-
tries’ commitment to the exchange rate peg would weaken because these countries
would not tolerate the rise in unemployment that would result from keeping interest
rates su‰ciently high to fend o¤ speculative attacks on their currencies.
At this stage, speculators were in e¤ect presented with one-way bets because the
currencies of countries like France, Spain, Sweden, Italy and the United Kingdom
could only go in one direction, depreciate against the mark. Selling these currencies
thus presented speculators with an attractive proﬁt opportunity with potentially highexpected returns, and the result was the speculative attack in September 1992. Only
in France was the commitment to the ﬁxed exchange rate strong enough, so that
France did not devalue. The governments in the other countries were unwilling to de-230 Chapter 10

fend their currencies at all costs and so eventually allowed their currencies to fall in
value.
The di¤erent response of France and the United Kingdom after the September
1992 exchange rate crisis illustrates the potential cost of an exchange-rate target.
France, which continued to peg to the mark and thereby was unable to use monetary
policy to respond to domestic conditions, found that economic growth remainedslow after 1992 and unemployment increased. The United Kingdom, on the other
hand, which dropped out of the ERM exchange-rate peg and adopted inﬂation tar-
geting (discussed later), had much better economic performance: economic growth
was higher, the unemployment rate fell, and yet inﬂation performance was not much
worse than France’s.
The aftermath of German reuniﬁcation and the September 1992 exchange rate cri-
sis dramatically illustrate two points: (1) an exchange-rate target does not guarantee
that the commitment to the exchange-rate based, monetary policy rule is su‰ciently
strong to maintain the target, and (2) the cost to economic growth from an exchange-
rate regime with its loss of independent monetary policy can be high.
For emerging market countries, it is far less clear that these countries lose much by
giving up an independent monetary policy when they target exchange rates. Because
many emerging market countries have not developed the political or monetary insti-
tutions that result in the ability to use discretionary monetary policy successfully,
they may have little to gain from an independent monetary policy, but a lot to lose.
Thus, they would be better o¤ by, in e¤ect, adopting the monetary policy of a coun-
try like the United States through targeting exchange rates than in pursuing their own
independent policy. Indeed, this is one of the reasons that so many emerging market
countries have adopted exchange-rate targeting.
Nonetheless, as is emphasized in Mishkin (1998a), there is an additional disadvan-
tage from an exchange-rate target in emerging market countries that suggests that for
them this monetary policy regime is highly dangerous. Exchange-rate targeting in
emerging market countries is likely to promote ﬁnancial fragility and possibly a full-
ﬂedged ﬁnancial crisis that can be highly destructive to the economy.
To see why exchange-rate targets in an emerging market country make a ﬁnancial
crisis more likely, we must ﬁrst understand what a ﬁnancial crisis is and why it is so
damaging to the economy. In recent years, an asymmetric information theory of ﬁ-
nancial crises has been developed which provides a deﬁnition of a ﬁnancial crisis
(Bernanke, 1983; Mishkin, 1991, 1996). A ﬁnancial crisis is a nonlinear disruption to
ﬁnancial markets in which asymmetric information problems (adverse selection and
moral hazard) become much worse, so that ﬁnancial markets are unable to e‰cientlychannel funds to economic agents who have the most productive investment oppor-
tunities. A ﬁnancial crisis thus prevents the e‰cient functioning of ﬁnancial markets,
which therefore leads to a sharp contraction in economic activity.International Experiences with Different Regimes 231

Because of uncertainty about the future value of the domestic currency, many non-
ﬁnancial ﬁrms, banks and governments in emerging market countries ﬁnd it much
easier to issue debt if the debt is denominated in foreign currencies. This tendency
can be further encouraged by an exchange-rate targeting regime which may encour-
age domestic ﬁrms and ﬁnancial institutions to issue foreign denominated debt. The
substantial issuance of foreign denominated debt was a prominent feature ofthe institutional structure in the Chilean ﬁnancial markets before the ﬁnancial crisis
in 1982, in Mexico before its ﬁnancial crisis in 1994 and in East Asian countries be-
fore their recent crisis.
With an exchange-rate target regime, depreciation of the currency when it occurs is
a highly nonlinear event because it involves a devaluation. In most developed coun-
tries a devaluation has little direct e¤ect on the balance sheets of households, ﬁrms
and banks because their debts are denominated in domestic currency. 1This is not
true, however, in emerging market countries with their very di¤erent institutional
structure. With debt contracts denominated in foreign currency as in emerging mar-
ket countries, when there is a devaluation of the domestic currency, the debt burden
of domestic ﬁrms increases. On the other hand, since assets are typically denomi-nated in domestic currency, there is no simultaneous increase in the value of ﬁrms’
assets. The result is that a devaluation leads to a substantial deterioration in balance
sheets and a decline in net worth, both for nonﬁnancial ﬁrms and ﬁnancial ﬁrms
which now are unable to collect on their loans to nonﬁnancial ﬁrms.
In addition, a devaluation can lead to a dramatic rise in both actual and expected
inﬂation in emerging market countries because their central banks are unlikely to
have deep-rooted credibility of inﬂation ﬁghters. Indeed Mexican inﬂation surged
to 50% in 1995 after the foreign exchange crisis in 1994 and a similar phenomenon
has been occurring in Indonesia. The rise in expected inﬂation then leads to a sharprise in interest rates, which because of the short duration of debt contracts leads to
huge increases in interest payments by ﬁrms, thereby weakening ﬁrms’ cash ﬂow po-
sition and further weakening their balance sheets.
The deterioration of balance sheets, by reducing e¤ective collateral, makes lending
less attractive and also increases moral hazard incentives for ﬁrms to take on greater
risk because they have less to lose if the loans go sour. Because lenders are now sub-
ject to much higher risks of losses, and because ﬁnancial intermediaries like banks
may be less able to lend because of the deterioration in their balance sheets, there is
a decline in investment and economic activity. The damage to balance sheets from
devaluation in the aftermath of the foreign exchange crisis was a major source of the
contraction of the economies of Chile in 1982, Mexico in 1994 and 1995 and EastAsia in 1997–98.
Another potential danger from an exchange-rate target is that by providing a more
stable value of the currency, it might lower perceived risk for foreign investors and232 Chapter 10

thus encourage capital inﬂows. Although these capital inﬂows might be channeled
into productive investments and thus stimulate growth, they might promote excessive
lending, manifested by a lending boom, because domestic ﬁnancial intermediaries
such as banks play a key role in intermediating these capital inﬂows. With inade-
quate bank supervision, a common problem in emerging market countries, the likely
outcome of a lending boom is substantial loan losses and a deterioration of bank bal-ance sheets. Not only will the deterioration in bank balance sheets lead banks to re-
duce their lending, but it also damages the economy because it makes a currency
crisis more likely, which, as we have seen, can trigger a ﬁnancial crisis. When a coun-
try’s banking system is in a weakened condition, a successful speculative attack is
more likely because the central bank has less of an option to raise interest rates to
defend the currency because doing so may cause the banking system to collapse.
The recent events in East Asia and Mexico, in which the weakness of the banking
sector and speculative attack on the currency tipped their economies into full-scale
ﬁnancial crises, illustrate how dangerous exchange-rate targeting can be for emerging
market countries. Indeed, the fact that an exchange-rate target in these countries
leaves them more prone to ﬁnancial fragility and ﬁnancial crises, with potentially cat-astrophic costs to their economies, suggests that exchange-rate targeting in emerging
market countries is highly problematic.
Given the above problems with exchange-rate targeting, when might it make sense?
In countries whose political and monetary institutions are particularly weak and
therefore have been experiencing continued bouts of hyperinﬂation, exchange-rate
targeting may be the only way to break inﬂationary psychology and stabilize the
economy. In this situation, exchange-rate targeting is the stabilization policy of last
resort. However, we have seen that in emerging market countries exchange-rate tar-
geting regimes are not always transparent, weakening the commitment mechanismand making them more likely to break down, often with disastrous consequences.
This suggests that if exchange-rate targeting is believed to be the only route possible
to stabilize the economy, then an emerging market country is probably best served
by going all the way and adopting a currency board in which the commitment to
the ﬁxed exchange rate is extremely strong and there is total transparency to mone-
tary policy because the actions of the central bank are automatic. However, as is dis-
cussed further in Mishkin (1998a), a currency board is still a potentially dangerous
monetary policy regime which requires important institutional reforms in order to
make it viable.
10.4 Monetary Targeting
In many countries, exchange-rate targeting is not an option because the country (orbloc of countries) is too large or has no obvious country whose currency can serveInternational Experiences with Different Regimes 233

as the nominal anchor. Exchange-rate targeting is therefore clearly not an option for
the United States, Japan or the European Monetary Union. Thus these countries, by
default, must look to other monetary policy regimes, one of which is monetary tar-
geting.
A major advantage of monetary targeting over exchange-rate targeting is that it
enables a central bank to adjust its monetary policy to cope with domestic consider-ations. It enables the central bank to choose goals for inﬂation that may di¤er from
those of other countries and allows some response to output ﬂuctuations. Also, like
an exchange-rate target, information on whether the central bank is achieving its tar-
get is known almost immediately—announced ﬁgures for monetary aggregates are
typically reported periodically with very short time-lags, within a couple of weeks.
Thus, monetary targets can send almost immediate signals to both the public and
markets about the stance of monetary policy and the intentions of the policymakers
to keep inﬂation in check. These signals then can help ﬁx inﬂation expectations
and produce less inﬂation. Monetary targets also have the advantage of being able
to promote almost immediate accountability for monetary policy to keep inﬂation
low and so help constrain the monetary policymaker from falling into the time-inconsistency trap.
All of the above advantages of monetary aggregate targeting depend on there be-
ing a strong and reliable relationship between the goal variable (inﬂation or nominal
income) and the targeted aggregate. If there is velocity instability, so that the rela-
tionship between the monetary aggregate and the goal variable is weak, then mone-
tary aggregate targeting will not work. The weak relationship implies that hitting
the target will not produce the desired outcome on the goal variable and thus
the monetary aggregate will no longer provide an adequate signal about the stance
of monetary policy. Thus, monetary targeting will not help ﬁx inﬂation expectationsand be a good guide for assessing the accountability of the central bank. The break-
down of the relationship between monetary aggregates and goal variables such as in-
ﬂation and nominal income certainly seems to have occurred in the United States
(Friedman and Kuttner, 1996; Estrella and Mishkin, 1997) and may also be a prob-
lem even for countries that have continued to pursue monetary targeting.
This problem with monetary targeting suggests one reason why even the most avid
monetary targeters do not rigidly hold to their target ranges, but rather allow under-
shoots and overshoots for extended periods of time. Moreover, an unreliable rela-
tionship between monetary aggregates and goal variables calls into question the
ability of monetary targeting to serve as a communications device that both increases
the transparency of monetary policy and makes the central bank accountable to thepublic.
The two countries which have pursued monetary targeting quite seriously are Ger-
many and Switzerland. The success of monetary policy in these two countries in con-234 Chapter 10

trolling inﬂation is the reason that monetary targeting still has strong advocates and
is part of the o‰cial policy strategy for the European Central Bank. (Monetary tar-
geting was less successful in the United States, Canada and the United Kingdom,
partially because it was not pursued seriously (Bernanke and Mishkin, 1992) but
also because the relationship between monetary aggregates and goal variables such
as inﬂation or nominal income broke down.)
The key fact about monetary targeting regimes in Germany and Switzerland is
that the targeting regimes are very far from a Friedman-type monetary targeting rule
in which a monetary aggregate is kept on a constant-growth-rate path and is the pri-
mary focus of monetary policy. As Otmar Issing, currently the Chief Economist of
the Bundesbank has noted, ‘‘One of the secrets of success of the German policy
of money-growth targeting was that …i t o f t e n d i d n o t feel bound by monetarist or-
thodoxy as far as its more technical details were concerned’’ (Issing, 1996, p. 120).
Monetary targeting in Germany and Switzerland should instead be seen primarily
as a method of communicating the strategy of monetary policy that focuses on
long-run considerations and the control of inﬂation.
The calculation of monetary target ranges is a very public exercise. 2First and
foremost, a numerical inﬂation goal is prominently featured in the setting of
target ranges. Then with estimates of potential output growth and velocity trends, a
quantity-equation framework is used to back out the target growth rate for the mon-
etary aggregate. Second, monetary targeting, far from being a rigid policy rule, has
been quite ﬂexible in practice. The target ranges for money growth are missed on the
order of ﬁfty percent of the time, often because of the Bundesbank’s and the Swiss
National Bank’s concern about other objectives, including output and exchange
rates. Furthermore, the Bundesbank has demonstrated its ﬂexibility by allowing its
inﬂation goal to vary over time, raising it when supply shocks occurred and thenletting it converge slowly to the long-run inﬂation goal quite gradually.
Third, the monetary targeting regimes in both Germany and Switzerland have
demonstrated a strong commitment to the communication of the strategy to the gen-
eral public. The money-growth targets are continually used as a framework for ex-
planation of the monetary policy strategy and both the Bundesbank and the Swiss
National Bank expend tremendous e¤ort, both in their publications and in frequent
speeches by central bank o‰cials, to communicate to the public what the central
bank is trying to achieve. Indeed, given that both central banks frequently miss their
money-growth targets by signiﬁcant amounts, their monetary-targeting frameworks
are best viewed as a mechanism for transparently communicating how monetary pol-
icy is being directed to achieve their inﬂation goals and as a means for increasing theaccountability of the central bank.
Germany’s monetary-targeting regime has been quite successful in producing low
inﬂation and its success has been envied by many other countries, explaining why itInternational Experiences with Different Regimes 235

was chosen as the anchor country for the exchange rate mechanism. An important
success story, discussed extensively in Bernanke et al. (1999), occurred in the after-
math of German reuniﬁcation in 1990. Despite a temporary surge in inﬂation stem-
ming from the terms of reuniﬁcation, high wage demands and the ﬁscal expansion,
the Bundesbank was able to keep these one-o¤ e¤ects from becoming embedded in
the inﬂation process, and by 1995, inﬂation fell back down below the Bundesbank’snormative inﬂation goal of 2%.
One potentially serious criticism of German monetary targeting, however, is that,
as demonstrated by Clarida and Gertler (1997), the Bundesbank has reacted asym-
metrically to target misses, raising interest rates in response to overshooting of the
money-growth target, but choosing not to lower interest rates in response to an un-
dershooting. This suggests that the Bundesbank may not be su‰ciently concerned
about undershoots of its normative inﬂation goal. Arguably this might have caused
the Bundesbank to be overly tight in its monetary policy stance in the mid 1990s
when German inﬂation fell below the 2% normative goal, which not only led to an
unnecessary increase in unemployment in Germany, but also in countries tied to the
deutsche mark, such as France.
Monetary targeting has been more problematic in Switzerland than in Germany,
suggesting the di‰culties of targeting monetary aggregates in a small open economy
which also underwent substantial changes in the institutional structure of its money
markets. In the face of a 40% trade-weighted appreciation of the Swiss franc from the
fall of 1977 to the fall of 1978, the Swiss National Bank decided that the country
could not tolerate this high a level of the exchange rate. Thus, in the fall of 1978 the
monetary targeting regime was abandoned temporarily, with a shift from a monetary
target to an exchange-rate target until the spring of 1979, when monetary targeting
was reintroduced although it was not announced. Furthermore, when the return tomonetary targeting was formally announced in 1980, the Swiss National Bank
deemed it necessary to switch the monetary aggregate targeted from M1 to the mon-
etary base.
The period from 1989 to 1992 was also not a happy one for Swiss monetary target-
ing because as stated by the Chief Economist of the Swiss National Bank, Georg
Rich, ‘‘the SNB (Swiss National Bank) failed to maintain price stability after it suc-
cessfully reduced inﬂation’’ (Rich, 1997, p. 115, emphasis in original). The substan-
tial overshoot of inﬂation from 1989 to 1992, reaching levels above 5%, was due to
two factors. The ﬁrst is that the strength of the Swiss franc from 1985 to 1987 caused
the Swiss National Bank to allow the monetary base to grow at a rate greater than
the 2% target in 1987 and then raised the money-growth target to 3% for 1988. Thesecond arose from the introduction of a new interbank payment system, the Swiss
Interbank Clearing (SIC), and a wide-ranging revision of the commercial banks’ li-236 Chapter 10

quidity requirements in 1988. The result of the shocks to the exchange rate and the
shift in the demand for monetary base arising from the above institutional changes
created a serious problem for its targeted aggregate. As the 1988 year unfolded, it be-
came clear that the Swiss National Bank had guessed wrong in predicting the e¤ects
of these shocks so that the demand for monetary base fell by more than the predicted
amount, resulting in monetary policy that was too easy even though the monetarytarget was undershot. The result was a subsequent rise in inﬂation to above the 5%
level.
The result of these problems with monetary targeting has resulted in a substantial
loosening of the monetary targeting regime in Switzerland. The Swiss National Bank
recognized that its money-growth targets were of diminished utility as a means of sig-
naling the direction of monetary policy. As a result, its announcement at the end of
1990 of the medium-term growth path was quite ambiguous because it did not spec-
ify a horizon for the target or the starting point of the growth path. Eventually the
Bank speciﬁed the time horizon of the horizon was a period of three to ﬁve years
and it was not till the end of 1992 that the Bank speciﬁed the basis of the starting
point for the expansion path. Finally at the end of 1994, the Bank announced a newmedium-term path for money base growth for the period 1995 to 1999, thus retroac-
tively revealing that the horizon of the ﬁrst path was also ﬁve years. Clearly, the
Swiss National Bank has moved to a much more ﬂexible framework in which hitting
one-year targets for money base growth has been abandoned. Nevertheless, Swiss
monetary policy has continued to be successful in controlling inﬂation, with inﬂation
rates falling back down below the 1% level after the temporary bulge in inﬂation from
1989 to 1992.
There are two key lessons to our discussion of German and Swiss monetary target-
ing. First, a targeting regime can restrain inﬂation in the longer run, even when theregime permits substantial target misses. Thus adherence to a rigid policy rule has
not been found to be necessary to obtain good inﬂation outcomes. Second, the key
reason why monetary targeting has been reasonably successful in these two countries,
despite frequent target misses, is that the objectives of monetary policy are clearly
stated, and both the Bundesbank and the Swiss National Bank actively engage in
communicating the strategy of monetary policy to the public, thereby enhancing
transparency of monetary policy and accountability of the central bank.
As we will see in the next section, these key elements of a successful targeting
regime—ﬂexibility, transparency and accountability—are also important elements
in inﬂation-targeting regimes. Thus, as suggested by Bernanke and Mishkin (1997),
German and Swiss monetary policy is actually closer in practice to inﬂation targetingthan it is to Friedman-like monetary targeting, and thus might best be thought of as
‘‘hybrid’’ inﬂation targeting.International Experiences with Different Regimes 237

10.5 Inflation Targeting
Given the breakdown of the relationship between monetary aggregates and goal vari-
ables such as inﬂation, many countries have recently adopted inﬂation targeting as
their monetary policy regime. New Zealand was the ﬁrst country to formally adopt
inﬂation targeting in 1990, with Canada following in 1991, the United Kingdom in
1992, Sweden in 1993, Finland in 1993, Australia in 1994 and Spain in 1994. Israel
and Chile have also adopted a form of inﬂation targeting.
Inﬂation targeting involves several elements: (1) public announcement of medium-
term numerical targets for inﬂation; (2) an institutional commitment to price stability
as the primary, long-run goal of monetary policy and to achievement of the inﬂation
goal; (3) an information-inclusive strategy, with a reduced role for intermediate tar-
gets such as money growth; (4) increased transparency of the monetary policy strat-
egy through communication with the public and the markets about the plans andobjectives of monetary policymakers; and (5) increased accountability of the central
bank for attaining its inﬂation objectives.
Inﬂation targeting has several important advantages. In contrast to exchange-rate
targeting, but like monetary targeting, inﬂation targeting enables monetary policy to
focus on domestic considerations and to respond to shocks to the domestic economy.
Inﬂation targeting also has the advantage that velocity shocks are largely irrelevant
because the monetary policy strategy no longer relies on a stable money–inﬂation
relationship. Indeed, an inﬂation target allows the monetary authorities to use all
available information, and not just one variable, to determine the best settings formonetary policy.
Inﬂation targeting, like exchange-rate targeting, also has the key advantage that it
is readily understood by the public and is thus highly transparent. Monetary targets
are less likely to be easily understood by the public than inﬂation targets, and if the
relationship between monetary aggregates and the inﬂation goal variable is subject to
unpredictable shifts, as has occurred in many countries including a long-standing
monetary targeter such as Switzerland, then monetary targets lose their transparency
because they are no longer able to accurately signal the stance of monetary policy.
Because an explicit numerical inﬂation target increases the accountability of the
central bank, inﬂation targeting also has the potential to reduce the likelihood that
the central bank will fall into the time-inconsistency trap in which it tries to expandoutput and employment by pursuing overly expansionary monetary policy. But since
time-inconsistency is more likely to come from political pressures on the central bank
to engage in overly expansionary monetary policy, a key advantage of inﬂation tar-
geting is that it can help focus the political debate on what a central bank can do in
the long run—that is, control inﬂation—rather than what it cannot do—raise eco-
nomic growth and the number of jobs permanently through expansionary monetary238 Chapter 10

policy. Thus inﬂation targeting has the potential to reduce political pressures on the
central bank to pursue inﬂationary monetary policy and thereby reduce the likeli-
hood of time-inconsistent policymaking.
Despite the rhetoric about pursuing ‘‘price stability,’’ in practice all the inﬂation-
targeting countries have chosen to target the inﬂation rate rather than the level of
prices per se. In addition, all the inﬂation targeters have chosen midpoints for theirinﬂation target to be substantially above zero, and above reasonable estimates of
possible upward measurement bias in the inﬂation rates calculated from consumer
price indices. For example, currently New Zealand has the lowest midpoint for an
inﬂation target, 1.5%, while Canada and Sweden set the midpoint of their inﬂation
target at 2%; the United Kingdom, Australia and Spain currently have their mid-
points at 2.5%, while Israel is at 8.5%. It is important to note that even Germany,
considered to be one of the most resolute opponents of inﬂation in the world, sets
its long-run inﬂation goal at 2% for many years (changed to 1.5 to 2% in December
1996), right in the middle of the pack for inﬂation targeters.
The decision by inﬂation targeters (and hybrid targeters like Germany) to choose
inﬂation targets well above zero and not price level targets reﬂects monetary policy-makers’ concerns that too low inﬂation, or particularly low inﬂation, can have
substantial negative e¤ects on real economic activity. There are particularly valid
reasons for fearing deﬂation, including the possibility that it might promote ﬁnancial
instability and precipitate a severe economic contraction (see Mishkin, 1991, 1996).
Indeed, deﬂation has been associated with deep recessions or even depressions, as in
the 1930s, and the recent deﬂation in Japan has been one factor that has weakened
the ﬁnancial system and the economy. Targeting inﬂation rates of above zero makes
periods of deﬂation less likely. The evidence on inﬂation expectations from surveys
and interest rate levels (Almeida and Goodhart, 1998; Bernanke et al., 1999) suggestthat maintaining a target for inﬂation above zero (but not too far above) for an
extended period does not lead to instability in inﬂation expectations or to a decline
in the central bank’s credibility.
Another key feature of inﬂation-targeting regimes is that they do not ignore tradi-
tional stabilization goals. Central bankers responsible in inﬂation-targeting countries
continue to express their concern about ﬂuctuations in output and employment, and
the ability to accommodate short-run stabilization goals to some degree is built into
all inﬂation-targeting regimes. All inﬂation-targeting countries have been willing to
take a gradualist approach to disinﬂation in order to minimize output declines by
lowering medium-term inﬂation targets towards the long-run goal slowly over time.
In addition, many inﬂation targeters, particularly the Bank of Canada, have
emphasized that the ﬂoor of the target range should be emphasized every bit as
much as the ceiling, thus helping to stabilize the real economy when there are nega-
tive aggregate demand shocks. Indeed, inﬂation targets can increase the ﬂexibility ofInternational Experiences with Different Regimes 239

the central bank to respond to declines in aggregate spending, because declines in ag-
gregate demand that cause the inﬂation rate to fall below the ﬂoor of the target range
will automatically stimulate the central bank to loosen monetary policy without fear-
ing that its action will trigger a rise in inﬂation expectations.
Another element of ﬂexibility in inﬂation-targeting regimes is that deviations from
inﬂation targets are routinely allowed in response to supply shocks. First, the priceindex on which the o‰cial inﬂation targets are based is often deﬁned to exclude or
moderate the e¤ects of ‘‘supply shocks’’; for example, the o‰cially targeted price in-
dex may exclude some combination of food and energy prices, indirect tax changes,
terms-of-trade shocks, and the direct e¤ects of interest rate changes on the index (for
example, through imputed rental costs). Second, following (or in anticipation of ) a
supply shock, such as a rise in the value-added tax, the normal procedure is for the
central bank ﬁrst to deviate from its planned policies as needed and then to explain
the reasons for its action to the public. New Zealand, on the other hand, has an ex-
plicit escape clause in its targeting regime which the central bank uses to justify such
actions, although it has also permitted target deviations on a more ad hoc basis.
Inﬂation-targeting regimes also put great stress on making policy transparent—
policy that is clear, simple, and understandable—and on regular communication
with the public. The central banks have frequent communications with the govern-
ment, some mandated by law and some in response to informal inquiries, and their
o‰cials take every opportunity to make public speeches on their monetary policy
strategy. These channels are also commonly used in countries that have not adopted
inﬂation targeting, Germany and the United States being prominent examples, but
inﬂation-targeting central banks have taken public outreach a step further: not only
have they engaged in extended public information campaigns, even engaging in the
distribution of glossy brochures, but they have engaged in publication of Inﬂation
Report type documents (originated by the Bank of England).
The publication of Inﬂation Reports is particularly noteworthy because these docu-
ments depart from the usual, dull-looking, formal reports of central banks to take on
the best elements of textbook writing (fancy graphics, use of boxes) in order to better
communicate with the public. An excellent description of the shift in emphasis in
these reports is reﬂected in the following quote from the Bank of Canada.
The new Monetary Policy Report will be designed to bring increased transparency and ac-
countability to monetary policy. It will measure our performance in terms of the Bank’s targets
for controlling inﬂation and will examine how current economic circumstances and monetary
conditions in Canada are likely to a¤ect future inﬂation (Bank of Canada, 1995, p. 7).
The above channels of communication are used by central banks in inﬂation-
targeting countries to explain the following to the general public, ﬁnancial marketparticipants and the politicians: (1) the goals and limitations of monetary policy,240 Chapter 10

including the rationale for inﬂation targets; (2) the numerical values of the inﬂation
targets and how they were determined, (3) how the inﬂation targets are to be
achieved, given current economic conditions; and (4) reasons for any deviations from
targets. These communication e¤orts have improved private-sector planning by
reducing uncertainty about monetary policy, interest rates and inﬂation; they have
promoted public debate of monetary policy, in part by educating the public aboutwhat a central bank can and cannot achieve; and they have helped clarify the respon-
sibilities of the central bank and of politicians in the conduct of monetary policy.
Another key feature of inﬂation-targeting regimes is the tendency toward increased
accountability of the central bank. Indeed, transparency and communication go
hand in hand with increased accountability. The strongest case of accountability of
a central bank in an inﬂation-targeting regime is in New Zealand, where the govern-
ment has the right to dismiss the Reserve Bank’s governor if the inﬂation targets are
breached, even for one quarter. In other inﬂation-targeting countries, the central
bank’s accountability is less formalized. Nevertheless, the transparency of policy
associated with inﬂation targeting has tended to make the central bank highly ac-
countable to both the public and the government. Sustained success in the conductof monetary policy as measured against a pre-announced and well-deﬁned inﬂation
target can be instrumental in building public support for a central bank’s indepen-
dence and for its policies. This building of public support and accountability occurs
even in the absence of a rigidly deﬁned and legalistic standard of performance evalu-
ation and punishment.
Two remarkable examples illustrate the beneﬁts of transparency and accountabil-
ity in the inﬂation-targeting framework. The ﬁrst occurred in Canada in 1996, when
the president of the Canadian Economic Association made a speech criticizing the
Bank of Canada for pursuing monetary policy that he claimed was too contraction-ary. His speech sparked o¤ a widespread public debate. In countries not pursuing
inﬂation targeting, such debates often degenerate into calls for the immediate expan-
sion of monetary policy with little reference to the long-run consequences of such a
policy change. In this case, however, the very existence of inﬂation targeting chan-
neled the debate into a substantive discussion over what should be the appropriate
target for inﬂation, with both the Bank and its critics obliged to make explicit their
assumptions and estimates of the costs and beneﬁts of di¤erent levels of inﬂation. In-
deed, the debate and the Bank of Canada’s record and responsiveness led to
increased support for the Bank of Canada, with the result that criticism of the Bank
and its conduct of monetary policy was not a major issue in the 1997 elections as it
had been before the 1993 elections.
The second example occurred upon the granting of operational independence to
the Bank of England on 6 May 1997. Prior to that date, it was the government, as
represented by the Chancellor of the Exchequer (equivalent to the ﬁnance ministerInternational Experiences with Different Regimes 241

or the secretary of the treasury), that controlled the decision to set monetary policy
instruments, while the Bank of England was relegated to acting as the government’s
counterinﬂationary conscience. On May 6, the new Chancellor of the Exchequer,
Gordon Brown, announced that the Bank of England would henceforth have the re-
sponsibility for setting both the base interest rate and short-term exchange-rate inter-
ventions. Two factors were cited by Chancellor Brown that justify the government’sdecision: ﬁrst was the Bank’s successful performance over time as measured against
an announced clear target; second was the increased accountability that an indepen-
dent central bank is exposed to under an inﬂation-targeting framework, making the
Bank more responsive to political oversight. The granting of operational indepen-
dence to the Bank of England occurred because it would now be operating under a
monetary policy regime that ensures that monetary policy goals cannot diverge from
the interests of society for extended periods of time, yet monetary policy can be insu-
lated from short-run political considerations. An important beneﬁt of an inﬂation-
targeting regime is therefore that it makes it more palatable to have an independent
central bank which focuses on long-run objectives, but which is consistent with a
democratic society because it is accountable.
The performance of inﬂation-targeting regimes has been quite good. Inﬂation-
targeting countries seem to have signiﬁcantly reduced both the rate of inﬂation and
inﬂation expectations beyond that which would likely have occurred in the absence
of inﬂation targets. Furthermore, once inﬂation is down, it has stayed down; follow-
ing disinﬂations, the inﬂation rate in targeting countries has not bounced back up
during subsequent cyclical expansions of the economy.
Also inﬂation targeting seems to ameliorate the e¤ects of inﬂationary shocks. For
example, shortly after adopting inﬂation targets in February 1991, the Bank of Can-
ada was faced with a new goods and services tax (GST)—an indirect tax similar to avalue-added tax—an adverse supply shock that in earlier periods might have led to
a ratcheting up in inﬂation. Instead the tax increase led to only a one-time increase in
the price level; it did not generate second- and third-round rises in wages in prices
that would lead to a persistent rise in the inﬂation rate. Another example is the expe-
rience of the United Kingdom and Sweden following their departures from the ERM
exchange-rate pegs in 1992. In both cases, devaluation would normally have stimu-
lated inﬂation because of the direct e¤ects on higher export and import prices and the
subsequent e¤ects on wage demands and price-setting behavior. Again it seems rea-
sonable to attribute the lack of inﬂationary response in these episodes to adoption of
inﬂation targeting, which short-circuited the second- and later-round e¤ects and
helped to focus public attention on the temporary nature of the devaluation shocks.Indeed, one reason why inﬂation targets were adopted in both countries was to
achieve exactly this result.242 Chapter 10

Although inﬂation targeting does appear to be successful in moderating and con-
trolling inﬂation, it is not without potential problems. In contrast to exchange-rate
and monetary targeting, inﬂation is not easily controlled by the monetary authorities.
This can be a particularly severe problem for an emerging market country that is try-
ing to bring down inﬂation from a previously high level and so is more likely to ex-
perience large inﬂation forecast errors. This suggests that hard targets from inﬂationmight be worth phasing in only after there has been some successful disinﬂation. This
is exactly the strategy followed by Chile (see Morande and Schmidt-Hebbel, 1997)
which adopted a weak form of inﬂation targeting in September 1990. Initially, inﬂa-
tion targets were announced and interpreted as o‰cial inﬂation projections, rather
than as hard targets. However, over time as inﬂation fell, this procedure was changed
and inﬂation targets came to be viewed by the central bank and the markets as hard
targets. Waiting to harden targets until after some success has already been achieved
on the inﬂation front, is also consistent with what inﬂation-targeting industrialized
countries have done: in every case, inﬂation targeting was not implemented until
after substantial disinﬂation has previously been achieved (see Mishkin and Posen,
1997; Bernanke et al., 1999).
Another potential problem with inﬂation targeting is that, because of the long lags
of monetary policy, inﬂation outcomes are revealed only after a substantial lag; thus
inﬂation targeting does not provide immediate signals to both the public and the
markets about the stance of monetary policy. However, we have seen that exchange-
rate targets remove the ability of the foreign exchange market to signal that overly
expansionary monetary policies might be in place, while the signals provided by
monetary aggregates are unlikely to be very strong because of the instability of the
relationship between money and inﬂation.
It is also important to recognize that the likely e¤ects of inﬂation targeting on the
real side of the economy are more ambiguous. Economic theorizing often suggests
that a commitment by a central bank to reduce and control inﬂation should improve
its credibility and thereby reduce both inﬂation expectations and the output losses
associated with disinﬂation. Experience and econometric evidence (e.g., see Almeida
and Goodhart, 1998; Bernanke et al., 1999) does not support this prediction, how-
ever. Inﬂation expectations do not immediately adjust downward following the adop-
tion of inﬂation targeting. Furthermore, there appears to be little if any reduction
in the output loss associated with disinﬂation, the sacriﬁce ratio, among countries
adopting inﬂation targeting.
A common concern raised about inﬂation targeting is that it will lead to low and
unstable growth in output and employment. Although inﬂation reduction is associ-ated with below-normal output during disinﬂationary phases in inﬂation-targeting
regimes, once low inﬂation levels have been achieved, output and employment returnInternational Experiences with Different Regimes 243

to levels at least as high as they were previously. A conservative conclusion is that
once low inﬂation is achieved, inﬂation targeting is not harmful to the real economy.
Given the strong economic growth after disinﬂation was achieved in many countries
that have adopted inﬂation targets, New Zealand being one outstanding example, a
case can even be made that inﬂation targeting promotes real economic growth in ad-
dition to controlling inﬂation. 3
Some economists, such as Friedman and Kuttner (1996), have criticized inﬂation
targeting because they believe that it imposes a rigid rule on monetary policymakers
that does not allow them enough discretion to respond to unforeseen circumstances.
This criticism is one that has featured prominently in the rules-versus-discretion de-
bate. For example, policymakers in countries that adopted monetary targeting did
not foresee the breakdown of the relationship between these aggregates and goal
variables such as nominal spending or inﬂation. With rigid adherence to a monetary
rule, the breakdown in their relationship could have been disastrous. However, the
interpretation of inﬂation targeting as a rule is incorrect and stems from a confusion
that has been created by the rules-versus-discretion debate. In my view, the tradi-
tional dichotomy between rules and discretion can be highly misleading. Useful pol-icy strategies exist that are ‘‘rule-like’’ in that they involve forward-looking behavior
which constrains policymakers from systematically engaging in policies with undesir-
able long-run consequences, thereby avoiding the time-inconsistency problem. These
policies would best be described as ‘‘constrained discretion.’’
Indeed, inﬂation targeting can be described exactly in this way. As emphasized
above, inﬂation targeting as actually practiced is very far from a rigid rule. First, in-
ﬂation targeting does not provide simple and mechanical instructions as to how the
central bank should conduct monetary policy. Rather, inﬂation targeting requires
that the central bank use all available information to determine what are the appro-priate policy actions to achieve the inﬂation target. Unlike simple policy rules, inﬂa-
tion targeting never requires the central bank to ignore information and focus solely
on one key variable. Second, inﬂation targeting as practiced contains a substantial
degree of policy discretion. As we have seen, inﬂation targets have been modiﬁed
depending on economic circumstances. Furthermore, central banks under inﬂation-
targeting regimes have left themselves considerable scope to respond to output
growth and ﬂuctuations through several devices.
However, despite its ﬂexibility, inﬂation targeting is not an exercise in policy dis-
cretion as subject to the time-inconsistency problem. The strategy of hitting an inﬂa-
tion target, by its very nature, forces policymakers to be forward looking rather than
narrowly focused on current economic conditions. Further, through its transparency,an inﬂation-targeting regime increases the central bank’s accountability, which con-
strains discretion so that the time-inconsistency problem is ameliorated.244 Chapter 10

10.6 Monetary Policy with an Implicit but Not an Explicit Nominal Anchor
Several countries in recent years, most notably the United States, have achieved
excellent macroeconomic performance (including low and stable inﬂation) without
using an explicit nominal anchor such as a target for the exchange rate, a monetary
aggregate, or inﬂation. Although in the US case, no explicit strategy has been articu-
lated, a coherent strategy for the conduct of monetary policy exists nonetheless. This
strategy involves an implicit, but not an explicit nominal anchor in the form of an
overriding concern by the Federal Reserve to control inﬂation in the long run. In ad-
dition it involves forward-looking behavior in which there is careful monitoring for
signs of future inﬂation, coupled with periodic ‘‘preemptive strikes’’ by monetary
policy against the threat of inﬂation.
The presence of long lags means that monetary policy cannot wait until inﬂation
has already reared its ugly head before responding. If the central bank waited untilovert signs of inﬂation appeared, it would already be too late to maintain stable
prices, at least not without a severe tightening of policy: inﬂation expectations would
already be embedded in the wage- and price-setting process, creating an inﬂation mo-
mentum that will be hard to halt. Indeed, inﬂation becomes much harder to control
once it has been allowed to gather momentum because higher inﬂation expectations
become ingrained in various types of contracts and pricing agreements.
In order to prevent inﬂation from getting started, monetary policy therefore needs
to be forward-looking and preemptive: that is, depending on the lags from monetary
policy to inﬂation, monetary policy needs to act well before inﬂationary pressures ap-pear in the economy. For example, if it takes roughly two years for monetary policy
to have a signiﬁcant impact on inﬂation, then, even if inﬂation is quiescent currently
and yet, with an unchanged stance of monetary policy, policymakers see inﬂation ris-
ing over the next two years, actions need to be taken today to tighten monetary pol-
icy to prevent the inﬂationary surge.
This preemptive monetary policy strategy is clearly also a feature of inﬂation-
targeting regimes because monetary policy instruments are adjusted to take account
of the long lags in their e¤ects in order to hit future inﬂation targets. However, the
policy regime in the United States, which does not have a nominal anchor and so
might best be described as a ‘‘just do it’’ policy regime, di¤ers from inﬂation target-
ing in that it does not o‰cially have a nominal anchor and is much less transparentin its monetary policy strategy.
The main argument for the ‘‘just do it’’ strategy is simply its demonstrated success.
The Federal Reserve has been able to bring down inﬂation in the United States from
double digit levels in 1980 to around the 3% level by the end of 1991; since then, in-
ﬂation has been stable at about that level or a bit below it. The Fed conducted aInternational Experiences with Different Regimes 245

successful preemptive strike against inﬂation from February 1994 until early 1995,
when in several steps it raised the federal funds rate from 3% to 6% even though in-
ﬂation was not increasing during this period. The subsequent lengthy expansion has
brought unemployment down below 5%, a level not seen since the 1960s, and despite
the business expansion, CPI inﬂation actually has even fallen to a level below 2%. In
addition, the overall growth rate of the US has continued to remain strong. Indeed,the performance of the US economy has become the envy of the industrialized world
in the 1990s.
Given the success of the ‘‘just do it’’ strategy, a natural question to ask is why
countries such as the United States should consider other monetary policy strategies
which would change something that has already worked well, especially given the in-
ability to know what types of challenges will confront monetary policy in the future:
In other words, ‘‘If it ain’t broke, why ﬁx it?’’ The answer is that the ‘‘just do it’’
strategy has some disadvantages that may cause it to work less well in the future.
An important disadvantage of the ‘‘just do it’’ strategy is a lack of transparency.
The constant guessing game about the Fed’s intentions created by its close-mouthed
approach creates unnecessary volatility in ﬁnancial markets and arouses uncertaintyamong producers and the general public about the future course of inﬂation and out-
put as well. Furthermore, the opacity of its policymaking is hardly conducive to
making the Federal Reserve accountable to Congress and the general public, because
there are no predetermined criteria for judging its performance. As a result, the cen-
tral bank is more susceptible to the time-inconsistency problem, whereby it may pur-
sue short-term objectives at the expense of long-term ones.
The lack of an explicit nominal anchor is also a potential problem for the ‘‘just do
it’’ strategy: For example, it may be that the Fed risks greater exposure than is nec-
essary to ‘‘inﬂation scares’’—the spontaneous increases in inﬂation fears described byGoodfriend (1993) that can become self-justifying if accommodated by the Fed. In
addition, this strategy may make it harder for the Fed to contain the medium-term
e¤ects of a supply shock because the absence of a nominal anchor makes inﬂation
expectations more susceptible to rise when this occurs.
Probably the most serious problem with the ‘‘just do it’’ approach is strong depen-
dence on the preferences, skills, and trustworthiness of the individuals in charge of
the central bank. In the United States, Federal Reserve Chairman Alan Greenspan
and other Federal Reserve o‰cials have emphasized forward-looking policies and in-
ﬂation control, with great success so far. The Fed’s prestige and credibility with the
public have risen accordingly. But the Fed’s leadership will eventually change, and
there is no guarantee that the new team will be committed to the same approach.Nor is there any guarantee that the relatively good working relationship now existing
between the Fed and the executive branches will continue. In a di¤erent economic
or political environment, the Fed might face strong pressure to engage in over expan-246 Chapter 10

sionary policies, raising the possibility that time-inconsistency may become a more
serious problem. In the past, after a successful period of low inﬂation, the Federal
Reserve has reverted to inﬂationary monetary policy—the 1970s are one example—
and without an explicit nominal anchor, this could certainly happen again in the
future.
The political problem with the US regime in which there is no explicit nominal
anchor is illustrated by events during the spring of 1997. At that time, following
several previous reductions of the federal funds rate, the Federal Reserve reversed
its policy and hiked the target for the funds rate by 25 basis points (one-quarter of a
percentage point). Although that rise was quite modest, particularly given the strong
growth of the US economy and the tight labor market at the time, it provoked a
storm of criticism, in Congress and elsewhere. Yet at about the same time, increases
in interest rates engineered by the Bank of England, an established inﬂation targeter,
were received quite calmly by the British public. Because of inﬂation targeting, it
is plausible that the British public had a better understanding of the long-run objec-
tives being pursued by the monetary authorities, and hence of the reason for their
policy action, than the US public. The absence of an explicit nominal anchor andthe accompanying transparency may thus make it harder for the Federal Reserve
to contain inﬂation in the future if undesirable shocks begin to propel inﬂation
upward.
10.7 An Overall Assessment of the Different Monetary Regimes
In examining international experiences with di¤erent monetary policy regimes, we
have looked at four basic types of frameworks: (1) exchange-rate targeting, (2) mon-
etary targeting, (3) inﬂation targeting, and (4) monetary policy with an implicit butnot an explicit nominal anchor. How do these di¤erent monetary policy regimes stack
up against each other? When might one monetary regime be more e¤ective in pro-
ducing desirable economic outcomes than another?
Our discussion of exchange-rate targeting suggests that as a strategy for stabilizing
the economy and controlling inﬂation, the disadvantages typically outweigh the
advantages, particularly when exchange-rate targets promote ﬁnancial instability
as in emerging market countries. However, if a country does not have political,
economic and cultural institutions that allow them to conduct their own monetary
policy successfully, then a transparent form of exchange-rate targeting, such as a cur-
rency board, might have enough beneﬁts to outweigh the potential costs. 4
The second monetary policy regime discussed here has worked well in a country
like Germany and is a key reason why the Governing Council of the European Cen-
tral Bank (ECB) announced in October 1998, that a component of its monetary pol-
icy strategy is ‘‘a prominent role for money with a reference value for the growth of aInternational Experiences with Different Regimes 247

monetary aggregate.’’ However, our earlier discussion suggests several reasons why
monetary targeting by the ECB may not be a very good idea. First, monetary aggre-
gates are not a particularly useful guide for monetary policy unless the relationship
between monetary aggregates and inﬂation is strong and reliable. A stable relation-
ship between money and inﬂation is, in fact, quite unlikely to exist in the ﬂedgling
EMU, since this relationship has not been particularly reliable in the past in most ofthe constituent countries of the Union, including even Germany (Estrella and Mish-
kin, 1996). The Bundesbank has not been unaware of the instability of the money–
inﬂation relationship, which helps to explain why it has been willing to tolerate
misses of its money-growth targets in half of the years for which the targets have
been set. Furthermore, the creation of the European Monetary Union and the Euro-
pean System of Central Banks at the start of Stage Three, together with ongoing ﬁ-
nancial deregulation and innovation, will cause major change in the operation of the
European ﬁnancial system in coming years. Those changes will a¤ect money and as-
set demands in unpredictable ways, making it likely that the relationship between
monetary aggregates and inﬂation in the Union as a whole will be even more un-
stable than it has been in the individual member countries.
The second objection to the adoption of monetary targeting by the European
Monetary Union is that monetary targets are likely to prove a less e¤ective vehicle
of communication for the EMU than they have for Germany and Switzerland. De-
spite frequent target misses, both the Bundesbank and the Swiss National Bank are
held in such high regard that they lose little by using the announcement of monetary
targets as the framework in which they explain their policy strategy, despite the fact
that their actual inﬂation targeting leads them to miss their stated monetary targets
so frequently. The European Central Bank, which will be starting from scratch, will
not at the outset command the credibility and anti-inﬂation reputation of the Bun-desbank and the Swiss National Bank, which are based primarily on strong political
support for low inﬂation in those two countries and on the demonstrated success
of the two central banks in ﬁghting inﬂation. Missing announced targets for money
growth may thus be far more problematic for the European Central Bank than it
was for the Bundesbank and the Swiss National Bank, because the public will be
less willing to accept the European Central Bank’s explanations for these misses and
declarations of anti-inﬂationary determination at face value. Furthermore, in many
European countries the public will have no experience with a monetary policy fo-
cused on monetary aggregates, and thus may ﬁnd the targets harder to understand
and less relevant to their daily lives than targets for inﬂation.
Inﬂation targeting, which is the newest of the monetary regimes studied here, has
been gaining popularity in recent years and has several major strengths. It enables
monetary policy to focus on domestic considerations as does monetary targeting,
but is not subject to velocity shock problems; it is readily understood and highly248 Chapter 10

transparent; it allows ﬂexibility and discretion in the conduct of monetary policy, but
because it increases the accountability of the central bank it constrains discretion so
that the time-inconsistency problem is ameliorated; and it helps shift the public de-
bate to focus on what monetary policy can do in the long run and thus helps reduce
political pressure to engage in time-inconsistent policies. The performance of
inﬂation-targeting countries has been very good up to now, enabling them to doquite well in hitting their targets and maintain low inﬂation rates, something they
have not always been able to do in the past, while it seems to improve the climate
for economic growth after the initial disinﬂation phase is past. However, inﬂation
targeting is no panacea: it does not seem to enable countries to eliminate inﬂa-
tion from their systems without cost, and anti-inﬂation credibility is not achieved im-
mediately upon the adoption of an inﬂation target. The evidence seems to suggest
that the only way for an inﬂation-targeting central bank to earn credibility is the
hard way: it has to earn it.
In addition to ‘‘reference values’’ for monetary aggregates, the announced strategy
of the European Central Bank also includes a numerically explicit inﬂation goal of
a year-on-year increase of below 2%. Because the signals from monetary aggregatesare even more likely to be weak when the European Monetary Union comes into
existence and a key element of any successful targeting strategy is transparency and
e¤ective communication with the public, the European Central Bank is likely to be
better served by downgrading the attention to monetary aggregates and putting inﬂa-
tion targets at the forefront instead.
But what about the need of the European Central Bank to inherit the mantle of
the Bundesbank, a monetary targeter of long standing? Doesn’t this suggest that the
European Central Bank should adopt monetary targeting in order to provide conti-
nuity with the policies of the Bundesbank, thereby inheriting the Bundesbank’s cred-ibility? There are indeed beneﬁts for the European Central Bank to be seen as
following in the footsteps of the Bundesbank. However, we have seen that the Bun-
desbank’s policy framework is actually quite close to inﬂation targeting. Both frame-
works have many characteristics in common, including: a strong commitment to
price stability; the speciﬁcation of numerical inﬂation goals (both in the medium
term and the long term); accountability of the central bank for meeting the goals;
transparency of policy and e¤ective communication with the public; a forward-
looking approach that takes into account the lags inherent in monetary policy; and
ﬂexibility to respond to short-run economic developments. In short, in practice an in-
ﬂation-targeting European Central Bank would function very much like the mone-
tary targeting Bundesbank, and the public could be actively educated to understandthis basic continuity. The di¤erences that exist—notably, the deemphasis on money
growth as the key piece of information for forecasting inﬂation—favor the inﬂation-
targeting approach.International Experiences with Different Regimes 249

The ﬁnal monetary regime discussed in this chapter is the ‘‘just do it’’ approach
followed by the United States in which there is an implicit, but not an explicit nomi-
nal anchor. The key argument for this approach is that it has worked in the past and
so ‘‘if it ain’t broke, why ﬁx it?’’ However, the ‘‘just do it’’ strategy su¤ers from a
lack of transparency and accountability of the central bank, which not only may
weaken the support for anti-inﬂationary monetary policy but also is not fully consis-tent with democratic principles (see Mishkin, 1999). Also replacement of the ‘‘just do
it’’ with an inﬂation-targeting approach would help to depersonalize US monetary
policy, which would strengthen the central bank’s commitment to the long-run goal
of price stability and make the achievement of low inﬂation less dependent on the
competence or convictions of a few individuals.
It seems likely that US monetary policy performance in the future could be
improved by the adoption of inﬂation targeting. Inﬂation targeting is not too far
from the current policymaking philosophy at the Federal Reserve, which has stressed
the importance of price stability as the overriding, long-run goal of monetary policy.
Also a move to inﬂation targeting is consistent with recent steps by the Fed to in-
crease the transparency of monetary policy, such as shortening the time beforethe minutes of the FOMC meeting are released and the practice of announcing the
FOMC’s decision about whether to change the target for the federal funds rates
immediately after the conclusion of the FOMC meeting. The current conditions for
adoption of inﬂation targeting are propitious: inﬂation has been low and stable
for over ﬁve years; the public sees the beneﬁt of a low inﬂation environment that
has helped produce a balanced, long-lived economic expansion; and the success of
inﬂation targeting regimes in other industrialized countries is becoming increasingly
apparent. Moving to a more explicit nominal anchor, as with an inﬂation targeting
regime, can help lock in the low and stable inﬂation rate that the United Statesis currently experiencing, promoting a more stable and successful monetary policy
regime in the future.
10.8 Conclusions
This overview of the international experiences with di¤erent monetary policy regimes
suggests that transparency and accountability are crucial to constraining discretion-
ary monetary policy so that it produces desirable long-run outcomes. Because the
devil is in the details in achieving transparency and accountability, what strategy will
work best in a country depends on its political, cultural and economic institutions
and its past history. The discussion here of the di¤erent international experienceswith monetary policy strategies will hopefully help provide guidance for policy-
makers in particular countries as to which monetary policy strategy is more likely to
produce low inﬂation, a stable economic environment, and a healthy economy.250 Chapter 10

Notes
Prepared for Sveriges Riksbank-IIES Conference on Monetary Policy Rules, Stockholm, Sweden, June
12–13, 1998. I thank for their helpful comments my discussant, Charles Goodhart, an anonymous referee,Robert King and my co-authors for our book, Inﬂation Targeting: Lessons from the International Experi-
ence (Princeton University Press, 1999) on which a substantial part of the discussion in this chapter is
based, Ben Bernanke, Thomas Laubach, and Adam Posen. Because of space constraints, many references
in this chapter have been deleted, but they can be found in a longer version of this chapter (Mishkin,
1998b). Any views expressed in this chapter are those of the author only and not those of Columbia Uni-versity or the National Bureau of Economic Research.
1. Indeed, a devaluation in developed countries can actually stimulate economic activity because it makes
the country’s goods more competitive internationally, thereby increasing its net exports and hence aggre-gate demand. Indeed, this was exactly the experience of the United Kingdom after the September 1992foreign-exchange crisis when it was forced to devalue its currency. Its economic performance after thedevaluation was substantially better than that of countries which remained in the ERM after 1992.
2. For a more extensive discussion of the procedures used in German monetary targeting, see Bernanke
et al. (1999) and the references therein.
3. Some economists have proposed that central banks should target the growth rate of nominal GDP
rather than inﬂation because of concerns that targeting inﬂation might produce excessive output ﬂuctua-
tions. Because nominal GDP targeting has up to now not been adopted anywhere in the world, I will dis-
cuss it only brieﬂy here. Relative to inﬂation, nominal GDP growth has the advantage that it does putsome weight on output as well as prices in the policymaking process. With a nominal GDP target, a de-cline in projected real output growth would automatically imply an increase in the central bank’s inﬂationtarget, which would tend to be stabilizing because it would automatically lead to an easier monetarypolicy.
Nominal GDP targeting is close in spirit to inﬂation targeting and might provide a reasonable alterna-
tive. The most important reason why I believe that inﬂation targeting has advantages over nominal GDP
targeting (other reasons are outlined in Mishkin (1998b)) is that a nominal GDP target forces the centralbank or the government to announce a number for potential GDP growth. Such an announcement ishighly problematic because estimates of potential GDP growth are far from precise and change overtime. Announcing a speciﬁc number for potential GDP growth may thus indicate a certainty that policy-makers may not have and may also cause the public to mistakenly believe that this estimate is actually a
ﬁxed target for potential GDP growth. Announcing a potential GDP growth number is likely to be politi-
cal dynamite because it opens policymakers to the criticism that they are willing to settle for growth ratesthat the public many consider to be too low. Indeed, a nominal GDP target may lead to an accusation thatthe central bank or the targeting regime is anti-growth, when the opposite is true because a low inﬂationrate is a means to promote a healthy economy with high growth. In addition, if the estimate for potentialGDP growth is too high and becomes embedded in the public mind as a target, it can lead to a positiveinﬂation bias. Also, as argued above, inﬂation targeting as it is actually practiced allows considerable ﬂex-
ibility for policy in the short run. Thus it is doubtful that, in practice, nominal GDP targeting would be
more e¤ective than inﬂation targeting in achieving short-run stabilization, and elements of monetary policytactics based on nominal GDP targeting could easily be built into an inﬂation-targeting regime.
4. Note that countries might ﬁnd it useful to target exchange rates for reasons which have little to do with
the conduct of monetary policy, such as encouraging integration of the domestic economy with its neigh-bors. Clearly this is the rationale for long-standing pegging of the exchange rate to the deutsche mark bycountries such as Austria and the Netherlands, and the more recent exchange-rate pegs in the run-up to theEuropean Monetary Union. (However, if economic integration is the goal, it is more likely to be accom-
plished by currency union rather than an exchange-rate peg.)
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Economics 39 (1) (June), 113–141.252 Chapter 10

11Why the Federal Reserve Should Adopt Inflation Targeting
Frederic S. Mishkin
11.1 Introduction
Under Alan Greenspan, the Federal Reserve has achieved extraordinary economic
performance: inﬂation has become low and stable, while over the last twenty yearsthe economy has experienced only two relatively mild recessions in 1990–91 and
2001. Although the Federal Reserve has not articulated an explicit strategy, a coher-
ent strategy for the conduct of monetary policy exists nonetheless. This strategy
involves an implicit, but not an explicit nominal anchor in the form of an overriding
concern by the Federal Reserve to control inﬂation in the long run. In addition, it
involves forward-looking behaviour in which there is careful monitoring for signs of
future inﬂation, using a wide range of information, coupled with periodic ‘‘pre-
emptive strikes’’ by monetary policy against the threat of inﬂation or deﬂation.
Because of the long lags from monetary policy to aggregate economic activity
and inﬂation, monetary policy needs to be forward-looking and pre-emptive: that is,
depending on the lags from monetary policy to inﬂation, monetary policy needs to
act well before inﬂationary or deﬂationary pressures appear in the economy. For ex-
ample, suppose it takes approximately two years for monetary policy to have a sig-
niﬁcant impact on inﬂation. In this case, even if inﬂation is currently low but policy
makers believe inﬂation will rise over the next two years, they must now tighten
monetary policy to prevent the inﬂationary surge. This is exactly what the Federal
Reserve has done. For example, the Federal Reserve raised the federal funds rate
from 3% to 6% from February 1994 to February 1995 before a rise in inﬂation got
a toehold. As a result, inﬂation not only did not rise, but fell slightly. In January
2001, the Federal Reserve reversed course extremely rapidly, cutting the federalfunds rate by 100 basis points (1 percentage point) in January even before the busi-
ness cycle peak in March, and then proceeded to cut the Federal Reserve funds rate
by another 350 basis points before the end of November when the NBER declared
that a recession had indeed occurred. The recession then turned out to be very mild,
especially given the adverse shocks of the September 11 terrorist attacks and the neg-
ative impacts of the Enron and other corporate scandals on the credit markets.

The main argument for the Federal Reserve’s pre-emptive monetary policy strat-
egy, which I like to call the ‘‘just do it’’ approach, is simply its demonstrated success.
In addition, the approach is ﬂexible and appropriately makes use of all available in-
formation in setting policy instruments. A natural question to ask then is why the
Federal Reserve should consider any other monetary policy strategy. In other words,
‘‘If it ain’t broke, why ﬁx it?’’ The answer is that the ‘‘just do it’’ strategy has somedisadvantages that may cause it to work less well in the future, particularly when
Alan Greenspan steps down from the Federal Reserve, something that will almost
surely occur by the time his term expires in two years.
An important disadvantage of the ‘‘just do it’’ strategy is a lack of transparency.
The constant guessing game about the Federal Reserve’s goals created by its close-
mouthed approach creates unnecessary volatility in ﬁnancial markets and arouses
uncertainty among producers and the general public. A case in point is the recent
sharp swings in long-term interest rates during the late Spring and Summer of 2003.
Because the market was confused about the Federal Reserve’s intentions, the ten-
year bond rate dropped from a level near 4% at the beginning of May to 3.2% in
the middle of June and then rose over 100 basis points to 4.5% by the end of July.The Federal Reserve has been struggling recently with how to communicate its plans
with regard to interest-rate policy and how it should structure its formal statement
immediately after each FOMC meeting. If the markets had a clearer picture of the
Federal Reserve’s longer-run objectives, particularly on inﬂation, then they would fo-
cus less on what the Federal Reserve’s next policy move would be, making it less
likely that Federal Reserve policy moves or changes in its formal statement would
lead to whipsawing of the market.
In addition, the opacity of its policy making is hardly conducive to making the
Federal Reserve accountable to Congress and the general public: The Federal Re-serve cannot be held accountable if there are no predetermined criteria for judging
its performance. This lack of accountability is also inconsistent with democratic
principles. There are good reasons—notably, insulation from short-term political
pressures—for the central bank to have a high degree of independence, as the Fed-
eral Reserve currently does, and empirical evidence does generally support central
bank independence. 1Yet the practical economic arguments for central bank inde-
pendence coexist uneasily with the presumption that government policies should be
made democratically, rather than by an elite group.
The lack of an explicit nominal anchor is also a potential problem for the ‘‘just do
it’’ strategy. For example, it may be that the Federal Reserve risks greater exposure
than is necessary to ‘‘inﬂation scares’’—the spontaneous increases in inﬂation fearsdescribed by Goodfriend (1993) that can become self-justifying if accommodated by
the Federal Reserve. Indeed, as Goodfriend (2005) points out, even Alan Greenspan
faced an inﬂation scare shortly after becoming the Federal Reserve Chairman.254 Chapter 11

Probably the most serious problem with the ‘‘just do it’’ approach is that its suc-
cess is based on highly capable individuals rather than good institutions. In the USA,
Federal Reserve Chairman Alan Greenspan and other Federal Reserve o‰cials have
emphasized forward-looking policies and inﬂation control, which have been key ele-
ments in their success. The Federal Reserve’s prestige and credibility with the public
have risen accordingly, with Greenspan having been given the title of ‘‘maestro’’in the media (Woodward 2000). I have acknowledged elsewhere in Mishkin (2000)
that the Federal Reserve currently does not su¤er from having a weak nominal an-
chor, but the strong nominal anchor is embodied in Alan Greenspan. Unfortunately,
a nominal anchor based on an individual cannot last forever. Greenspan’s tenure at
the Federal Reserve will come to an end soon and there might be some doubts that
the new Chairman will be committed to the same approach, just as there were some
doubts in the markets that Greenspan would be as serious about controlling inﬂation
as his predecessor, Paul Volcker; see Goodfriend (2005). Nor is there any guarantee
that the relatively good working relationship now existing between the Federal Re-
serve and the executive branch, which started with the Clinton administration, will
continue. In a di¤erent economic or political environment, the Federal Reservemight face strong pressure to engage in over expansionary policies, raising the possi-
bility that the time-inconsistency problem of Kydland and Prescott (1977) and Calvo
(1978) may become more serious in the future. In the past, after a successful period
of low inﬂation, the Federal Reserve has reverted to inﬂationary monetary policy—
the 1970s are one example—and without an explicit nominal anchor, this could cer-
tainly happen again in the future.
11.2 Why Inflation Targeting?
Inﬂation targeting has the potential to avoid the above problems in the FederalReserve’s current approach. To be clear, inﬂation targeting involves the following
ﬁve elements:
1. Public announcement of forward-looking medium-term numerical targets for
inﬂation
2. An institutional commitment to price stability as the primary, long-run goal of
monetary policy and to achievement of the inﬂation goal
3. An information inclusive strategy4. Increased transparency of the monetary policy strategy through communication
with the public and the markets about the plans and objectives of monetary policy
makers
5. Increased accountability of the central bank for attaining its inﬂation objectives 2Why the Federal Reserve Should Adopt Inflation Targeting 255

Inﬂation targeting has many of the desirable features of the current Federal Re-
serve approach. It is forward looking, uses all information in deciding on the setting
of policy instruments and does focus on achieving long-run price stability. However,
it goes beyond the current Federal Reserve approach and this provides several
advantages. First, an inﬂation target is readily understood by the public and is thus
highly transparent. Framing the discussion of monetary policy around an inﬂationgoal makes it easier for the Federal Reserve to communicate with the public and
the markets. It can help to decrease uncertainty about future monetary policy
moves, thereby decreasing market volatility. It can help to focus the political debate
on what a central bank can do in the long-run—that is control inﬂation, rather
than on what it cannot do, which is permanently increase economic growth and the
number of jobs through expansionary monetary policy. Thus, inﬂation targeting has
the potential to reduce the likelihood that the central bank will fall into the time-
consistency trap, trying to expand output and employment in the short-run by pursu-
ing overly expansionary monetary policy. Indeed, inﬂation targeting has been able to
change public debate in countries that have adopted it, with an increased focus on
the long-run rather than on the short-run issue of ‘‘jobs, jobs, jobs’’ as in the USA;see Mishkin and Posen (1997) and Bernanke et al. (1999).
Because an explicit numerical inﬂation target increases the accountability of the
central bank, inﬂation targeting is also more consistent with democratic principles.
Sustained success in the conduct of monetary policy as measured against a pre-
announced and well-deﬁned inﬂation target can be instrumental in building public
support for a central bank’s independence and for its policies. The granting of oper-
ational independence to the Bank of England in 1997 illustrates this point. On May
6, 1997, the new Chancellor of the Exchequer, Gordon Brown, announced that the
Bank of England would henceforth have the responsibility for setting interest rates,which previously was done by the Chancellor of the Exchequer. In the press confer-
ence, Gordon Brown explained that the inﬂation targeting regime justiﬁed the gov-
ernment’s decision: the Bank had demonstrated successful performance over time as
measured against an announced clear target, and was now more accountable, mak-
ing it more responsive to political oversight.
11.3 Objections to Inflation Targeting?
Of course not everyone sees inﬂation targeting positively, as is evidenced by Ben
Friedman (2004). There are several important objections to inﬂation targeting that
require a response.
First, inﬂation targeting might be too inﬂexible, leading to higher output ﬂuctua-
tions. Ben Friedman has taken this position, especially in Friedman and Kuttner
(1996), in which they worry that inﬂation targeting might be a rigid rule that would256 Chapter 11

fare as badly as Milton Friedman’s constant-money-growth-rate rule would have if it
had been implemented. As Ben Bernanke and I have argued elsewhere (Bernanke
and Mishkin 1997), this is a mischaracterization of inﬂation targeting which can be
quite ﬂexible and is very far from a rigid policy rule. Instead, we have argued that
inﬂation targeting is best described as ‘‘constrained discretion.’’
However, the concern that inﬂation targeting could lead to increased output ﬂuc-
tuations is one that does have to be taken seriously. If a central bank solely focused
on inﬂation control, something that Mervyn King (1996) has described as being an
‘‘inﬂation nutter,’’ then it could lead to overly high output ﬂuctuations. However,
this is not the way inﬂation targeting is actually practised. I agree strongly with Larry
Meyer (2004) that a central bank needs to adhere to a dual mandate of the type in the
Federal Reserve Act that indicates that monetary policy objectives include not only
price stability but also output stability. Indeed, the literature on optimal monetary
policy typically speciﬁes an objective function for monetary policy which puts a neg-
ative weight on both output as well as inﬂation ﬂuctuations—see, for example, the
papers in Taylor (1999)—and operating with this type of objective function is consis-
tent with what inﬂation-targeting central banks have actually done (Bernanke et al.1999). The result has been that countries that have adopted inﬂation targeting have
not found that output ﬂuctuations have increased.
The argument that inﬂation targeting might increase output ﬂuctuations can be
turned on its head. I would argue that inﬂation targeting can actually make it easier
to reduce output ﬂuctuations and probably has done so. First, the presence of an in-
ﬂation target which provides an e¤ective nominal anchor enables a central bank to
be even more aggressive in the face of negative shocks to the economy because the
central bank has less fear that these moves will blow out inﬂation expectations. A
classic example of this happened in Australia in July 1997 when the Reserve Bankof Australia lowered interest rates immediately after the currency crisis in Thailand
that brought on the East Asian crisis. Despite the prospects of a substantial depreci-
ation of the Australian dollar, the Reserve Bank believed that the success of their
inﬂation-targeting regime meant that inﬂation expectations would not rise above
their targets with a monetary policy easing and thus they could ease to counter the
negative demand shock arising from the deterioration in their terms of trade that
was resulting from the East Asian crisis. Second, the emphasis on the ﬂoor of the
inﬂation-target range that has become a standard feature of inﬂation targeting in
industrialized countries makes it more likely that central banks will be aggressive in
combating negative shocks, so that deﬂationary spirals are less likely. If the Bank of
Japan had an inﬂation target with the appropriate emphasis on the ﬂoor of the targetrange, then it is very likely that they would have avoided the disastrous policies pur-
sued under the leadership of Masuro Hayami and would have been far more expan-
sionary. Also, they would have been far more likely to avoid the time-inconsistencyWhy the Federal Reserve Should Adopt Inflation Targeting 257

problem outlined by Eggertsson (2003) in which the Bank of Japan was unable to
commit to a long-run policy of expansion, thereby making temporary expansionary
policy ine¤ective.
Critics of inﬂation targeting, most notably Don Kohn (2004), who is a member of
the Board of Governors of the Federal Reserve, have also worried that inﬂation tar-
geting may be too rigid because inﬂation-targeting central banks in advanced econo-mies have often adopted a horizon for their inﬂation targets of two years or so, with
the Bank of England being a prominent example. This can give the impression that
the horizon for inﬂation targets is ﬁxed, which could mean that inﬂation targeting
will not be ﬂexible enough. After all, models such as Svensson (1997) and Woodford
(2004) tell us that optimal monetary policy will surely adjust the target horizon and
path for inﬂation depending on the nature and persistence of shocks. This criticism is
a valid one. The use of a speciﬁc horizon such as two years, which is consistent with
estimates of policy lags from monetary policy actions to inﬂation, has not been a
problem for inﬂation targeting in advanced economies like the UK only because in-
ﬂation has not been subject to big shocks so that it has remained close to the target
level. However, as Svensson (1997) demonstrates, if the inﬂation rate is shocked awayfrom its long-run target, then the target horizon should be longer than the policy ho-
rizon. Although this situation has not occurred yet in advanced-economy inﬂation
targeters, a big shock to inﬂation will come one day. Then for monetary policy to
minimize output and inﬂation ﬂuctuations optimally, the target path for inﬂation
will have to be adjusted as it has been in Brazil recently; see Fraga et al. (2003).
This valid criticism of the ﬁxed horizon for inﬂation targets does not mean that inﬂa-
tion targeting should not be adopted by the Federal Reserve. What it does mean is
that an inﬂation targeting regime in the USA should make it clear, even before it
is necessary, that the horizon for inﬂation targets needs to be ﬂexible and will varydepending on the nature and persistence of shocks.
The second serious objection to inﬂation targeting is raised in Ben Friedman
(2004). He argues that inﬂation targeting will not lead to transparency because it
encourages central banks to avoid discussing reduction of output ﬂuctuations as an
objective of monetary policy. I would argue that inﬂation targeting is not the issue
here. Central bankers, whether they inﬂation target or not, are extremely reluctant
to discuss concerns about output ﬂuctuations. Indeed, I like to refer to the fact that
central bankers care about output ﬂuctuations but are often reluctant to talk about it
as ‘‘the dirty little secret of central banking.’’ One remarkable manifestation of this
occurred in August of 1994 at the Federal Reserve Bank of Kansas City’s Jackson
Hole Conference, which is arguably the most prominent central bank conferencethat occurs on a regular basis. Alan Blinder, then the vice-chairman of the FOMC,
had the temerity to mention that a short-run trade-o¤ between output and inﬂation
exists and that therefore monetary policy should be concerned about minimizing258 Chapter 11

output as well as inﬂation ﬂuctuations. Blinder was then pilloried by many central
bankers and in the press, with a Newsweek columnist declaring that he was not qual-
iﬁed to be a central banker (Samuelson 1994). From an academic economist’s per-
spective, this was quite amazing since Alan Blinder did not say anything that was
inconsistent with what our models tell us. However, it does indicate the discomfort
that central bankers as a group have with discussing the role of output ﬂuctuationsin the conduct of monetary policy.
Why do central bankers have di‰culty with being transparent about their concerns
about output ﬂuctuations? I have touched on this issue in an earlier article (Mishkin
2002). Central bankers’ interactions with the political process has shown them that,
when politicians talk about the need for central banks to reduce output ﬂuctuations,
politicians do not focus on the appropriate long-run trade-o¤ between output ﬂuctu-
ations and inﬂation ﬂuctuations, but rather on the short-run need to create jobs.
Central bankers then fear that if they agree that they should try to minimize output
ﬂuctuations as well as inﬂation ﬂuctuations, politicians will use this to pressure the
central bank to pursue a short-run strategy of overly expansionary policy that will
lead to poor long-run outcomes. In addition, central bankers know that it is ex-tremely di‰cult to measure potential output and so being forced to focus too much
on output ﬂuctuations can lead to serious policy mistakes, as it did during the Arthur
Burns’ years at the Federal Reserve (Orphanides 2002). The response to these prob-
lems is that central bankers engage in a ‘‘don’t ask, don’t tell’’ strategy which Ben
Friedman rightfully criticizes.
I do think that Ben gets it exactly wrong when he criticizes inﬂation targeting for
encouraging ‘‘don’t ask, don’t tell.’’ To the contrary, I believe that inﬂation targeting
can actually help to deal with the problem that Ben raises, making it easier for cen-
tral bankers to be more transparent about their desire to keep output ﬂuctuationslow. Because having an inﬂation target makes it easier for central banks to focus on
the long-run trade-o¤ between output and inﬂation ﬂuctuations, central bankers will
be more comfortable indicating that a dual mandate for monetary policy is com-
pletely consistent with pursuit of price stability. Recent speeches which advocated a
Federal Reserve announcement of an inﬂation goal by Federal Reserve governor
Bernanke and former governor Meyer at the Federal Reserve Bank of St. Louis con-
ference in October 2003 did exactly this; see Bernanke (2004) and Meyer (2004).
Second, an inﬂation-targeting central bank should announce that it will not try
to hit its inﬂation target over too short a horizon because this would result in un-
acceptably high output losses, especially if the economy is hit by shocks that knock
it substantially away from its long-run inﬂation goal. Inﬂation targeting banks havebeen moving in this direction: for example, the Reserve Bank of New Zealand has
modiﬁed its inﬂation-targeting regime to lengthen the horizon over which it tries to
achieve its inﬂation target; see Sherwin (1999), Drew and Orr (1999) and ReserveWhy the Federal Reserve Should Adopt Inflation Targeting 259

Bank of New Zealand (2000). Inﬂation-targeting central banks can go even farther in
this direction by indicating that they are ready to emulate what the Brazilians have
done recently when they were faced with a substantial overshoot of their targets
(Fraga et al. 2003). In January 2003, the Banco Central do Brasil announced that it
was adjusting its targets upwards for 2003 from 4% to 8.5%. They also explained that
reaching to the non-adjusted target of 4% too quickly would entail far too high a lossof output. Speciﬁcally, the announcement indicated that an attempt to achieve an in-
ﬂation rate of 6.5% in 2003 would be expected to entail a decline of 1.6% of GDP,
while trying to achieve the previous target of 4% would be expected to lead to an
even larger decline of GDP of 7.3%.
By announcing that they would do what the Brazilians have done if a situation
arose in which inﬂation were shocked substantially away from the long-run goal,
central bankers can let the dirty little secret out of the closet that they do have an
appropriate concern about output ﬂuctuations. Yet, they will still be able to assure
the public that they continue to worry about the long run and the importance of
achieving price stability. In addition, as I argued above, monetary authorities can
further the public’s understanding that they have an appropriate concern aboutreducing output ﬂuctuations by emphasizing that monetary policy needs to be just
as vigilant in preventing inﬂation from falling too low as it is from preventing it
from being too high.
11.4 Conclusion: The Federal Reserve Should Adopt Inflation Targeting
The bottom line from my commentary here is that the Federal Reserve should adopt
a ﬂexible form of inﬂation targeting in the near future. Although inﬂation targeting
in the USA would probably have provided small beneﬁts in recent years because ofthe superb performance of the Federal Reserve under Greenspan and the tremendous
credibility that Alan Greenspan has achieved, now is not the time to be complacent.
It is time to make sure that the legacy of Greenspan’s Federal Reserve of low and
stable inﬂation is maintained. Adopting an inﬂation target is the best way for the
Federal Reserve to do this.
Notes
Any views expressed in this chapter are those of the author only and not those of Columbia University or
the National Bureau of Economic Research.
1. For example, see Alesina and Summers (1993), Cukierman (1992), and Fischer (1994). However, there is
some question whether causality runs from central bank independence to low inﬂation, or rather, whethera third factor is involved, such as the general public’s preferences for low inﬂation that create both centralbank independence and low inﬂation (Posen, 1995).
2. Detailed analyses of experiences with inﬂation targeting can be found in Leiderman and Svensson
(1995), Haldane (1995), Mishkin and Posen (1997) and Bernanke et al. (1999).260 Chapter 11

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IIIMonetary Policy Strategy in Emerging Market and Transition
Economies

Introduction to Part III
Before going to the Federal Reserve Bank of New York in September 1994, I had
done very little research on emerging market countries, focusing most of my research
on the United States. Indeed, although I had traveled extensively, it was almost
always to advanced countries. My experience with the developing countries, now re-
ferred to as emerging market countries, which were then coming onto the international
stage, was extremely limited. This all changed when, shortly after arriving at the New
York Fed, the Mexican ‘‘tequila’’ crisis erupted in December 1994. Bill McDonough,the president of the bank, was continually asking me about what was going on in
Mexico and I didn’t have good answers. In early 1995, I was sent down to the Bank
of Mexico to interact with my counterparts there and I came to realize that many of
the prevailing assumptions about how the macro economy works were based on the
institutional features that apply to advanced economies, but which are not descrip-
tive of conditions in emerging market countries. I began a learning process that has
continued ever since and has led me to put a lot of my research e¤orts into thinking
about better policy prescriptions for emerging market countries.
My initial interest in emerging market countries focused on ﬁnancial crises (for ex-
ample, Mishkin 1996, 1998a,b,c, 1999a,b,c, 2003; and Hahm and Mishkin 2000),
culminating in my recent book, The Next Great Globalization: How Disadvantaged
Nations Can Harness Their Financial Systems to Get Rich (2006). Given my interest
in monetary policy strategy, it was natural that I would broaden my research to
think about monetary policy strategies in emerging market and transition countries
(which are emerging market countries that were previously under the yoke of com-
munism). These topics are the subject of this part of the book.
For the 1999 Inter-American Seminar on Economics, I was invited to write a pa-
per on monetary policy in Latin America. The ensuing work resulted in chapters 12,
13, and 14. Chapters 13 and 14 were written in 1999 with Miguel Savastano, a Peru-
vian, who I met when I was conducting an evaluation of research activities in the In-ternational Monetary Fund for the executive board of that institution. (The outcome
of that evaluation can be found in Giavazzi, Mishkin, and Srinivasan [2000].) These

two chapters originally were combined into one paper for the conference, but space
limitations in the journal required that the paper be broken into two separate papers.
Chapter 13 lays out a general framework to evaluate possible monetary policy strat-
egies for Latin America that may help lock in the gains attained by the region during
the 1990s in the ﬁght against inﬂation, while chapter 14 contains case studies sup-
porting the analysis laid out in the preceding chapter. After writing the papers withMiguel, I wrote a shorter paper with a narrower focus on inﬂation targeting in
emerging market countries, which was presented at the American Economic Associ-
ation meetings in 2000.
In these three chapters, I argue that much of the debate about the Latin American
conduct of monetary policy has been misfocused on whether the nominal exchange
rate should be ﬁxed or ﬂexible. Instead, the emphasis should be on whether the mon-
etary policy regime appropriately constrains discretion in monetary policymaking.
This alternative focus suggests that there are three basic frameworks that deserve se-
rious discussion to ensure viable and e¤ective long-run strategies for monetary policy
in Latin America: 1) a hard exchange-rate peg, 2) monetary targeting, and 3) inﬂa-
tion targeting. These chapters look at the advantages and disadvantages of each ofthese strategies in light of the recent track record of monetary policy in several Latin
American countries for clues as to which of the three strategies might be best suited
to the region’s economies. The conclusion is that countries that do not appear to
have political and other institutional checks to constrain monetary policy may need
to resort to hard pegs, including full dollarization, which allow little or no discretion
to the monetary authorities. On the other hand, there are many Latin American
countries that seem to have the ability to constrain discretion, with Chile being the
clearest example, and for these cases inﬂation targeting is likely to produce a mone-
tary policy that keeps inﬂation low and yet appropriately copes with domestic andforeign shocks.
Given my interest in emerging market countries, it seemed natural to study inﬂa-
tion targeting in transition countries that have recently emerged from communism.
Transition countries are worth studying because of three unique features: 1) these
are new democracies, 2) these nations are undergoing radical restructuring, and 3)
they are very likely to enter the European Union (EU) and Economic and Monetary
Union (EMU) in the near future. I thus wrote chapter 15 with Jiri Jonas, a Czech
who knows these countries well. We met while I was evaluating the IMF’s research
activities, and we presented the paper at an NBER conference in 2003. In this chap-
ter, we look at the inﬂation targeting experience in the three transition countries that
have adopted it: the Czech Republic, Poland, and Hungary. While these countrieshave often missed inﬂation targets by a large margin, they nevertheless progressed
well with disinﬂating their economies. A key lesson from the experience of the
inﬂation-targeting transition countries is that economic performance will improve,266 Introduction to Part III

and support for the central bank will be higher, if the central banks emphasize avoid-
ing undershooting the inﬂation target as much as they try avoiding overshooting it.
Undershooting the inﬂation target eroded support for the central bank in both the
Czech Republic and Poland. Economic performance will be enhanced if inﬂation-
targeting central banks in transition countries do not engage in active manipulation
of the exchange rate, which created problems in Hungary. The relationship betweenthe central bank and the government in these countries has been quite di‰cult, but
this conﬂict can be alleviated by having the government directly involved in setting
the inﬂation target and having the central bank take a more active role in communi-
cating with both the government and the public. In addition, having technocrats
appointed as the head of the central bank rather than politicians, as has been com-
mon in transition countries, may help depersonalize the conduct of monetary policy
and increase support for central bank independence. The chapter also addresses the
future perspective of monetary policy in these three transition economies that are
slated for EU accession: inﬂation targeting can remain the main pillar of monetary
strategy even after these three countries join the EU and before they join the EMU.
After a decade of experience with inﬂation targeting, a post-mortem analysis of
the experience seemed worth pursuing. Chapter 16 was written with Klaus Schmidt-
Hebbel of the Central Bank of Chile and was presented at their annual conference in
2000. This is a wide-ranging chapter that reviews brieﬂy the main design features of
eighteen inﬂation targeting experiences, analyzes statistically if countries under inﬂa-
tion targeting are structurally di¤erent from noninﬂation-targeting industrial coun-
tries, and reviews existing evidence about the success of inﬂation targeting. It then
looks at the interaction of inﬂation targeting design features and the conduct of mon-
etary policy during the transition to low inﬂation. The chapter ends by discussing
two unresolved issues: what the long-run inﬂation goal should be and the merits oftargeting the price level rather than inﬂation. The chapter’s message is that inﬂation
targeting has been quite successful in controlling inﬂation and improving the
economic performance. Yet there is still much to learn about how best to operate
inﬂation-targeting regimes.
The ﬁnal two chapters of this part of the book look at the perennial debate over
whether to ﬁx or ﬂoat the exchange rate as part of a monetary policy strategy. Chap-
ter 17, written in 1998, suggests that although pegging the exchange rate provides a
nominal anchor for emerging market countries that can help them control inﬂation,
there are serious problems with this strategy. First, there are the usual criticisms that
exchange-rate pegging entails the loss of an independent monetary policy, exposes
the country to the transmission of shocks from the anchor country, increases the like-lihood of speculative attacks, and potentially weakens the accountability of policy-
makers to pursue anti-inﬂationary policies. However, most damaging to the case for
exchange-rate pegging in emerging market countries is that this strategy can increaseIntroduction to Part III 267

ﬁnancial fragility and make the potential for ﬁnancial crises more likely. Because of
the devastating e¤ects on the entire economy that ﬁnancial crises can leave in their
wake, an exchange-rate peg is a very dangerous strategy for controlling inﬂation in
emerging market countries. A strategy with a greater likelihood of success involves
granting of independence to the central bank and having it adopt an inﬂation-
targeting regime.
My thinking on the ﬁx-versus-ﬂex debate, however, has evolved over time, partic-
ularly because of my interaction with Guillermo Calvo, who has been a close friend
for a very long time. (Guillermo, along with Maury Obstfeld, was very active in
recruiting me to Columbia more than twenty years ago.) In the economics profes-
sion, Guillermo and I have often been viewed as being on the opposite sides of the
ﬁx-versus-ﬂex debate: Guillermo has been a hard peg advocate in the past and I
have been a strong proponent of ﬂexible exchange rates with inﬂation targeting. In
conversations together, often late at night over a very good bottle of wine, Guillermo
and I realized that we have much more in common between our views than ﬁrst
appeared to be the case. We thus started to write chapter 18 in 2002, ﬁnished in
2003, which sets out our argument that too much attention in emerging market coun-tries has been focused on the ﬁx-versus-ﬂex debate, a point that Miguel Savastano
and I also make in chapter 13. Guillermo and I argue that the standard theory of
the exchange-rate regime choice in emerging market countries is missing some key
elements because it leaves out the special institutional features of emerging market
countries. The chapter next discusses a range of institutional traits that might predis-
pose a country to favor either ﬁxed or ﬂoating rates, and then turns to the converse
question of whether the choice of exchange-rate regime may favor the development
of certain desirable institutional traits. We end up believing that the key to macro-
economic success in emerging market countries is not primarily their choice ofexchange-rate regime, but rather the health of the individual country’s fundamental
macroeconomic institutions including the institutions associated with ﬁscal, ﬁnancial,
and monetary stability. We conclude that less attention should be focused on the
general question of whether a ﬂoating or ﬁxed exchange rate is preferable, and more
on these deeper institutional arrangements. In other words, ‘‘It’s the Institutions, Stu-
pid.’’ We believe that a focus on institutional reforms rather than on the exchange-
rate regime may encourage emerging market countries to be healthier and less prone
to the crises that we have seen in recent years.
References
Giavazzi, Francesco, Frederic S. Mishkin, and T. N. Srinivasan. 2000. External Evaluation of IMF Eco-
nomic Research Activities: Report by a Group of Independent Experts . International Monetary Fund:
Washington DC.268 Introduction to Part III

Hahm, Joon-Ho, and Frederic S. Mishkin. 2000. ‘‘The Korean Financial Crisis: An Asymmetric Informa-
tion Perspective.’’ Emerging Markets Review , vol. 1, no. 1 (2000): 21–52.
Mishkin, Frederic S. 1996. ‘‘Understanding Financial Crises: A Developing Country Perspective.’’ In
Michael Bruno and Boris Pleskovic, eds., Annual World Bank Conference on Development Economics
1996. World Bank: Washington DC: 29–62.
Mishkin, Frederic S. 1998a. ‘‘The Mexican Financial Crisis of 1994–95.’’ In Scheherazade S. Rehman, ed.,
Financial Crisis Management in Regional Blocs . Kluwer Academic Publishers: Boston: 149–181.
Mishkin, Frederic S. 1998b. ‘‘International Capital Movements, Financial Volatility and Financial Insta-
bility.’’ Schriften des Vereins fur Socialpolitik, Band 261, zugleich Beiheft 7, Zeitschrift fur Wirtschafts- und
Sozialwissenschaften, Jahrestagung 1997, Finanzmarkete im Spannungsfeld von Globalisierung, Regulierungund Geldpolitik , Dieter Duwendag, ed. Drucker and Humblot: Berlin: 11–40.
Mishkin, Frederic S. 1999a. ‘‘Lessons from the Asian Crisis.’’ Journal of International Money and Finance
18, 4 (August): 709–723.
Mishkin, Frederic S. 1999b. ‘‘Lessons from the Tequila Crisis.’’ Journal of Banking and Finance 23 (1999):
1521–1533.
Mishkin, Frederic S. 1999c. ‘‘Global Financial Instability: Framework, Events, Issues.’’ Journal of Eco-
nomic Perspectives (Fall), vol. 13, no. 4: 3–20.
Mishkin, Frederic S. 2003. ‘‘Financial Policies and the Prevention of Financial Crises in Emerging Market
Countries.’’ In Martin Feldstein, ed., Economic and Financial Crises in Emerging Market Countries . Chi-
cago: University of Chicago Press: 93–130.
Mishkin, Frederic S. 2006. The Next Great Globalization: How Disadvantaged Nations Can Harness Their
Financial Systems to Get Rich . Princeton, N.J.: Princeton University Press.Introduction to Part III 269

12Inflation Targeting in Emerging Market Countries
Frederic S. Mishkin
The unhappy experience of Latin American and East Asian countries with pegged
exchange-rate regimes when those countries found themselves in deep ﬁnancial crises
in the 1990’s has led emerging-market countries to search for alternative nominal
anchors. (I am including transition countries in Eastern Europe and the former So-
viet Union in the emerging-market category.) Inﬂation targeting, a monetary policy
strategy which has been successfully used by a number of industrialized countries,
has thus become an increasingly attractive alternative and has been adopted by agrowing number of emerging-market countries, including Chile, Brazil, the Czech
Republic, Poland, and South Africa. In this chapter, I outline what inﬂation target-
ing involves for these countries and discuss the advantages and disadvantages of this
monetary-policy strategy. The bottom line is that, although inﬂation targeting is not
a panacea and may not be appropriate for many emerging-market countries, it can
be a highly useful monetary policy in a number of them.
12.1 What Is Inflation Targeting?
Inﬂation targeting is a monetary-policy strategy that encompasses ﬁve main ele-ments: (i) the public announcement of medium-term numerical targets for inﬂation;
(ii) an institutional commitment to price stability as the primary goal of monetary
policy, to which other goals are subordinated; (iii) an information-inclusive strategy
in which many variables, and not just monetary aggregates or the exchange rate, are
used for deciding the setting of policy instruments; (iv) increased transparency of the
monetary-policy strategy through communication with the public and the markets
about the plans, objectives, and decisions of the monetary authorities; and (v)
increased accountability of the central bank for attaining its inﬂation objectives.
The list should clarify one crucial point about inﬂation targeting: it entails much
more than a public announcement of numerical targets for inﬂation for the yearahead. This is important in the context of emerging markets countries because
many of them routinely reported numerical inﬂation targets or objectives as part of

the government’s economic plan for the coming year, and yet their monetary-policy
strategy should not be characterized as inﬂation targeting, which requires the other
four elements for it to be sustainable over the medium term.
12.2 Advantages of Inflation Targeting
Inﬂation targeting has several advantages as a medium-term strategy for monetarypolicy. In contrast to an exchange-rate peg, inﬂation targeting enables monetary pol-
icy to focus on domestic considerations and to respond to shocks to the domestic
economy. In contrast to monetary targeting, another possible monetary policy strat-
egy, inﬂation targeting has the advantage that a stable relationship between money
and inﬂation is not critical to its success: the strategy does not depend on such a re-
lationship, but instead uses all available information to determine the best settings
for the instruments of monetary policy. Inﬂation targeting also has the key advan-
tage that it is easily understood by the public and is thus highly transparent.
Because an explicit numerical target for inﬂation increases the accountability of
the central bank, inﬂation targeting also has the potential to reduce the likelihoodthat the central bank will fall into the time-inconsistency trap. Moreover, since the
source of time-inconsistency is often found in (covert or open) political pressures on
the central bank to undertake overly expansionary monetary policy, inﬂation target-
ing has the advantage of focusing the political debate on what a central bank can do
in the long-run (i.e., control inﬂation) rather than what it cannot do (raise output
growth, lower unemployment, and increase external competitiveness) through mone-
tary policy.
For inﬂation targeting to deliver these outcomes, there must exist a strong institu-
tional commitment to make price stability the primary goal of the central bank. Thisis particularly important in emerging-market countries which have often had a past
history of monetary mismanagement. The institutional commitment involves legisla-
tive support for an independent central bank whose charter ought to contain two key
features: (i) su‰cient insulation of the policy-making board of the central bank from
the politicians, with members of the government excluded and the members of the
board appointed to long terms and protected from arbitrary dismissal; and (ii) giving
the central bank full and exclusive control over the setting of monetary-policy instru-
ments. The institutional commitment to price stability also requires that the central
bank be given a mandate to have price stability as its primary goal, making it clear
that when there is a conﬂict with other goals, such as exchange-rate stability or pro-
motion of high employment, price stability must be accorded the higher priority.
Inﬂation-targeting regimes also put great stress on the need to make monetary pol-
icy transparent and to maintain regular channels of communication with the public;
in fact, these features have been central to the strategy’s success in industrialized272 Chapter 12

countries. As illustrated in Mishkin and Adam Posen (1997) and in Ben Bernanke
et al. (1999), inﬂation-targeting central banks have frequent communications with
the government, and their o‰cials take every opportunity to make public speeches
on their monetary-policy strategy. Inﬂation-targeting central banks have taken pub-
lic outreach a step further: they publish ‘‘Inﬂation Report’’-type documents (origi-
nated by the Bank of England) to present clearly their views about the past andfuture performance of inﬂation and monetary policy.
Another key feature of inﬂation-targeting regimes is that the transparency of pol-
icy associated with inﬂation targeting has tended to make the central bank highly
accountable to the public. Sustained success in the conduct of monetary policy as
measured against a preannounced and well-deﬁned inﬂation target can be instrumen-
tal in building public support for an independent central bank, even in the absence of
a rigidly deﬁned and legalistic standard of performance evaluation and punishment.
12.3 Disadvantages of Inflation Targeting
Critics of inﬂation targeting have noted seven major disadvantages of this monetarypolicy strategy. Four of those disadvantages (that inﬂation targeting is too rigid, that
it allows too much discretion, that it has the potential to increase output instability,
and that it will lower economic growth) have been discussed in Mishkin (1999) and
in Bernanke et al. (1999) and are in reality not serious objections to a properly
designed inﬂation-targeting strategy, which is best characterized as ‘‘constrained dis-
cretion.’’ The ﬁfth disadvantage, that inﬂation targeting can only produce weak
central-bank accountability because inﬂation is hard to control and because there
are long lags from the monetary-policy instruments to the inﬂation outcomes, is an
especially serious one for emerging-market countries. The sixth and seventh dis-advantages, that inﬂation targeting cannot prevent ﬁscal dominance, and that the
exchange-rate ﬂexibility required by inﬂation targeting might cause ﬁnancial instabil-
ity, are also very relevant in the emerging-market-country context.
In contrast to exchange rates and monetary aggregates, the inﬂation rate cannot be
easily controlled by the central bank; furthermore, inﬂation outcomes that incorpo-
rate the e¤ects of changes in instruments settings are revealed only after a substantial
lag. The di‰culty of controlling inﬂation creates a particularly severe problem for
emerging-market countries when inﬂation is being brought down from relatively
high levels. In those circumstances, inﬂation forecast errors are likely to be large, in-
ﬂation targets will tend to be missed, and it will be di‰cult for the central bank to
gain credibility from an inﬂation-targeting strategy, and for the public to ascertainthe reasons for the deviations. This suggests that, as noted by Paul Masson et al.
(1997), inﬂation targeting is likely to be a more e¤ective strategy if it is phased in
only after there has been some successful disinﬂation.Inflation Targeting in Emerging Market Countries 273

One other factor a¤ecting inﬂation controllability that is especially relevant in the
emerging-market context is the (at times large) incidence of government-controlled
prices on the index used to compute headline inﬂation. As a result, inﬂation targeting
may demand a high degree of coordination between monetary and ﬁscal authorities
on the timing and magnitude of future changes in controlled prices or, alternatively,
the exclusion of controlled prices from the targeted price index, as in the CzechRepublic.
A sixth shortcoming of inﬂation targeting is that it may not be su‰cient to ensure
ﬁscal discipline or to prevent ﬁscal dominance. Governments can still pursue irre-
sponsible ﬁscal policy with an inﬂation-targeting regime in place. In the long run,
large ﬁscal deﬁcits will cause an inﬂation-targeting regime to break down: the ﬁscal
deﬁcits will eventually have to be monetized or the public debt eroded by a large de-
valuation, and high inﬂation will follow. Absence of outright ﬁscal dominance is
therefore a key prerequisite for inﬂation targeting, and the setting-up of institutions
that help keep ﬁscal policy in check are crucial to the success of the strategy (Masson
et al., 1997). Similarly, a sound ﬁnancial system is another prerequisite for successful
inﬂation targeting because, when ﬁnancial systems blow up, there is typically a surgein inﬂation in emerging-market countries. However, as pointed out in Mishkin and
Miguel Savastano (2000), a sound ﬁnancial system and the absence of ﬁscal domi-
nance are also crucial to the sustainability and success of any other monetary-policy
strategy, including a currency board or full dollarization. Indeed, inﬂation targeting
may help constrain ﬁscal policy to the extent that the government is actively involved
in setting the inﬂation target (including through the coordination of future adjust-
ments to government-controlled prices).
Finally, a high degree of (partial) dollarization may create a potentially serious
problem for inﬂation targeting. In fact, in many emerging-market countries, the bal-ance sheets of ﬁrms, households, and banks are substantially dollarized, on both
sides, and the bulk of long-term debt is denominated in dollars (Guillermo Calvo,
1999). Because inﬂation targeting necessarily requires nominal exchange-rate ﬂexibil-
ity, exchange-rate ﬂuctuations are unavoidable. However, large and abrupt depre-
ciations may increase the burden of dollar-denominated debt, produce a massive
deterioration of balance sheets, and increase the risks of a ﬁnancial crisis along the
lines discussed in Mishkin (1996). This suggests that emerging-market countries can-
not a¤ord to ignore the exchange rate when conducting monetary policy under inﬂa-
tion targeting, but the role they ascribe to it should be clearly subordinated to the
inﬂation objective. It also suggests that inﬂation targeting in partially dollarized
economies may not be viable unless there are stringent prudential regulations on(and strict supervision of ) ﬁnancial institutions that ensure that the system is capable
of withstanding exchange-rate shocks.274 Chapter 12

12.4 Lessons from Recent Experience
The earliest example of an emerging-market country’s adoption of inﬂation targeting
is Chile, which in 1990, with the inﬂation rate in excess of 20 percent, ﬁrst started to
announce an inﬂation objective in September for the 12-month inﬂation rate ending
in December of the following year. 1As pointed out above, for inﬂation targeting to
be a success, institutions in the country must support independence of the central
bank, as well as a strong ﬁscal position and sound ﬁnancial system. Before embark-
ing on inﬂation targeting, Chile passed new central-bank legislation in 1989 (that
took e¤ect in 1990), which gave independence to the central bank and mandated
price stability as one of its primary objectives. 2A sound ﬁscal policy was also in
place, with the ﬁscal balance in surplus in every year from 1991 to 1997. In addition,
due largely to the measures taken in the aftermath of its severe banking crisis in the
early 1980’s, Chile’s standards and practices in the areas of banking regulation andsupervision were of a quality comparable to those found in industrialized countries.
Chile’s central bank was well aware of the di‰culty of controlling inﬂation and
precisely hitting the target when inﬂation was in the double digits, and it dealt with
this problem in several ways. First, like the industrialized countries that have
adopted inﬂation targeting (see Bernanke et al., 1999), Chile phased in inﬂation tar-
geting gradually after initial successes in lowering inﬂation. When the inﬂation ob-
jective was ﬁrst announced in September 1990, it was interpreted more as o‰cial
inﬂation projections rather than as formal or ‘‘hard’’ targets. Only after the central
bank experienced success in both meeting the inﬂation objectives and lowering inﬂa-tion, did it begin to emphasize that the inﬂation objectives should be interpreted as
hard targets for which the central bank would be accountable (Felipe Morande and
Klaus Schmidt-Hebbel, 1997). Second, Chile’s central bank pursued a very gradualist
approach to lowering its inﬂation objectives, starting with targets of over 20 percent
for 1991 and lowering them slowly to 3.5 percent by the end of the decade. Third,
because of the di‰culty of controlling inﬂation at inﬂation rates which were still
above 10 percent, a realistic range for the inﬂation outcomes would have been very
large. Thus, as part of the process of hardening the inﬂation targets, Chile’s central
bank switched from target ranges to point targets with its announcement in Septem-
ber 1994 for the 1995 objective.
The Chilean experience with inﬂation targeting looks quite successful. Inﬂation fell
from levels above 20 percent, when inﬂation projections were ﬁrst introduced, to a
level around 3 percent at present. Over the same period, output growth was very
high, averaging more than 8 percent per year from 1991 to 1997, a level comparable
to those exhibited by the (former) Asian tigers. Only in the last two years has the
economy entered a recession with output growth falling to 3.4 percent in 1998 andInflation Targeting in Emerging Market Countries 275

to a/C02.9-percent rate for the ﬁrst half of 1999. In 1998 the Chilean central bank was
reluctant to ease monetary policy and let the exchange rate depreciate in order to
cushion the e¤ects of a large, negative terms-of-trade shock. Instead, the Chilean
central bank raised interest rates and even narrowed the exchange-rate band. In
hindsight, these decisions appear to have been a mistake: the inﬂation target was un-
dershot, and the economy entered a recession for the ﬁrst time in more than 15 years.Not surprisingly, the central bank came under increased criticism and in 1999
reversed course, by lowering interest rates and allowing the peso to depreciate.
The Chilean example suggests that inﬂation targeting can be used as a successful
strategy for gradual disinﬂation in emerging-market countries, even when initial in-
ﬂation is on the order of 20 percent. It is important to emphasize that the success of
inﬂation targeting cannot be solely attributed to the actions of the Chilean central
bank: supportive policies such as absence of large ﬁscal deﬁcits and rigorous regula-
tion and supervision of the ﬁnancial sector have been crucial to its success. 3Another
important element of Chile’s strategy has been a gradual hardening of the targets
over time. However, the experience in Chile of the last two years, as well as that of
industrialized countries, indicates that a key requirement for successful inﬂation-targeting regimes in emerging-market economies is the recognition that undershoot-
ing inﬂation targets is just as costly as overshooting the targets. Support for an
independent central bank that is pursuing price stability can erode if the central
bank is perceived as focusing solely on lowering inﬂation to the detriment of other
objectives such as minimizing output variability.
In addition, Chile has not yet fully accomplished a full-ﬂedged, inﬂation-targeting
regime. The Chilean central bank has not yet produced an ‘‘Inﬂation Report’’-type
of document, nor does it publish inﬂation forecasts; the accountability mechanisms
of monetary policy are also weak. Brazil, on the other hand, which adopted inﬂationtargeting in the wake of its currency crisis in early 1999, shows that a full-ﬂedged
inﬂation-targeting regime can be put in place remarkably quickly. Within four
months of the announcement by the newly appointed central-bank president that in-
ﬂation targeting would be adopted, the central bank of Brazil implemented an
inﬂation-targeting regime with all the ‘‘bells and whistles’’ found in inﬂation targeters
in industrialized countries, including an ‘‘Inﬂation Report’’ with published inﬂation
forecasts. Despite the initial success of Brazilian inﬂation targeting which has kept
inﬂation below 10 percent despite a substantial exchange-rate depreciation, there are
still serious doubts about whether it will be ultimately successful because it is by no
means clear whether Brazil can solve its deep-rooted ﬁscal problems.
As noted, a critical issue for inﬂation targeting in emerging-market countries is
the role of the exchange rate. Emerging-market countries, including those engaging
in inﬂation targeting, have rightfully been reluctant to adopt an attitude of ‘‘benign276 Chapter 12

neglect’’ of exchange-rate movements, partly because of the existence of a sizable
stock of foreign currency or a high degree of (partial) dollarization. Nonetheless,
emerging-market countries probably have gone too far, for too long, in the direction
of limiting exchange-rate ﬂexibility, not only through the explicit use of exchange-
rate bands, but also through frequent intervention in the foreign-exchange market.
Responding too heavily and too frequently to movements in a ‘‘ﬂexible’’ exchangerate runs the risk of transforming the exchange rate into a nominal anchor for mon-
etary policy that takes precedence over the inﬂation target, at least in the eyes of the
public. One possible way to avoid this problem is for inﬂation-targeting central
banks in emerging-market countries to adopt a transparent policy of smoothing
short-run exchange-rate ﬂuctuations that helps mitigate potentially destabilizing
e¤ects of abrupt exchange-rate changes while making it clear to the public that
they will allow exchange rates to reach their market-determined level over longer
horizons.
Notes
I thank Miguel Savastano for helpful comments. The views expressed in this chapter are exclusively those
of the author and not those of Columbia University or the National Bureau of Economic Research.
1. See Mishkin and Savastano (2000) for a more detailed discussion of the experience with inﬂation target-
ing in Latin America.
2. The legislation also stipulated a central-bank objective to ensure equilibria in domestic and external
payments. Partly because of this, Chile maintained an exchange-rate band around a crawling peg dur-
ing most of the 1990’s. Importantly, however, the central bank made it clear that, when there was a
potential conﬂict between the exchange-rate band and the inﬂation target, the inﬂation target would takeprecedence.
3. The Chilean controls on short-term capital ﬂows have often been cited as another important factor be-
hind the relative stability of the Chilean economy and the success of monetary policy, but rigorous pruden-tial supervision was probably more important. For a recent overview of the debate surrounding Chile’scapital controls, see Sebastian Edwards (1999).
References
Bernanke, Ben S.; Laubach, Thomas; Mishkin, Frederic S. and Posen, Adam S. Inﬂation targeting: Les-
sons from the international experience . Princeton, NJ: Princeton University Press, 1999.
Calvo, Guillermo. ‘‘Capital Markets and the Exchange Rate.’’ Mimeo, University of Maryland, October
1999.
Edwards, Sebastian. ‘‘How E¤ective are Capital Controls?’’ Journal of Economic Perspectives , Fall 1999,
13(4), pp. 65–84.
Masson, Paul R.; Savastano, Miguel A. and Sharma, Sunil. ‘‘The Scope for Inﬂation Targeting in Devel-
oping Countries.’’ International Monetary Fund (Washington, DC) Working Paper No. 97/130, October1997.
Mishkin, Frederic S. ‘‘Understanding Financial Crises: A Developing Country Perspective,’’ in Michael
Bruno and Boris Pleskovic, eds., Annual World Bank Conference on Development Economics . Washington,
DC: World Bank, 1996, pp. 29–62.Inflation Targeting in Emerging Market Countries 277

———. ‘‘International Experiences with Di¤erent Monetary Regimes.’’ Journal of Monetary Economics ,
June 1999, 43(3), pp. 579–606.
Mishkin, Frederic S. and Posen, Adam S. ‘‘Inﬂation Targeting: Lessons from Four Countries.’’ Federal
Reserve Bank of New York Economic Policy Review , August 1997, 3(3), pp. 9–110.
Mishkin, Frederic S. and Savastano, Miguel A. ‘‘Monetary Policy Strategies for Latin America.’’ National
Bureau of Economic Research (Cambridge, MA) Working Paper No. 7617, March 2000.
Morande, Felipe and Schmidt-Hebbel, Klaus. ‘‘Inﬂation Targets and Indexation in Chile.’’ Mimeo, Cen-
tral Bank of Chile, Santiago, August 1997.278 Chapter 12

13Monetary Policy Strategies for Latin America
Frederic S. Mishkin and Miguel A. Savastano
13.1 Why the Issue Is Not Fixed versus Flexible Exchange Rates
The monetary policy experience of Latin America has not been a happy one. Econo-
mies in this region have gone through extreme episodes of monetary instability,swinging from very high inﬂations, to massive capital ﬂight, to collapses in their ﬁ-
nancial systems. The unsurprising outcome has been low credibility, slow growth,
recurrent recessions and even depressions. However, a new era may be dawning in
Latin America. In the past decade or so, most countries in the region have become
outward looking, and the public, politicians and policymakers have come to recog-
nize the high costs of protectionism and inﬂation, producing a growing commitment
to open markets and price stability. Evidence of this more favorable environment are
the successful inﬂation stabilization programs adopted by many Latin American
countries in the early 1990s, and the historically low rates of inﬂation attained bythe region in recent years, falling from an average of over 400% in 1989 to below
10% by 1999. Where should Latin American countries go from here in designing ap-
propriate long-run strategies for the conduct of their monetary policy?
The central issue in addressing this question is whether the countries of the region
have a chance of setting up institutions and mechanisms that will e¤ectively and e‰-
ciently constrain the discretion of their monetary authorities. Whether the exchange
rate is ﬁxed or ﬂexible (and precisely how ﬂexible) follows from the answer one gives
to that question. Thus, we believe that there is a need to refocus the debate away
from a discussion of whether the nominal exchange rate should be ﬁxed or ﬂexible.
One advantage of the alternative approach that focuses on underlying institutions to
appropriately constrain monetary policy discretion rather than on the ﬂexibility ofthe exchange rate is that it allows one to draw on the experiences of countries outside
Latin America to a larger extent than what is possible in the present round of the
‘‘Fix versus Flex’’ debate. 1
In principle, there are four broad monetary policy strategies that can produce a
nominal anchor that credibly constrains the discretion of the central bank over the

medium term: ‘‘hard’’ exchange-rate pegs, ‘‘soft’’ exchange-rate pegs, monetary tar-
geting, and inﬂation targeting. 2The severe shortcomings of soft pegs (in their multi-
ple manifestations) as a medium-term strategy for monetary policy have been amply
demonstrated by recent experiences in industrial and emerging market economies
(including many from Latin America) and need not be repeated here. 3This leaves
us with three potential medium-term strategies for monetary policy that we evaluatein the following sections. In each section, we look at the advantages and disadvan-
tages of each strategy, and then examine the recent experience of relevant Latin
American countries for clues as to which of the three might be best suited for coun-
tries in the region.
13.2 Hard Pegs
There are essentially two types of ‘‘hard peg’’ regimes for monetary policy: a cur-
rency board and full dollarization. In a currency board, the domestic currency is
backed 100% by a foreign currency (say, US dollars) and the note-issuing authority,
whether the central bank or the government, ﬁxes a conversion rate to this currencyand stands ready to exchange domestically issued notes for the foreign currency on
demand. A currency board is a hard peg because the commitment to the ﬁxed ex-
change rate has a legal (or even constitutional) backing and because monetary policy
is, in e¤ect, put on autopilot and completely taken out of the hands of the central
bank and the government. Full dollarization involves eliminating altogether the do-
mestic currency and replacing it with a foreign currency (the US dollar). It represents
a stronger commitment to monetary stability than a currency board because it makes
it much more costly—though still not impossible—for the government to regain con-
trol over monetary policy and/or change the parity of the (non-existent) domesticcurrency.
13.2.1 Advantages of Hard Pegs
The advantages of hard pegs, especially of currency boards, have been discussedextensively in recent years. 4Put succinctly, hard pegs can deliver everything that
ﬁxed-but-adjustable pegs proved incapable of delivering—with or without capital
mobility.
First, they provide a nominal anchor that helps keep inﬂation under control by
tying the prices of domestically produced tradable goods to those in the anchor coun-
try, attenuating (and eventually breaking) the inertial component of inﬂation that
feeds into wages and prices of nontradable goods, and making inﬂation expectationsconverge to those prevailing in the anchor country.
Second, hard pegs reduce and, in the limit, eliminate the currency risk component
from domestic interest rates thus lowering the cost of funds for the government and280 Chapter 13

the private sector and improving the outlook for ﬁnancial deepening, investment,
and growth.
Third, hard pegs provide an automatic adjustment mechanism for the money sup-
ply that helps mitigate (or plainly eliminates) the time-inconsistency problem of mon-
etary policy. A fall in the demand for domestic assets, including domestic currency
notes, produces an automatic outﬂow of hard currency and a rise in interest rateswithout creating pressures on the peg, while an increase in the demand for domestic
assets has the opposite e¤ects. Discretionary, expansionary and time-inconsistent
monetary policy, including to ﬁnance the government deﬁcit, is not a policy option.
Finally, hard pegs have the advantage of simplicity and clarity, which make them
easily understood by the public. A ‘‘sound (foreign) currency’’ policy is an easy-to-
understand rallying cry for monetary stability and, according to some, also for ﬁscal
discipline.
13.2.2 Disadvantages of Hard Pegs
The main disadvantage of a hard peg as a medium term monetary regime is that itleaves (almost) no scope for domestic monetary policy because with open capitalmarkets, a hard peg causes domestic interest rates to be closely linked to those in
the anchor country to which it is pegged. The country which chooses a hard peg
thus loses the ability to use monetary policy to respond to domestic shocks that are
independent of those hitting the anchor country. Furthermore, a hard peg means that
shocks to the anchor country are directly transmitted to the pegging country because
changes in interest rates in the anchor country lead to a corresponding change in do-
mestic interest rates. As long as domestic prices and wages are ‘‘sticky’’ and markets
are incomplete, the loss of an independent monetary policy, which can help the mon-
etary authorities counter the e¤ects of certain of these shocks, can be costly.
This point can be illustrated with the simple model outlined in Svensson (1997),
which comprises an aggregate supply curve:
p
t¼pt/C01ța1yt/C01țet ð13:1Ț
and an aggregate demand curve:
yt¼b1yt/C01/C0b2ðit/C01/C0pt/C01Țțht ð13:2Ț
where pt¼pt/C0pt/C01¼the inﬂation rate at time t(with ptthe log of the price
level), yt¼the output gap (the log of the actual to potential output), it¼the
nominal interest rate, and etand ht, i.i.d. aggregate supply and demand shocks, re-
spectively.
In this setup, optimal monetary policy involves setting the interest rate each period
to minimize the intertemporal loss function:Strategies for Latin America 281

EtXy
t¼tdt/C0tLt ð13:3Ț
where d<1 is the authorities’ discount rate and where the period-by-period loss
function is
Lt¼ðpt/C0p/C3Ț2=2țly2
t=2: ð13:4Ț
The optimal setting of the interest rate is then a ‘‘Taylor rule,’’
it¼ptțb1ðpt/C0p/C3Țțb2yt ð13:5Ț
in which the interest rate responds to both the inﬂation gap, pt/C0p/C3, and the output
gap, yt.5
With a hard peg, the interest rate is in e¤ect set by the anchor country and it will
di¤er from the optimal setting of the interest rate given in Eq. (13.5). The loss from
having a hard peg will be small only if the pegging country is so integrated with the
anchor country that its inﬂation and output gaps are highly correlated since in those
circumstances setting the interest rate on the basis of the conditions prevailing in the
anchor country will also be optimal for the domestic economy. However, this re-quirement is unlikely to be met in practice, particularly if the anchor country is the
United States. 6
The key message from this analysis is that hard pegs will (almost) always represent
a second best solution for most Latin American economies—especially the large
ones, so that these countries are better o¤ having some scope for ‘‘good’’ monetary
policy than having no monetary policy at all. Of course advocates of hard pegs for
Latin America point out that having no monetary policy is better than having
‘‘bad’’—i.e., discretionary and inﬂationary—monetary policy. However, although
Latin America’s dismal monetary history is full of episodes of mismanaged monetarypolicy, it is not clear why the past should serve as a predictor for the future, espe-
cially when one considers the great strides that most countries in the region have
made in lowering inﬂation in recent years.
Another disadvantage of hard pegs is that the central bank, when it exists, loses its
ability to act as a lender of last resort. This may turn out not to be a major drawback
of those regimes in the short run. As discussed in Mishkin (1999b), central banks of
emerging economies typically have very limited scope to act as lenders of last resort,
even under ﬂexible rates. The main reason for this is lack of credibility. Central bank
lending to the banking system in the wake of a ﬁnancial crisis is likely to unleash
fears of an inﬂationary explosion and produce a sharp exchange rate depreciation.
Given the substantial ‘‘liability dollarization’’ of households, ﬁrms and banks inthose economies, the depreciation will tend to have a major negative impact on the
net worth of the private sector, including banks, which will then amplify asymmetric282 Chapter 13

information problems in ﬁnancial markets and exacerbate the ﬁnancial crisis. Over
the longer run, however, as central banks demonstrate their commitment to price sta-
bility and banking supervision is strengthened, those problems will tend to disappear
and the central banks’ scope for acting as lenders of last resort will increase. This is
something that hard peg regimes can never count on having.
13.2.3 Currency Board versus Full Dollarization
The main disadvantage of a currency board relative to full dollarization is that the
former does not eliminate completely the possibility of a devaluation. If investors’
sentiment turns against a country with a currency board and speculators launch an
attack, they are presented with a one-way bet because the only direction the value
of the currency can go is down. The probability of this event is embedded in domes-
tic interest rates, even in ‘‘calm’’ periods, making those rates higher and more volatile
than the ones in the anchor country. These problems are mitigated under full dollari-
zation. Since there is no uncertainty about the value of the currency circulating in the
country (dollars will always be dollars) the currency risk component of domestic in-
terest rates will necessarily disappear, and interest rates will be lower.
However, this does not mean that under full dollarization domestic interest rates
will converge to those prevailing in the US, as has been argued by some—e.g.,
Schuler (1999). Domestic interest rates will continue to carry a country-risk pre-
mium. One important reason for this, but by no means the only one, is that interest
rates will continue to reﬂect a ‘‘conﬁscation risk,’’ at least for a while. Conﬁscation of
assets (denominated in both domestic and foreign currency) has a long tradition in
Latin America. In the early 1980s, Bolivia, Mexico and Peru forcedly converted
dollar deposits held in domestic banks into domestic currency deposits at below
market exchange rates in a desperate—and failed—attempt to arrest capital ﬂight(Savastano, 1992). In the late 1980s, Argentina and Brazil forcedly converted short-
term bank deposits into long-term bonds to lower the government’s interest bill and
pave the way for a rapid disinﬂation. Ecuador’s freeze of bank deposits in March
1999, a year before the abolition of the domestic currency, makes it di‰cult to argue
that the region has abandoned completely those conﬁscatory practices. The logic
here is not just that if it happened (more than) once, it may happen again. Conﬁsca-
tion may be forced upon the authorities.
Consider the following example. Suppose that there is a sudden loss of conﬁdence
in a fully dollarized country that leads to a massive withdrawal of bank deposits,
a severe squeeze of banks’ liquidity and a sharp decline in economic activity. A
country fully committed to preserve full dollarization may be willing and able towithstand the outﬂow and the ensuing economic downturn, but only under some
conditions. In particular, if the attack is driven by perceptions, let alone evidence, of
ﬁscal insolvency, conﬁscation of dollar assets to secure resources for the governmentStrategies for Latin America 283

and prevent a meltdown of the banking system may become a self-fulﬁlling proph-
ecy. Of course, this could happen under both types of hard pegs, and in both cases
the conﬁscation of assets would cause the collapse of the regime and have cata-
strophic consequences for the ﬁnancial system and the real economy. Under full dol-
larization, however, the damage is likely to be far more serious because the domestic
currency and monetary policy that will have to be created from scratch in the after-math will have no credibility. A small probability of this catastrophic event occurring
sometime in the future is more than su‰cient reason to expect a country risk pre-
mium in domestic interest rates under full dollarization.
13.2.4 Lessons from Recent Experience
The two prime examples of hard pegs in Latin America are Argentina and Panama.Both hard pegs were created under special, and quite di¤erent, historical circum-
stances. In the case of Argentina, the hard peg of a currency board was the corner-
stone of the stabilization program of 1990–1991 that ended the hyperinﬂation
episodes of the 1980s. Up until 1999, Panama was the only fully dollarized country
in Latin America, i.e., it was the only country which had decided to adopt the USdollar as the legal tender and to eschew the creation of a central bank, a decision it
made in 1904, the year after the country was founded.
The experiences of these two countries suggest a number of conclusions (see Mish-
kin and Savastano, 2000, for detailed case studies of the two experiences). First, hard
pegs do deliver low inﬂation rates. The ﬁrst 4 years of Argentina’s currency board
were highly successful and have become the textbook example of the beneﬁts of a
currency board for stopping high inﬂation (Hanke and Schuler, 1994). Inﬂation in
Argentina fell from an 800% annual rate in 1990, to less than 5% by 1994 and
declined even more after the Tequila crisis of 1995. Panama’s inﬂation from 1960 to1998 averaged 2.8% per year, which is signiﬁcantly lower than in any other country
in Latin America, and is even lower than the 4.6% average over the same period for
the United States.
Second, there are two necessary conditions for the success of a hard peg: a solid
banking and ﬁnancial system, and sound and sustainable ﬁscal policies. The sole
adoption of a hard peg does not ensure that these two conditions will be met, at least
not rapidly or automatically.
For example, despite its currency board, the weakness of Argentina’s banking sys-
tem almost brought down its (quasi-) currency board during the Tequila crisis of
1995. From December 1994 until March 1995, the prices of Argentine stocks and
bonds plummeted, the banking system lost 17% of its total deposits, the centralbank lost more than a third of its international reserves ($5.5 billion), the money sup-
ply contracted, interest rates shot up—with the interbank rate brieﬂy exceeding 70%,
and external credit lines vanished. The Argentine central bank had its lender of last284 Chapter 13

resort role constrained by the Convertibility Law, yet it mitigated the adverse e¤ects
of the run on bank deposits by lowering reserve requirements, providing direct credit
via rediscounts and swaps, and participating actively in the restructuring, privatiza-
tion and liquidation of troubled banks. By the end of April, the central bank had
managed to provide over $5 billion of liquidity to the banking system, more than a
third of it in the form of direct loans, and was able to avert a large scale collapseof the banking system. Despite all these e¤orts, and substantial assistance from the
multilaterals (the IMF, the World Bank and the Interamerican Development Bank)
the real economy took a nose dive; the May unemployment rate shot up to 18%
and 1995 real GDP fell by more than 3%. It was not until 1996 that the Argentine
economy began to recover.
Panama’s banking system, on the other hand, has earned a reputation of strength
and sophistication. However, although the low inﬂation environment produced by
full dollarization contributed to this outcome, the strength of Panama’s banking sys-
tem cannot be attributed to full dollarization. The take-o¤ of Panama’s ﬁnancial
system only began in 1970 with the passage of a banking law—Cabinet Decree
238—that eased licensing and portfolio allocation requirements on foreign banks,strengthened secrecy provisions, and allowed unrestricted movements of capital
(Moreno, 1999). The goal of transforming Panama into an o¤shore banking center
was achieved fairly quickly. By 1987, there were more than 120 banks located in
the country, the majority foreign-owned, and broad money and private sector credit
as a share of GDP had risen by more than 15 percentage points (to 40% and
54%, respectively). Except for a banking crisis in 1988–1989 which occurred as a
result of economic sanctions imposed on Panama in 1988, including a freezing of
the deposits held in the United States by the Banco Nacional de Panama, the Pana-
manian banking system has fared well. 7One result is that private sector borrowers
in Panama have access to international ﬁnancial markets and can borrow at low
interest rates. Indeed, Panamanian ﬁrms and banks do not face a ‘‘sovereign ceiling’’
and can often borrow at lower rates than the government. However, the small
spread between domestic and foreign interest rates is probably more a reﬂection of
Panama’s sound and internationally oriented banking system than the result of full
dollarization.
On the ﬁscal requirements, small ﬁscal deﬁcits were key to the early success of
Argentina’s currency board but persistent ﬁscal imbalances in the second half of the
1990s, which averaged 2.7% from 1996 to 1998 despite a pick-up in growth, raised
recurrent concerns about the sustainability of the hard peg. The ﬁscal problems of
Panama, on the other hand, have been as entrenched and protracted as those of thetypical (non-dollarized) Latin American country. Panama has had ﬁscal deﬁcits
jumping from 2% of GDP in the 1960s to over 7% in the 1970s, and averaging 5%
in the 1980s. A reﬂection of its ﬁscal proﬂigacy is the fact that Panama has requestedStrategies for Latin America 285

13 IMF programs from 1973 to 1997, more than any country in Latin America dur-
ing that period. The claim that hard pegs ensure ﬁscal discipline and prevent ﬁscal
dominance receives little support from these two experiences.
The third conclusion borne out by these experiences is that hard pegs remain sub-
ject to speculative attacks and bank runs, as evidenced by the spillovers of the Te-
quila crisis on Argentina and the runs on Panama’s banks in the late 1980s.
The fourth conclusion is that hard pegs are ill-equipped to counter country-speciﬁc
shocks and so can lead to increased output volatility. Although Panama’s real GDP
growth has been about one percentage point higher than the average for Latin Amer-
ica from 1960 to 1998, output volatility in Panama has been among the highest in the
region (e.g., see Hausmann and Gavin, 1995). The two recessions that Argentina has
su¤ered in less than 5 years—the ﬁrst after the Tequila crisis which sent the unem-
ployment rate to 18%, and the second accelerated by the Brazilian devaluation in
1999—illustrate even more graphically the consequences for output volatility that a
hard peg can bring.
Another problem of hard pegs is that they do not have an easy exit strategy, not
even when changes in the country’s political and economic institutions make it possi-ble and desirable to have a monetary policy able to focus on domestic considerations.
Exiting from a currency board is highly dangerous unless the currency is likely to ap-
preciate, but this is exactly when things are going well and so the political will to exit
is likely to be weak, or nonexistent. Exiting from a fully dollarized economy is even
more troublesome because the (new) monetary authorities, and the new currency, are
likely to encounter a serious problem of lack of credibility.
These shortcomings notwithstanding, we are of the view that hard pegs may be the
only sustainable monetary policy strategy for those Latin American countries whose
political and economic institutions cannot support an independent central bank fo-cused on preserving price stability. In particular, countries that cannot ﬁnd ways of
locking-in the gains from their recent ﬁght against (high) inﬂation, or those that have
not yet started that ﬁght, may ﬁnd in hard pegs a reasonable second best strategy for
monetary policy.
13.3 Monetary Targeting
A monetary targeting strategy focused on controlling inﬂation comprises three key
elements: (1) reliance on information conveyed by a monetary aggregate to conduct
monetary policy, (2) announcement of targets on a monetary aggregate to guide the
public’s inﬂation expectations, and (3) some accountability mechanism that precludeslarge and systematic deviations from the monetary targets. In addition, the strategy
presupposes that monetary policy is not dictated by ﬁscal considerations—i.e., lack
of ﬁscal dominance—and that the exchange rate is ‘‘ﬂexible.’’286 Chapter 13

13.3.1 Advantages of Monetary Targeting
The two major advantages of monetary targeting over exchange-rate pegs (hard and
soft) are that it enables the central bank to choose goals for inﬂation that may di¤erfrom those of other countries, and that it allows some scope for monetary policy to
deal with transitory output ﬂuctuations and certain external shocks. Also, like an
exchange-rate peg, the strategy is easy to monitor since information on whether the
central bank is complying with its target is readily available—actual ﬁgures for mon-
etary aggregates are typically reported within a couple of weeks. Thus, comparisons
between targeted and actual monetary aggregates might send timely and periodic sig-
nals to the public and markets about the stance of monetary policy and the inten-
tions of the authorities to keep inﬂation in check. In turn, these signals might help
consolidate inﬂation expectations and produce less inﬂation. Targets on money
aggregates might also be conducive to making the central bank accountable for
meeting its low inﬂation objective, helping to mitigate the time-inconsistency prob-lem of monetary policy.
13.3.2 Disadvantages of Monetary Targeting
All the above advantages of monetary targeting depend on a big if: there must be a
strong and reliable relationship between the goal variable (inﬂation) and the mone-
tary aggregate chosen as target. If the relationship between the monetary aggregate
and the goal variable is or becomes weak, monetary targeting will produce poor out-
comes. This is easily seen by adding a money demand equation to the simple model
sketched in section 13.2.
mt/C0pt¼gyt/C0kitțut ð13:6Ț
where mtis the log of money balances and utis an error term. To the extent that
shocks to the money demand error term are large and unpredictable (or that the
parameters of the money demand equation are unstable), the relationship between
the monetary aggregate and output and inﬂation will weaken. In those circum-
stances, targeting the monetary aggregate will lead to large deviations of the interest
rate from the optimal policy as represented by the optimal rule in Eq. (13.5). The re-
sult will be larger volatility of output, inﬂation and interest rates (see Clarida et al.,
1999).
As is well-known and amply documented, a weak and unstable relationship be-
tween monetary aggregates and the rate of inﬂation was the main problem with thisstrategy in industrialized countries. 8Though the existing evidence is not nearly as
conclusive, the problem is likely to be just as bad if not worse for the emerging
economies of Latin America. The main reason for this is that in the new environment
of low inﬂation and increasing ﬁnancial integration, it will be highly unlikely that the
relationship between monetary aggregates and inﬂation in those countries remains,Strategies for Latin America 287

or becomes, stable. A weak and unstable relationship between money and inﬂation
will give rise to situations where hitting the monetary target will not produce the
desired inﬂation outcome, where monetary aggregates will fail to provide reliable sig-
nals of the stance of monetary policy, and where there will be no e¤ective anchor for
inﬂation expectations. Furthermore, a weak relationship between the targeted mone-
tary aggregate and inﬂation will make it di‰cult for the central bank to be transpar-ent and accountable to the public. Although this does not necessarily imply that
monetary policy will be expansionary or irresponsible, it will complicate greatly
the central bank’s communication with the public and the markets, and impair its
credibility.
13.3.3 Lessons from Recent Experience
Despite what is often said, no central bank in Latin America has truly practicedmonetary targeting. In their relatively recent experience with low(er) inﬂation and
ﬂexible exchange rates, the monetary policy frameworks of many Latin American
central banks have contained the ﬁrst of the three key elements mentioned earlier—
i.e., using the information conveyed by a monetary aggregate to conduct monetarypolicy—but the other two elements (public announcements of the targets and some
type of accountability mechanism) rarely have been present at the same time (see
Cottarelli and Giannini, 1997). Regimes where monetary targets are not announced,
or are announced but not given a chance to perform as the main nominal anchor, are
not monetary targeting regimes. A case in point is Peru, which has been often char-
acterized as having undertaken a ‘‘money-based stabilization’’ (e.g., Calvo and Vegh,
1994, 1999) and relied on a monetary anchor to reduce inﬂation (Corbo, 1999;
Favaro, 1996). 9Peru’s central bank did not pursue a monetary targeting strategy
during the 1990s: it did not make its monetary targets public, nor was it accountablefor meeting its targets. Instead the central bank used the information contained in a
monetary aggregate (speciﬁcally, base money) to guide the setting of its policy instru-
ments, a procedure followed in many (non-monetary targeting) industrial countries.
Those central banks in Latin America that have been regarded as monetary targeters
should instead be seen as having followed a discretionary monetary policy with a
focus on price stability. Even if that approach proves to be successful for a period
of time as has been the case in Peru, it is a highly dangerous strategy. Two crippling
shortcomings of the approach are that it depends too much on the preferences, skills
and credibility of the individuals running the central bank, and that it does not lend
itself to make monetary policy transparent and accountable. 10
The instability of the money-inﬂation relationship has also been very visible in
Latin America. For example, Peru’s central bank did not make its targets for money
base growth public during the 1990s because it was highly aware of the uncertainties288 Chapter 13

surrounding the demand for this aggregate in a dollarized economy (80% of bank
deposits and loans in Peru are dollar-denominated). Mexico’s central bank also has
found the monetary base target it adopted as part of its program with the IMF in the
aftermath of the Tequila crisis to be highly problematic. In 1997, the monetary base
exceeded its target by 4.1%, yet inﬂation fell to 15.7%, close to its year-end objective
of 15%, while in 1998, inﬂation exceeded the year-end objective of 12% by almost 7percentage points, even though base money ended up 1.5% below its forecast. The
opposite problem occurred in 1999, when the inﬂation rate fell below the year-end
target (12.3% versus 13%) while base money exceeded its target by more than 21%.
Not surprisingly, with this record, the Bank of Mexico under Guillermo Ortiz has
backed o¤ from its ﬂirtation with monetary targeting, downplaying publicly the role
that money base forecasts play in the setting of monetary policy. Indeed, as we will
argue in the next section, the Bank of Mexico has been gradually moving in the di-
rection of inﬂation targeting.
The recent experiences of Mexico and Peru illustrate the di‰culties that the insta-
bility of the money-inﬂation relationship creates for monetary targeting as a strategy
for monetary policy in Latin America. This does not mean that monetary aggregateshave no role to play in the conduct of monetary policy in the region. The signal-to-
noise ratio of monetary aggregates in many countries is likely to be high owing to
their history of high inﬂation and large swings in money growth. However, as inﬂa-
tion falls to single digit levels and remains there, money growth rates are likely to
lose informational content and become less useful indicators of monetary policy, as
occurred in industrial countries (see Estrella and Mishkin, 1997). As money aggre-
gates become less reliable indicators of future inﬂation, central banks will be forced
to downplay the importance of monetary targets, and search for alternative nominal
anchors and communication devices.
In sum, monetary targeting is a strategy for monetary policy that has not been
used by Latin American countries in the recent past, and is probably not an advis-
able medium-term strategy for the future. This is so because the problems that led
to the abandonment of this strategy in industrialized countries (Bernanke and Mis-
hkin, 1992) are also likely to arise in Latin America as low inﬂation becomes a
more permanent feature. Indeed, even Germany, the quintessential monetary tar-
geter, encountered problems with the money–inﬂation relationship which led the
Bundesbank to miss the target ranges for its monetary targets on the order of half
the time. 11The secret to the Bundesbank’s success was its long-term adherence to a
‘‘monetarist’’ framework to communicate to the public its commitment to price sta-
bility, along with the credibility it earned over the years which made its explanationsof target misses believable to the public. Germany’s relative success with monetary
targeting is not a model for Latin America, where central banks need to assert theirStrategies for Latin America 289

credibility over the next few years. In fact, the Bundesbank’s success may not even be
a model for how the European Central Bank should conduct monetary policy (see
Bernanke et al., 1999; Mishkin, 1999a).
13.4 Inflation Targeting
Inﬂation targeting is a monetary policy strategy that involves ﬁve main elements: (1)the public announcement of medium-term numerical targets for inﬂation; (2) an insti-
tutional commitment to price stability as the primary goal of monetary policy, to
which other goals are subordinated; (3) an information-inclusive strategy in which
many variables, and not just monetary aggregates or the exchange rate, are used for
deciding the setting of policy instruments; (4) a transparent monetary policy strategy
that ascribes a central role to communicating to the public and the markets the plans,
objectives, and rationale for the decisions of the central bank; and (5) mechanisms
that make the central bank accountable for attaining its inﬂation objectives. The list
should clarify one crucial point about inﬂation targeting: it entails much more than a
public announcement of numerical targets for inﬂation for the year ahead. This is im-portant in the Latin American context, because many countries in the region have
routinely reported numerical inﬂation targets or objectives as part of the govern-
ment’s economic plan for the coming year (see Fry et al., 1999) and yet they have
notbeen pursuing an inﬂation targeting strategy. The monetary policy strategy must
contain the other four elements listed above for it to be consistent with inﬂation tar-
geting and, hence, sustainable over the medium term.
13.4.1 Advantages of Inflation Targeting
Inﬂation targeting has several advantages over hard pegs and monetary targeting as
a medium-term strategy for monetary policy. In contrast to a hard peg, inﬂation tar-
geting enables monetary policy to focus on domestic considerations and to respond
to shocks of both domestic and foreign origin. Inﬂation targeting also has the advan-
tage that stability in the relationship between money and inﬂation is not critical to its
success because it does not depend on such a relationship. Indeed, an inﬂation target-
ing strategy allows the monetary authorities to use all available information, and not
just the information contained in one or two variables, to determine the best settings
for the instruments of monetary policy. This is also illustrated by the model sketched
in section 13.2 (Eqs. (13.1)–(13.5)). If the weight on output ﬂuctuations in the period
loss function is zero, i.e., l¼0 in Eq. (13.4), then Svensson (1997) has shown that
setting the interest rate instrument according to the optimal rule in Eq. (13.5) isequivalent to making the expected value of the inﬂation rate two periods ahead equal
to the inﬂation target, i.e.,290 Chapter 13

Etptț2¼p/C3: ð13:7Ț
In other words, setting monetary policy so as to attain the inﬂation target two peri-
ods (years) ahead is an optimal policy under these conditions. If l>0, i.e., if policy-
makers are also concerned about output ﬂuctuations, then the interest rate instrument
is also set according to Eq. (13.5), but now optimal policy implies that the approach
to the inﬂation target is more gradual, i.e.,
Etptț2/C0p/C3¼cðEtptț1/C0p/C3Ț: ð13:8Ț
Svensson calls this type of policy reaction ‘‘ﬂexible inﬂation targeting,’’ and the evi-
dence discussed in Bernanke et al. (1999) suggests that it is a realistic approximation
of what inﬂation targeting countries do in practice.
Because an explicit numerical target for inﬂation increases the accountability of
the central bank relative to a discretionary regime, inﬂation targeting also has the
potential to reduce the likelihood that the central bank will fall into the time-
inconsistency trap. Moreover, since the source of time-inconsistency is often found
in (covert or open) political pressures on the central bank to engage in expansionary
monetary policy, inﬂation targeting has the advantage of focusing the political de-
bate on what a central bank can do on a sustainable basis—i.e., control inﬂation—rather than on what it cannot do through monetary policy—e.g., raise output growth,
lower unemployment, or increase external competitiveness.
For inﬂation targeting to deliver these outcomes, there must exist a strong institu-
tional commitment to make price stability the primary goal of the central bank. This
is particularly important in Latin America, given its history of monetary mismanage-
ment. The institutional commitment involves legislative support for an independent
central bank whose charter ought to contain two key features: (1) su‰cient insulation
of the decision-making board of the central bank from the political process and the
politicians—with the members of the board appointed to long terms and protected
from arbitrary dismissal; and (2) giving the central bank full and exclusive control
over the setting of monetary policy instruments. The institutional commitment toprice stability also requires that the central bank be given a mandate to have price
stability as its primary goal, making it clear that when there is a (perceived or actual)
conﬂict with other goals, such as exchange rate stability or promotion of high em-
ployment, price stability must be accorded the higher priority.
Inﬂation-targeting regimes also put great stress on the need to make monetary pol-
icy transparent and to maintain regular channels of communication with the public;
in fact, these features are central to the strategy’s success. Inﬂation-targeting central
banks have frequent communications with the government, some mandated by law
and some in response to informal inquiries, and their o‰cials take every opportunityto make public speeches on their monetary policy strategy. While these practices areStrategies for Latin America 291

also commonly used in countries that have not adopted inﬂation targeting (promi-
nent examples being Germany and the United States), inﬂation-targeting central
banks have taken public outreach a step further: not only do they engage in extended
public information campaigns, but they publish Inﬂation Report -type documents (ori-
ginated by the Bank of England) to present their views about the past and future per-
formance of inﬂation and monetary policy. The publication of these documents isnoteworthy because they represent a departure from the traditional, more formal
reports of central banks and introduce new design elements that help enhance com-
munication with the public.
The rationale for ascribing a central role to communication under inﬂation target-
ing is to keep the general public, ﬁnancial markets and the politicians permanently
informed about: (1) the goals and limitations of monetary policy, including the ratio-
nale for inﬂation targets; (2) the numerical values of the inﬂation targets and how
they were determined; (3) how the inﬂation targets are to be achieved, given current
economic conditions—i.e., baseline inﬂation forecasts; and (4) reasons for any devia-
tions from targets. In countries that have adopted inﬂation targeting, this emphasis
on communication has improved private-sector planning by reducing uncertaintyabout monetary policy, interest rates and inﬂation; has promoted public debate of
monetary policy, in part by educating the public about what a central bank can and
cannot achieve; and has helped clarify the responsibilities of the central bank and of
politicians in the conduct of monetary policy (see Bernanke et al., 1999).
Another key feature of inﬂation-targeting regimes is the tendency toward increased
accountability of the central bank. Indeed, transparency and communication go hand
in hand with increased accountability. The strongest case of accountability of a cen-
tral bank in an inﬂation-targeting regime is that of New Zealand, where the govern-
ment has the right to dismiss the Reserve Bank’s governor if the inﬂation targets arebreached, even for one quarter. In other inﬂation-targeting countries, the central
bank’s accountability is less formalized. Nevertheless, the transparency of policy
associated with inﬂation targeting has tended to make the central bank highly ac-
countable to the public and the government. Sustained success in the conduct of
monetary policy as measured against a pre-announced and well-deﬁned inﬂation tar-
get can be instrumental in building public support for an independent central bank,
even in the absence of a rigid standard of performance evaluation and penalties.
13.4.2 Disadvantages of Inflation Targeting
Critics of inﬂation targeting have noted at least seven major disadvantages of thismonetary policy strategy. Four of those disadvantages—that inﬂation targeting istoo rigid, that it is tantamount to full discretion, that it necessarily increases output
instability, and that it hurts economic growth—we believe are misplaced. The ﬁfth
disadvantage, that inﬂation targeting can only produce weak central bank account-292 Chapter 13

ability because inﬂation is hard to control and because there are long lags from the
monetary policy instruments to the inﬂation outcome, is a serious one indeed. This
disadvantage is particularly important in the Latin American context because the
question of inﬂation controllability in an environment of low inﬂation and ﬂexible
exchange rates is fairly new for the region and hence central banks cannot draw on
minimally robust ﬁndings and regularities, and because the accountability and credi-bility of public institutions, including the central bank, are quite low by international
standards. The sixth and seventh disadvantages, that inﬂation targeting cannot pre-
vent ﬁscal dominance, and that the exchange rate ﬂexibility required by inﬂation tar-
geting might cause ﬁnancial instability, especially when there is partial dollarization,
are also very relevant in the Latin American context.
Some economists, most notably Friedman and Kuttner (1996), have criticized
inﬂation targeting because they see it as imposing a rigid rule on the monetary
authorities that does not allow them enough discretion to respond to unforeseen cir-
cumstances. For example, the central banks of the industrial countries that adopted
monetary targeting in the 1970s and 1980s did not foresee the breakdown of the rela-
tionship between monetary aggregates and goal variables such as nominal spendingor inﬂation. With rigid adherence to a monetary rule, that breakdown could have
had disastrous consequences. But this is not what happened. The point here is that
the useful analytical distinction between rules and discretion can be highly mislead-
ing when translated into practical policy advice. There exists useful policy strategies
that are ‘‘rule-like’’ in that they involve forward-looking behavior that limits policy-
makers from systematically engaging in policies with undesirable long-run conse-
quences. For the case of monetary policy, such policies avoid the time-inconsistency
problem and can be suitably described as providing the monetary authorities with
‘‘constrained discretion’’ (see Bernanke and Mishkin, 1997).
Inﬂation targeting can be described exactly in this way. Inﬂation targeting, as actu-
ally practiced, is far from a rigid rule. Its does not imply simple or mechanical
instructions as to how the central bank should conduct monetary policy. Rather, as
illustrated in the Eqs. (13.7) and (13.8) above, inﬂation targeting requires that the
central bank uses all the information available at a given point in time to determine
what are the appropriate policy actions to achieve its preannounced inﬂation target.
Unlike simple policy rules, inﬂation targeting mitigates the risk that the central bank
ignores important information by focusing exclusively on a reduced set of variables.
In fact, it gives the central bank considerable room for choosing what weight to as-
sign to the information its receives, for changing the setting of its policy instruments
and, under certain well-deﬁned circumstances, for modifying or even breaching theinﬂation targets (Bernanke et al., 1999).
Other critics of inﬂation targeting, (e.g., Calvo 1999; Calvo and Mendoza, 2000)
have raised the exact opposite criticism and argue that inﬂation targeting allows tooStrategies for Latin America 293

much discretion to monetary policy making and, thus, is a harbinger for a myriad of
undesirable outcomes. As explained in Bernanke et al. (1999), this criticism is also
unwarranted. The increased transparency and accountability to which all central
banks that adopt inﬂation targeting become subject substantially constrains their dis-
cretion and scope for making systematic policy mistakes. Transparent discussions of
the conduct of monetary policy make it very di‰cult for the central bank to followan overly expansionary monetary policy without it being noticed, while accountabil-
ity means that the central bank pays a high price if it engages in discretionary policy
that leads to high inﬂation or to excessive output instability (see below). The incen-
tives and scope for central banks to adopt a purely discretionary monetary policy are
thus greatly reduced.
A third criticism of inﬂation targeting is that by focusing monetary policy on low-
ering inﬂation it necessarily exacerbates output instability. The counter to this argu-
ment is that inﬂation targeting does not require an exclusive focus on inﬂation, but
simply makes inﬂation the primary goal of monetary policy. In fact, experience has
shown that inﬂation targeters do display substantial concern about output ﬂuctua-
tions. For example, all the industrialized countries that follow this strategy have settheir inﬂation targets above zero: 12at present, New Zealand has the lowest midpoint
for an inﬂation target, 1.5%; Canada and Sweden have set the midpoint of their in-
ﬂation target at 2%; while the United Kingdom and Australia have them at 2.5%.
The decision by inﬂation targeters to choose inﬂation targets above zero reﬂects
the monetary authorities’ concerns that (de-facto) deﬂation can have substantial neg-
ative e¤ects on real economic activity. More generally, central bankers in inﬂation-
targeting countries continue to express their concern about ﬂuctuations in output
and employment, and the ability to accommodate short-run stabilization goals to
some degree is built into all inﬂation-targeting regimes; one manifestation of this isthat the behavior of inﬂation targeters is better captured by Eq. (13.8), than by Eq.
(13.7), and have lowered inﬂation targets quite gradually toward the long-run inﬂa-
tion goal.
Furthermore, many inﬂation targeters have stressed that the ﬂoor of the target
range should be considered every bit as binding as the ceiling (which is what Eq.
(13.8) suggests should be the optimal policy to follow), thus helping to stabilize the
real economy when there are negative shocks to aggregate demand. Inﬂation targets
can in fact increase the central bank’s ability to respond to those types of shocks;
declines in aggregate demand that may cause the (future) rate of inﬂation to fall
below the ﬂoor of the target range will automatically induce the central bank to ease
monetary policy without fearing that its action will trigger a rise in inﬂation expec-tations. Another element of ﬂexibility in an inﬂation targeting strategy is that devia-
tions from inﬂation targets are routinely allowed in response to supply shocks that294 Chapter 13

could have large adverse e¤ects on output. There are two ways in which this is done
in practice: excluding certain items from the price index on which the o‰cial inﬂation
targets are deﬁned (for example, excluding some combination of food and energy
prices from the o‰cially targeted price index); or accommodating the ﬁrst-round
e¤ects on inﬂation of an observable supply shock (e.g., a rise in the value-added tax
or a natural disaster that raises agricultural prices) and then explaining to the publicthe reasons for the deviations and its implications for the attainment of the inﬂation
target.
A fourth concern about inﬂation targeting is that it will lead to low growth in
output and employment. This is the age-old concern about the output costs of dis-
inﬂation (from low inﬂation levels). Although inﬂation reduction has been associ-
ated with below-normal output during disinﬂationary phases in inﬂation-targeting
regimes, particularly in industrialized countries, evidence shows that once low inﬂa-
tion was achieved, output and employment returned to their pre-disinﬂation levels.
Hence, a conservative conclusion is that inﬂation targeting is not harmful to the real
economy after the disinﬂation has occurred. Given the strong economic growth expe-
rienced by many inﬂation targeting countries once they attained their medium-terminﬂation goal, however, a case could be made that inﬂation targeting in fact fosters
output growth in addition to controlling inﬂation.
The last three disadvantages that have been noted in the current debate—that in-
ﬂation targeting does little for central bank accountability because inﬂation is hard to
control, that it does not cure or prevent ﬁscal dominance, and that it might expose
the economy to ﬁnancial instability, especially when there is partial dollarization—
deserve, in our view, more serious consideration.
In contrast to exchange rates and monetary aggregates, the inﬂation rate cannot be
easily controlled by the central bank; furthermore, inﬂation outcomes that incorpo-rate the e¤ects of changes in instruments settings are revealed only after a substantial
lag. To address this problem an inﬂation targeting strategy should place a high value
on transparency; periodic releases of the central bank’s inﬂation forecasts and
explanations of its policy decisions, for example, become crucial for guiding inﬂation
expectations and building credibility in the regime (see Svensson, 1997). However,
the di‰culty of controlling inﬂation creates a particularly severe problem for those
countries in Latin America where inﬂation is being brought down from relatively
high levels. In those circumstances, inﬂation forecast errors are likely to be large, in-
ﬂation targets will tend to be missed more often, and it will be di‰cult for the central
bank to gain credibility from an inﬂation targeting strategy, and for the public to as-
certain the reasons for the deviations. This suggests that, as noted by Masson et al.(1997), inﬂation targeting is likely to be a more e¤ective strategy if it is phased in
only after there has been some successful disinﬂation.Strategies for Latin America 295

Two other factors a¤ecting inﬂation controllability that are especially relevant in
the Latin American context are the (at times large) incidence of government-
controlled prices on the index used to compute headline inﬂation, and the historically
high passthrough from exchange rate depreciations. The former suggests that inﬂa-
tion targeting may demand a high degree of coordination between monetary and
ﬁscal authorities on the timing and magnitude of future changes in controlled prices,while the latter suggests that the central banks of the region probably cannot a¤ord
an attitude of ‘‘benign neglect’’ towards exchange rate depreciations, at least until low
inﬂation induces a change in the expectations-formation process and in the price-
setting practices of households and ﬁrms (more on this below).
A sixth shortcoming of inﬂation targeting is that it may not be su‰cient to ensure
ﬁscal discipline or prevent ﬁscal dominance. Governments can still pursue irresponsi-
ble ﬁscal policy with an inﬂation-targeting regime in place. In the long run, large
ﬁscal deﬁcits will cause an inﬂation-targeting regime to break down: the ﬁscal deﬁcits
will eventually have to be monetized or the public debt eroded by a large devalua-
tion, and high inﬂation will follow. Absence of outright ﬁscal dominance is a there-
fore key prerequisite for inﬂation targeting, and the setting up of institutions thathelp keep ﬁscal policy in check are crucial to the success of the strategy (Masson
et al., 1997). However, as we have seen, absence of ﬁscal dominance is also crucial
to the success of a full dollarization strategy, and it is not at all clear that full dolla-
rization is more e¤ective than inﬂation targeting to prevent its occurrence. In fact,
inﬂation targeting may help constrain ﬁscal policy to the extent that the government
is actively involved in setting the inﬂation target (including through the coordination
on future adjustments to government-controlled prices).
Finally, a high degree of (partial) dollarization may create a potentially serious
problem for inﬂation targeting. In fact, in many Latin American countries, the bal-ance sheets of ﬁrms, households and banks are substantially dollarized, on both sides,
and the bulk of long-term debt is denominated in dollars (Calvo, 1999). Because in-
ﬂation targeting necessarily requires nominal exchange rate ﬂexibility and because
the economies of the region are highly open and dependent on external ﬁnancing, ex-
change rate shocks are unavoidable. However, large and abrupt depreciations may
increase the burden of dollar-denominated debt, produce a massive deterioration of
balance sheets, and increase the risks of a ﬁnancial crisis along the lines discussed in
Mishkin (1996).
The importance of these e¤ects can be appreciated by incorporating an exchange
rate term into the aggregate demand and supply Eqs. (13.1) and (13.2) as in Ball
(1999).
p
t¼pt/C01ța1yt/C01ța2et/C01țe0
t ð13:10Ț
yt¼b1yt/C01/C0b2ðit/C01/C0pt/C01Țțb3ðet/C01/C0et/C02Țțh0
t ð13:20Ț296 Chapter 13

with the exchange rate determined by
et¼fitțut ð13:9Ț
where etis the log of the real exchange rate expressed as a deviation from a ‘‘nor-
mal’’ (medium-term) level, utis an error term, and fcaptures the positive relation
that exists between interest rates and the value of the currency (e.g., through capital
ﬂows and appreciation).
The optimal policy for setting the interest rate in this modiﬁed system then
becomes:
it¼ptțb1ðp/C0p/C3Țțb2ytțb3et: ð13:50Ț
This modiﬁcation of the Taylor rule to take explicit account of the exchange rate in
setting the monetary policy instrument is consistent with an inﬂation-targeting re-
gime. As we have seen before, in the case of l¼0, monetary policy tries to achieve
the long-run inﬂation target in two periods, while if l>0, the long-run inﬂation tar-
get is approached more gradually.
The view that in Latin America exchange rate ﬂuctuations are likely to have a big-
ger a¤ect on aggregate demand and aggregate supply (because the pass-through may
be larger) just indicates that the weight on the exchange rate in the modiﬁed Taylor-rule, b
3, may be relatively large. However, this is in no way inconsistent with inﬂa-
tion targeting. It just implies that an inﬂation-targeting regime will care about
exchange rate ﬂuctuations, just as it should care about output ﬂuctuations. It also
suggests that inﬂation targeting in partially dollarized economies may not be viable
unless there are stringent prudential regulations on, and strict supervision of, ﬁnan-
cial institutions that ensure that the system is capable of withstanding exchange rate
shocks.
13.4.3 Lessons from Recent Experience
Inﬂation targeting is often in the eyes of the beholder. The monetary policy frame-works of several countries in Latin America—Chile, Colombia, Peru, Mexico andBrazil—contain some of the elements of inﬂation targeting that we have outlined
earlier. However, this does not mean that all these countries should be regarded as
following an inﬂation targeting strategy. (For a more detailed discussion of the inﬂa-
tion targeting experiences in these countries the reader is again referred to Mishkin
and Savastano, 2000).
The Chilean experience with inﬂation targeting is possibly the most important to
highlight because Chile was the pioneer in the region with this type of monetary pol-
icy strategy. After enacting new central bank legislation in 1989, which gave indepen-
dence to the monetary authority and mandated price stability as one of its primaryobjectives, the central bank announced its ﬁrst inﬂation objective in September 1990Strategies for Latin America 297

for the 12-month inﬂation rate as of December 1991. Since then, the (December to
December) inﬂation objective for the following year has been announced every year
in the ﬁrst 15 days of September. However, because of the uncertainty about inﬂation
control, the inﬂation objective was initially treated more as an o‰cial inﬂation pro-
jection rather than as a formal or ‘‘hard’’ target (Morande and Schmidt-Hebbel,
1997). In fact, Chile’s central bank pursued a very gradualist approach to loweringits inﬂation objectives, starting with targets of over 20% for 1991 and lowering them
slowly to below 5%. Over time, the central bank put greater emphasis on the price
stability objective and with its success in both disinﬂating and meeting its inﬂation
objectives, the public began to interpret those objectives as ‘‘hard’’ targets for which
the central bank could be made accountable. As part of this process of hardening the
targets, in September 1994 the central bank started to announce point targets rather
than target ranges for its inﬂation objective for the following year. However, it
was only in 1999 when the central bank explicitly announced a multi-year target for
inﬂation—consisting of a target of 3.5% for the year 2000, and a longer-term target
of 2–4% for 2001 onwards.
The Chilean experience with inﬂation targeting looks quite successful. 13Inﬂation
has fallen from levels above 20% when inﬂation projections were ﬁrst introduced to
a level around 3% at present. Over the same period, output growth was very high,
almost averaging over 8.5% per year from 1991 to 1997, a level comparable to those
exhibited by the (former) Asian tigers. This success suggests that inﬂation targeting
can be used to promote gradual disinﬂation, even when inﬂation starts from double
digit levels, and that the gradual hardening of targets as inﬂation falls is an appropri-
ate strategy to deal with the controllability problems when inﬂation is initially high.
Indeed, not only has this strategy been used by Chile, but it is also the strategy that
was followed by many of the industrialized countries that adopted inﬂation targeting,as is documented in Bernanke et al. (1999).
Mexico also appears to be following a gradual approach to implementing inﬂation
targeting. In fact, senior o‰cials of the Bank of Mexico have recently characterized
Mexico’s monetary policy framework as being in ‘‘a transition period towards a
clear-cut inﬂation targeting scheme’’ (Carstens and Werner, 1999). For a number of
years, Mexico has made public an explicit inﬂation objective at the time the Minister
of Finance submitted to Congress the government’s economic program for the fol-
lowing year. However, the Bank of Mexico has increasingly placed an emphasis on
the inﬂation goal as the central objective of its monetary policy. In 1999, after annual
inﬂation came in at 12.3%, below the 13% target, the central bank for the ﬁrst time
announced the (10%) inﬂation target for the year 2000 before the Ministry of Fi-nance submitted to Congress the economic program for the year. Also for the ﬁrst
time, the Bank of Mexico announced a multi-year target for inﬂation by stating that
it intended to lower inﬂation to ‘‘international levels,’’ (i.e., somewhere in the 2–3%298 Chapter 13

range) by 2003. Starting in April of 2000, the Bank of Mexico has been issuing an
Inﬂation Report , which documents what has been happening on the inﬂation front
and how the Bank of Mexico intends to achieve its inﬂation objective. These devel-
opments are likely to contribute to raise the accountability of the Bank of Mexico for
complying with its inﬂation objectives.
In contrast, and despite the central bank’s announcement since 1991 of explicit nu-
merical targets for 1-year ahead inﬂation as part of the government’s economic pro-
gram, Colombia did not make a serious commitment to lowering inﬂation during the
1990s. Reducing inﬂation from the 20–25% range was not a priority of monetary
policy: Colombia’s central bank continued to give priority to other objectives, espe-
cially output stability, whenever those goals seemed to be put in jeopardy by the
inﬂation target (see Cardenas and Partow, 1998). Not surprisingly, Colombia’s
anti-inﬂation strategy was unsuccessful: average annual inﬂation in the period
1991–1998 (22.7%) was essentially the same as the average for the 1980s (23.6%),
and from 1991 to 1996 the central bank consistently exceeded its always modest in-
ﬂation targets. The inﬂation target was met for the ﬁrst time in 1997—with inﬂation
ending slightly below the 18% target—but the target was breached again in 1998(16.7% versus 16%). In that year, investors’ concerns about Colombia’s large ﬁscal
and external deﬁcits (in the order of 4% and 5% of GDP, respectively) and about its
political situation led to a string of speculative attacks on the peso. In response, the
central bank ﬁrst raised interest rates to record-high levels and then, in September
1998, depreciated both edges of the exchange rate band by 9%. The response did
not arrest the speculative pressures and induced a sharp slowdown in activity. In Sep-
tember 1999, when international reserves reached dangerously low levels, the trading
band was eliminated and the peso was allowed to ﬂoat. The failed defense of the
exchange rate band led Colombia to su¤er its ﬁrst recession in seven decades andbrought inﬂation below 10% for the ﬁrst time since the 1970s, but it was apparent
that this was not a desired policy outcome. Nonetheless, as had been done in Brazil
a year earlier (see below), the authorities took advantage of the circumstances to
reformulate monetary policy. The inﬂation target for 2000 was set at 10% and, in Oc-
tober 2000, the authorities publicly adopted inﬂation targeting as their framework
for monetary policy by announcing numerical inﬂation targets for the years 2001
(8%) and 2002 (6%) and taking concrete actions to increase the accountability and
transparency of the central bank.
Fiscal discipline and a sound and well-regulated banking system are crucial for the
viability and success of inﬂation targeting, just as they are for the success of hard
pegs, and the experience in Chile supports this view. The ﬁscal balance in Chileended in surplus every year from 1991 to 1998, and during 1991–1997, the surplus
averaged 2.8% of GDP, clear indications that ﬁscal policy was kept under control.
In addition, due largely to the measures taken in the aftermath of the severe bankingStrategies for Latin America 299

crisis of the early 1980s, Chile’s standards and practices in the areas of banking reg-
ulation and supervision during the 1990s have been of a quality comparable to those
found in industrialized countries and far superior to those found in the rest of Latin
America (with the possible exception of Argentina since 1995). The resulting solidity
of the Chilean ﬁnancial system has meant that the ability of the central bank to take
steps to defend the currency and the banks has never been in question, which mayhave helped Chile experience less pressures on its currency than other countries of
the region at the time of the Tequila crisis (see IMF, 1996). The controls on short-
term capital inﬂows have also been cited often as another important factor behind
the low vulnerability and relative stability of the Chilean economy in the 1990s.
However, the controls are highly controversial and their contribution is di‰cult to
ascertain. 14Our reading of the evidence suggests that, from the perspective of mone-
tary policy and inﬂation control, strict prudential supervision was probably more
important.
Chile seems to be way ahead of the other countries who have adopted some form
of inﬂation targeting in Latin America in terms of broad compliance with the basic
requirements. Lack of ﬁscal discipline is a particularly serious concern in Brazil andColombia, whereas weaknesses in the banking system are the big question mark in
Mexico, and, to a lesser extent, Peru. Inﬂation targeting alone will not solve these
problems; neither will hard pegs. Setting multi-year inﬂation targets in coordination
with the government (including on the issue of government-controlled prices) may
help reduce the risk of ﬁscal proﬂigacy, but it is not enough. Setting up institutions
that help keep ﬁscal policy in check and others that promote and enforce sound
banking practices, seem to be the only solutions that may prove lasting and workable
in the region.
The Chilean experience in 1998–1999, when the economy entered a recession (with
output growth falling to 3.4% in 1998 and by an estimated /C01.3% in 1999) illustrates
the tricky issues that arise when the exchange rate is an important consideration
in the conduct of monetary policy. As part of its monetary policy regime, from the
mid-1980s until August 1999, Chile had an exchange rate band around a crawling
peg which was (loosely) tied to lagged domestic inﬂation. The central bank stressed
that the purpose of the exchange rate band was not inﬂation control, and this was the
reason why, for most of the period, the rate of crawl was set on a backward-looking
rather than a forward-looking basis. Rather the central bank argued that the purpose
of the exchange rate band was to keep the real exchange rate in a range consistent
with medium- and long-term external equilibrium and, thus, preclude an ‘‘excessive’’
current account deﬁcit. Over time, the central bank also made it clear through itsactions that the inﬂation target would take precedence over the exchange rate band
when there was a potential conﬂict between the two objectives. Thus, for example, in
various instances from 1992 to 1997 when large capital inﬂows pushed the exchange300 Chapter 13

rate close to the appreciated edge of the band, the central bank widened the band
and even revalued the central parity while keeping the inﬂation target unchanged,
thus signaling to the public that it attached a higher weight to lowering inﬂation
than to resisting a real appreciation that seemed warranted by the ‘‘fundamental’’
determinants of the real exchange rate.
The focus on the exchange rate did help lead to a serious policy mistake in 1998.
In the aftermath of the Asian crisis and then the meltdown in Russia, the Chilean
central bank was reluctant to ease monetary policy and let the exchange rate depre-
ciate in order to cushion the e¤ects of a substantial negative terms of trade shock.
Instead, the central bank raised interest rates sharply and narrowed its exchange
rate band. As a result, the inﬂation target was undershot and the economy entered a
recession for the ﬁrst time under the inﬂation targeting regime. Not surprisingly
given these outcomes, the central bank came under strong criticism. 15During 1999,
the central bank reversed course, eased monetary policy by lowering interest rates,
and allowed the peso to depreciate.
The other countries in Latin America that are moving toward inﬂation targeting
also have been reluctant to adopt an attitude of ‘‘benign neglect’’ of exchange ratemovements (i.e., a ‘‘pure ﬂoat’’). Although some focus on the exchange rate seems
broadly appropriate—especially while they were undertaking a disinﬂation—all of
them probably went too far for too long in the direction of limiting exchange rate
ﬂexibility—not only through the explicit use of exchange rate bands, employed by
all countries, except Peru, for a good part of the 1990s, but also through frequent di-
rect and indirect intervention in the foreign exchange market. The main problem
with responding too heavily and too frequently to movements in a ‘‘ﬂexible’’ ex-
change rate is, of course, that the strategy runs the risk of transforming the exchange
rate into a nominal anchor for monetary policy that takes precedence over the inﬂa-tion target, at least in the eyes of the public. With time, this practice may become
observationally equivalent with a strategy of nominal exchange rate targeting.
To mitigate the risk that the exchange rate might replace the inﬂation target as the
economy’s main nominal anchor, central banks can increase the transparency of
the role of the exchange rate by emphasizing that concerns about exchange rate
e¤ects on aggregate demand and supply imply that the setting of interest rates would
necessarily reﬂect exchange rate movements, as is illustrated by Eq. (13.5
0). What this
means in practice is that the central bank would be smoothing exchange rate ﬂuctua-
tions, but would not involve attempting to prevent the exchange rate from reaching
its market-determined level over longer horizons. Exchange rate smoothing via for-
eign exchange market interventions might be necessary at times to prevent or arrestlarge and abrupt exchange rate ﬂuctuations that are clearly divorced from fundamen-
tals. However, persistent exchange market interventions, particularly unsterilized
ones, are likely to be counterproductive because they are not transparent. Instead,Strategies for Latin America 301

exchange rate smoothing via changes in the interest rate instrument will tend to be
more transparent and help signal that the inﬂation targets, and not the exchange
rate remains the primary nominal anchor of the economy.
Central banks should also explain to the public the rationale for exchange rate in-
tervention in a manner analogous to that for interest-rate smoothing, i.e., as a policy
aimed not at resisting market-determined movements in an asset price, but at miti-gating potentially destabilizing e¤ects of abrupt and sustained changes in that price.
More generally, we think it is important that central banks understand that there are
no ‘‘good ﬂoats’’ or ‘‘bad ﬂoats,’’ but that there is such a thing as ‘‘good’’ and ‘‘bad’’
monetary policy under ﬂexible exchange rates. Letting the exchange rate become the
de-facto nominal anchor of the economy through excessive intervention in a quasi-
inﬂation targeting regime is an example of the latter.
It is also important that central banks in Latin America recognize that, as is the
case for most economic relationships, the passthrough from exchange rate changes
to prices is likely to be regime-dependent. After a sustained period of low inﬂation
with e¤ective, as opposed to ﬁctional, exchange rate ﬂexibility, the informational
content of the exchange rate in the expectations-formation process and price-settingpractices of households and ﬁrms is likely to fall. Thus, the widespread view that a
currently high passthrough from exchange rate changes to prices is a barrier to suc-
cessful inﬂation targeting is probably overdone. Indeed, the low pass-through that
occurred after the Brazilian devaluation in 1999, which might have been reduced by
the adoption of an inﬂation targeting regime (as well as by the slack in the economy),
suggests that a high pass-through is not a permanent feature of Latin American
economies.
Another lesson from the Chilean experience is that a key requirement for inﬂation-
targeting regimes in Latin America, as elsewhere, is the recognition that undershoot-ing inﬂation targets, which occurred recently not only in Chile but also Peru, is just
as costly as overshooting the targets. Support for an independent central bank which
is pursuing price stability can erode if the central bank is perceived as focusing too
narrowly on lowering inﬂation to the detriment of other objectives, especially output
stability. By just as readily admitting their mistakes when an inﬂation target is under-
shot as when it is overshot, and continuously reﬁning their technical expertise to min-
imize the occurrence of such events, central banks may increase support for their
independence and for the inﬂation targeting regime.
Brazil’s inﬂation targeting regime is too recent to evaluate fully, although so far
the results have been encouraging, with Brazil able to keep inﬂation within the target
range of 6–10% and 4–8% in 1999 and 2000, respectively. Brazil decided to adopt aninﬂation-targeting regime shortly after the collapse of the real, when the new gover-
nor of the central bank, Arminio Fraga, announced its intention to enact such a
framework for monetary policy. On June 21, 1999, the President of Brazil issued a302 Chapter 13

decree instituting an inﬂation targeting framework for the conduct of monetary pol-
icy. The regime contemplated in the decree contains all the key elements of an inﬂa-
tion targeting strategy, namely: (1) the announcement of multi-year inﬂation targets
(with explicit numerical targets for the 12-month rate of inﬂation in the years 1999,
2000 and 2001, and a commitment to announce the targets for 2002 onwards 2 years
in advance); (2) assigning to the National Monetary Council the responsibility forsetting the inﬂation targets and tolerance ranges based on a proposal by the Minister
of Finance; (3) giving to the central bank of Brazil full responsibility to implement
the policies needed to attain the inﬂation targets; (4) establishing procedures to in-
crease the central bank’s accountability (speciﬁcally, if the target range is breached,
the central bank president would have to issue an open letter to the Minister of Fi-
nance explaining the causes of the deviation, the measures that will be taken to elim-
inate it, and the time it will take to get inﬂation back inside the tolerance range); and
(5) taking actions to improve the transparency of monetary policy (concretely, the
central bank was requested to issue a quarterly Inﬂation Report modeled after that
produced by the Bank of England).
The Brazilian framework has all the ‘‘bells and whistles’’ of an inﬂation targeting
regime, and was clearly the ﬁrst comprehensive attempt to establish a regime of this
type in Latin America. What is especially striking about Brazil’s move to inﬂation
targeting is how fast it occurred. The ﬁrst inﬂation report was issued in July 1999,
just a few months after Fraga was conﬁrmed, with the second, right on schedule in
September. The reports not only discuss clearly the conditions prevailing in the econ-
omy and the prospects for inﬂation, but also provide the central bank’s inﬂation fore-
casts under di¤erent scenarios—including through the use of ‘‘fan charts’’ depicting
the probabilities of di¤erent inﬂation paths. Many central bankers in the Latin
American region have been concerned that it might take them a long time to acquirethe technical capability to issue an inﬂation report of this type. Brazil has shown the
way, indicating that an inﬂation targeting regime, with a high degree of transparency
and accountability can indeed be implemented quickly.
The other three countries in the region mentioned here have lagged behind in
adopting other key elements of inﬂation targeting. Even, Chile, with the success of
its inﬂation targeting regime in reducing inﬂation, was slow to adopt a full-ﬂedged
inﬂation targeting regime: it was not until May 2000 that the Chilean central bank
began to produce an Inﬂation Report -type of document in which it publishes its base-
line inﬂation forecasts.
13.5 Conclusion
We have taken the view that the real debate over monetary policy regimes in LatinAmerica should not be over whether the exchange rate regime should be ﬁxed orStrategies for Latin America 303

ﬂexible. Instead, the debate should be over what is the best way to constrain discre-
tion over monetary policy in Latin American countries. Like most economists, we
come up with the answer that ‘‘it depends.’’ In particular, we think that the key to
the answer lies on the institutional environment in each country. There are some
countries in Latin America which do not appear to have the political and other insti-
tutions to constrain monetary policy if it is allowed some discretion. In these coun-tries, there is a strong argument for hard pegs, including full dollarization, which
allow little or no discretion to the monetary authorities. On the other hand, there
are countries in Latin America that seem to have the ability to constrain discretion,
with Chile being the clearest example, and for these cases, we believe that inﬂation
targeting is likely to produce a monetary policy which keeps inﬂation low and yet
appropriately copes with domestic and foreign shocks.
Monetary targeting as a strategy for Latin America is not viable because of the
likely instability of the relationship between monetary aggregates and inﬂation, of
which there is ample international evidence. Therefore, it is not surprising that no
Latin American country has truly followed a monetary targeting strategy, and those
that have tried or have been regarded as trying, have instead conducted a highly dis-cretionary monetary policy which is, of necessity, non-transparent and has the poten-
tial of breaking down at any point.
Proponents of di¤erent strategies for the conduct of monetary policy often have a
tendency to argue that their preferred strategy will be a panacea that will help resolve
hard problems such as ﬁscal dominance. The experience in Latin America suggests
that these arguments are quite problematic because a monetary policy strategy, no
matter whether it involves a hard peg or an inﬂation target, will not be successful in
maintaining low inﬂation over the medium term unless government policies create
the right institutional environment. Rigorous prudential supervision, which ensuresthe safety and soundness of the ﬁnancial system, is crucial to the success of an inﬂa-
tion targeting regime just as it is for hard pegs. Also, sound and sustainable ﬁscal
policy is as essential to the success of inﬂation targeting regimes as it is to the viabil-
ity of hard pegs. Large ﬁscal deﬁcits and the ensuing buildup of government debt will
eventually lead to the failure of both types of regime.
The bottom line is that adopting a strategy for monetary policy, whether it be a
hard peg or a regime with greater ﬂexibility of exchange rates, like inﬂation target-
ing, cannot solve the basic problems that have existed in Latin American economies
for a long time. Successful monetary policy in Latin America cannot be done in a
vacuum. Design of the basic institutional infrastructure in those economies must be
addressed and improved in order to attain and preserve low and stable inﬂation.
A number of economists (e.g., Eichengreen and Hausmann, 1999) have become
convinced that Latin America is subject to some type of ‘‘original sin’’ and thus is
unlikely to grow up and develop institutions which would promote good monetary304 Chapter 13

policy. With this view, it seems sensible to e¤ectively close down central banks and
adopt a currency board or to go for (unilateral) full dollarization. We are quite skep-
tical of the ‘‘original sin’’ argument. The recent successes in bringing down inﬂation
in many countries of the region suggests to us that it is possible for Latin America to
develop institutions which would allow its central banks to follow a monetary policy
focused on keeping inﬂation low while preserving some scope to mitigate output ﬂuc-tuations. We are thus not convinced that it is time to give up on the maturation of
Latin America, and believe that the move towards inﬂation targeting that has started
in the region will continue and make further inroads in the years ahead.
Acknowledgements
The views expressed in this paper are exclusively those of the authors and not those
of Columbia University, the National Bureau of Economic Research or the Interna-
tional Monetary Fund. We thank Sebastian Edwards, Esteban Jadresic, Fernando
Losada, Federico Sturzenegger, Lars Svensson, participants in the Macro Lunch at
Columbia University, participants at the Interamerican Seminar, and an anonymousreferee, for helpful comments and Iva ´n Guerra for helpful research assistance.
Notes
Prepared for the Interamerican Seminar on Economics, Buenos Aires, December 2–4, 1999.
1. For a discussion of two fallacies that arise recurrently in discussions of monetary policy and exchange
rate regimes in Latin America, see Mishkin and Savastano (2000).
2. A ﬁfth possible strategy that has been suggested by some as best suited for semi-open economies is nom-
inal income targeting (e.g., Frankel, 1995). A major problem with this strategy, however, is that it hasnever been tried in practice, either in industrial or emerging economies. This, plus the fact that nominalincome targeting could be seen as broadly equivalent to inﬂation targeting under some reasonable assump-tions but with some serious disadvantages (McCallum, 1996; Mishkin, 1999a), leads us to drop it from the
set of monetary policy strategies that we consider relevant for Latin American countries.
3. For a review of the main arguments against soft pegs and of the lessons from recent experience, see
Obstfeld and Rogo¤ (1995), Eichengreen and Masson (1998) and Mishkin (1998, 1999a). Note that we
are not ruling out the use of exchange-rate pegs, even if not of the hard peg variety, as a tool in the initialphases of a stabilization program. However, the shortcomings of soft pegs indicate that they will be far lessuseful as a longer-run strategy for monetary policy.
4. See, for example, Hanke and Schuler (1994), Williamson (1995), and Ghosh et al. (1998).5. As Svensson (1997) indicates, the Taylor rule in Eq. (13.5) above is only optimal if inﬂation and the
output gap are su‰cient statistics for the model, i.e., if no other variables enter the aggregate supply anddemand functions. If other variables do a¤ect aggregate demand and supply, the optimal rule would needto be modiﬁed to have the interest rate respond to these variables as well. Note that in practice, a Taylorrule like Eq. (13.5) would never be followed slavishly in practice because central banks use judgement
in setting policy instruments. Thus, a Taylor rule is better thought of providing a useful benchmark for
policymakers, but should not be characterized as a rule which solve the time-inconsistency problem. Theuse of the word ‘‘rule’’ in Taylor rule can therefore be somewhat misleading.
6. Clarida et al. (1998) give a nice illustration of how unlikely this can be by demonstrating that the Taylor
rules estimated for countries like Italy, France and the United Kingdom would have led to very di¤erentsettings of interest rates during the period of the ERM than those generated by Germany.Strategies for Latin America 305

7. The US economic warfare against Panama sparked a series of bank runs that nearly caused the collapse
of the Panamanian payments system (see Garber, 1999). When the standstill ended, after almost 2 years, a
number of small banks had disappeared, the money supply had shrunk by 30%, and real output had fallenby 18%. This episode illustrates that a country with a hard peg is not exempt from bank runs and panics,whatever their origin may be. The fact that the United States also had frequent bank panics in the 19th andearly 20th century even when it had a hard peg (the gold standard) also illustrates this point—e.g., seeMishkin (1991).
8. See, for instance, Goodhart (1989), Bernanke and Mishkin (1992), and Estrella and Mishkin (1997).9. See Mishkin and Savastano (2000) for a fuller discussion of the monetary policy strategy of Peru and
Mexico during the 1990s.
10. One of us has argued elsewhere that even the discretionary monetary policy regime in the United
States, which has been so successful, may not produce desirable outcomes over the long run and needs tobe modiﬁed, even though the environment for ‘‘good’’ discretion in the United States is far more favorable
than in Latin America (see Mishkin, 1999a).
11. Partly because of this, a number of researchers regard Germany’s monetary policy as being closer to
an inﬂation targeting regime than to a monetary targeting regime. See, for example, Clarida and Gertler(1998), Bernanke et al. (1999), and Mishkin (1999a).
12. CPI indices typically contain an upward bias in the measurement of true inﬂation and so it is not sur-
prising that the chosen inﬂation targets were all above zero. However, the point is that these countries havechosen targets for inﬂation that exceed zero even after taking account of measurement bias.
13. Corbo (1998) and Landerretche et al. (1999) analyze the factors behind Chile’s successful disinﬂation
of the 1990s. For a critical view of the disinﬂation, see Calvo and Mendoza (1999).
14. For a recent overview of the debate surrounding Chile’s capital controls, see Edwards (1999).15. In contrast, during this same period, Australia eased monetary policy, thereby allowing the currency to
depreciate to cushion the e¤ects of its own negative terms of trade shock. This policy met with great suc-cess, resulting in an economy that remained strong while the inﬂation target continued to be met. One rea-son why Chile’s central bank did not react in a similar manner to a comparable shock may have been its(unwarranted) concern that a large peso depreciation would lead to inﬂation exceeding the target and,
hence, erode its credibility.
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14Monetary Policy Strategies for Emerging Market Countries:
Lessons from Latin America
Frederic S. Mishkin and Miguel A. Savastano
14.1 Introduction
The conduct of monetary policy in emerging market (and transition) countries con-
fronts di¤erent challenges from that in industrialized countries. In contrast to the ex-perience in industrialized countries, the past monetary policy experience of many
emerging market countries has been dismal, with extreme episodes of monetary in-
stability, swinging from very high inﬂations, to massive capital ﬂight, to collapses in
their ﬁnancial systems. However, in recent years the prospects for successful mone-
tary policy in emerging market countries have increased, as exempliﬁed by the far
lower rates of inﬂation in the Latin American region, which have fallen from an av-
erage of over 400% in 1989 to below 10% at the beginning of the millennium. (See
ﬁgures 14.1 and 14.2.)
Given the more favorable environment for the conduct of monetary policy in
emerging market and transition countries, where should they go from here in design-
ing appropriate long-run strategies for the conduct of their monetary policy? The
central issue in addressing this question is whether an emerging market country has
a chance of setting up institutions and mechanisms that will e¤ectively and e‰ciently
constrain the discretion of its monetary authorities. In principle, there are three
broad monetary policy strategies that can produce a nominal anchor that credibly
constrains the discretion of the central bank over the medium term: ‘‘hard’’
exchange-rate pegs, monetary targeting, and inﬂation targeting. 1
An earlier paper, Mishkin and Savastano (2001), provides a theoretical framework
for discussing the advantages and disadvantages of each of these three strategies.
This chapter complements the analysis in that paper by conducting detailed casestudies of recent monetary policy experiences in Latin America in order to evaluate
how well each strategy has worked in practice. The evidence from these case studies
provides useful clues as to which of the three strategies might be best suited to con-
ditions in di¤erent emerging market countries.

14.2 Hard Pegs
There are essentially two types of ‘‘hard peg’’ regimes for monetary policy: a cur-
rency board and full dollarization. In a currency board, the domestic currency is
backed 100% by a foreign currency (say, U.S. dollars) and the note-issuing authority,
whether the central bank or the government, ﬁxes a conversion rate to this currency
and stands ready to exchange domestically issued notes for the foreign currency on
demand. A currency board is a hard peg because the commitment to the ﬁxed ex-
change rate has a legal (or even constitutional) backing and because monetary policy
is, in e¤ect, put on autopilot and completely taken out of the hands of the central
bank and the government. Full dollarization involves eliminating altogether the do-
mestic currency and replacing it with a foreign currency (say, the U.S. dollar). It rep-
resents a stronger commitment to monetary stability than a currency board because
it makes it much more costly—though still not impossible—for the government to
regain control over monetary policy and/or change the parity of the (non-existent)
domestic currency.
14.2.1 Lessons from the Recent Experience in Latin America
The two prime examples of hard pegs in Latin America are Argentina and Panama.
Both hard pegs were created under special, and quite di¤erent, historical circum-
stances. In the case of Argentina, the hard peg was the cornerstone of the stabiliza-
tion program of 1990–91 that ended the hyperinﬂation bouts of the 1980s. In the
case of Panama, the government’s decision to adopt the U.S. dollar as the legal ten-
Figure 14.1
Latin America: Inﬂation in the 1990s. 12-month percentage change in the regional CPI.
Source: IMF, World Economic Outlook.310 Chapter 14

Figure 14.2
Latin America: Inﬂation 1990–1999. 12-month percentage change in CPI.
Source: IMF, International Financial Statistics.Strategies for Emerging Market Countries 311

der and to eschew the creation of a central bank was made in 1904, the year after the
country was founded.
Argentina The extreme inﬂation of the 1980s wreaked havoc with the Argentine
economy. Numerous stabilization plans failed to break the inﬂationary dynamics
and psychology fueled by high ﬁscal deﬁcits, entrenched indexation practices andballooning interest payments on government debt. To end this cycle of inﬂationary
surges, Argentina tightened monetary and ﬁscal policies in early 1990 and then de-
cided to adopt a hard peg with the passage of the Convertibility Law of April 1,
1991. The law transformed the central bank into a quasi-currency board that could
only issue domestic currency when it was fully backed by foreign exchange (except
for up to 10% of the monetary base which could be backed by dollar-denominated
government bonds), could not alter the exchange rate from one new peso to the
dollar, and could not provide credit to the government. The law also eliminated all
exchange controls, banned automatic indexation clauses and allowed contracts to be
expressed and settled in foreign currency (Cavallo, 1993).
The ﬁrst four years of Argentina’s quasi-currency board were highly successful and
have become the textbook example of the beneﬁts of a currency board for stopping
high inﬂation (Hanke and Schuler, 1994). Inﬂation fell from an 800% annual rate in
1990 to less than 5% by the end of 1994, and economic growth was rapid, averaging
almost 8% per year from 1991 to 1994 (see ﬁgures 14.2 and 14.3). Fiscal deﬁcits were
also kept moderate, averaging below 1% of GDP, and the government implemented
far-reaching structural reforms, especially in the areas of privatization and trade.
However, in the aftermath of the Mexican crisis of late 1994, a speculative attack
against the Argentine currency board quickly turned into a major banking crisis.
From December 1994 until March 1995, the prices of Argentine stocks and bondsplummeted, the banking system lost 17% of its total deposits, the central bank lost
more than a third of its international reserves ($5.5 billion), the money supply con-
tracted, interest rates shot up—with the interbank rate brieﬂy exceeding 70%, and
external credit lines vanished. An interesting feature of this attack is that the run on
the banks had two distinct phases: a ﬁrst phase where the public moved peso deposits
from small banks to large banks and switched part of those deposits into dollars, and
a second phase, during March 1995, where the run of deposits spread to the dollar
segment of the system and a¤ected all ﬁnancial institutions—including local
branches of large foreign banks (IMF, 1996). A run on dollar deposits in large banks
(including foreign ones) clearly suggests that the public was not only hedging against
a devaluation of the peso but against something worse, such as a conﬁscation, theimposition of exchange controls or a complete meltdown of the banking system.
Whatever the forces at play, the severity of the attack brought home the point that
the Argentine currency board was not exempt from a sudden loss of conﬁdence from312 Chapter 14

Figure 14.3
Argentina: Inﬂation and growth, 1993–1999.
Source: Central Bank of Argentina, Ministry of Economy and IFS.Strategies for Emerging Market Countries 313

domestic and foreign investors, and that the Argentine banking system was not pre-
pared to cope with those shocks.
The Argentine central bank had its lender of last resort role constrained by the
Convertibility Law, yet it mitigated the adverse e¤ects of the run on bank deposits
by lowering reserve requirements, providing direct credit via rediscounts and swaps,
and participating actively in the restructuring, privatization and liquidation oftroubled banks. By the end of April, the central bank had managed to provide over
$5 billion of liquidity to the banking system, more than a third of it in the form of
direct loans, and was able to avert a large-scale collapse of the banking system. An
often overlooked aspect of the success of the Argentine government in containing the
banking crisis and preserving its quasi-currency board was the substantial assistance
it received from the multilaterals (i.e., the IMF, the World Bank, and the Interamer-
ican Development Bank) who lent Argentina almost $5 billion during 1995. Despite
all these e¤orts the real economy took a nosedive; the May unemployment rate shot
up to 18% and 1995 real GDP fell by more than 3%. It was not until 1996 that the
economy began to recover.
The overall performance of the Argentine economy from 1996 to 1998 was more
uneven than in the ﬁrst half of the 1990s. Real output grew at an average rate of 6
percent and inﬂation fell to practically zero, but, apart from a strengthening of pru-
dential regulations and supervision and a fast process of bank consolidation, the
authorities’ drive for undertaking further structural reforms and ﬁscal adjustment
started to falter. The ﬁscal deﬁcit, which had reached almost 4% of GDP in 1995,
averaged 2.7% from 1996 to 1998 despite the pick-up in growth; the current account
deﬁcits widened, and all debt indicators deteriorated markedly. Investors’ concerns
about these developments surfaced in the Fall of 1998, following the Russian crisis
and the decline in commodity prices. Domestic interest rates and spreads on Argen-tine bonds, which had been largely una¤ected by the Asian crises of 1997, shot up in
September 1998 to levels not seen since the Tequila crisis. Although the spike was
short lived and the Argentine government continued tapping the markets with IMF
support, external ﬁnancing dried up and real output fell by 3.5 percent in the second
half of the year (see ﬁgure 14.3).
The devaluation of the Brazilian real in January 1999 sent Argentina into a full-
blown recession that lasted more than three years. The sudden loss of competitive-
ness vis-a `-vis a major trading partner exacerbated the downturn that had started in
late 1998. Although there was no run on deposits and no loss of reserves until late
2000, interest rates and spreads on Argentine paper rose steadily, bank credit stalled,
and industrial production plummeted. By mid-2001 the unemployment rate reached18% and the ﬁscal situation became completely unsustainable, with spreads on gov-
ernment debt in excess of 2,500 basis points, collapsing tax revenues and no available
sources of ﬁnancing. On December 25, 2001, in the midst of a social and political314 Chapter 14

crisis that brought down the de la Rua government, Argentina declared default on
$150 billion of government debt.
What transpired in Argentina in 2001 is a dramatic example of the perils of ﬁscal
proﬂigacy in a hard peg regime stressed in Mishkin and Savastano (2001). Faced
with a weakening ﬁscal position and with no access to foreign credit, the Argentine
government forced the banks to absorb large amounts of government debt (ﬁrst byremoving the central bank governor and appointing one that was willing to lower
banks’ liquidity requirements, and later by resorting to all forms of ‘‘arm twisting’’).
The ensuing decline in the value of the government debt in banks’ balance sheets
along with rising bad loans caused by the severity of the recession fueled increasing
doubts about the solvency of the banking system. This led to a full scale banking
panic in October–November, with the public rushing to withdraw their deposits and
interbank interest rates soaring. On December 1, after losing more than $8 billion of
deposits, the government imposed wide-ranging controls on banking and foreign ex-
change transactions, including setting a $1000 monthly limit on deposit withdrawals.
Three weeks later the government was pushed out of o‰ce.
The government of President Duhalde that took o‰ce at the beginning of 2002 ﬁ-
nally pulled the plug on the currency board. On January 6, the exchange rate appli-
cable to exports, essential imports and most capital transactions was set at 1.4 pesos/
dollar, while a ﬂoating exchange was created for all other transactions. Announce-
ments that banks would (eventually) be required to repay their dollar deposit liabil-
ities in full, while bank loan assets of under $100,000 would be converted into pesos
(with their consequent lower value) created, overnight, a massive hole on banks’ bal-
ance sheets. The draconian limits on deposit withdrawals were maintained, thus
aggravating the disruption to the payments system and bringing the whole economy
to a virtual halt. The precise unfolding of the crisis remained unclear at the time ofthis writing, but the near term prospects seem unambiguously grim.
Panama Panama has recently come into the limelight because it was the only fully
dollarized country in Latin America until Ecuador abolished its domestic currency
in 2000. 2The inﬂation performance of Panama illustrates the key advantage of full
dollarization: its ability to deliver low inﬂation. From 1960 to 2000, Panama’s inﬂa-
tion rate has averaged 2.8% per year, which is signiﬁcantly lower than in any other
country in Latin America, and is even lower than the 4.6% average over the same
period for the United States. Panama’s growth performance during the same period
was also good, but far less impressive. Since 1960, Panama’s real GDP grew at an
average of 4.2%—about one percentage point faster than Latin America as a whole(see ﬁgure 14.4). However, some studies have shown that output volatility in Panama
has been among the highest in the region, and that a main factor behind that volatil-
ity has been its exchange-rate regime (e.g., Hausmann and Gavin, 1995, tables 4 andStrategies for Emerging Market Countries 315

14). These ﬁndings seem fully consistent with the earlier noted tradeo¤ between price
stability and output stability that a¤ects countries with no monetary policy.
A hallmark and a key strength of Panama’s economy is the soundness and sophis-
tication of its banking system. Although the low inﬂation environment produced by
full dollarization contributed to this outcome, full dollarization does not appear to be
the primary source of the well-functioning banking system. The take-o¤ of Panama’s
ﬁnancial system only began in 1970 with the passage of a banking law—Cabinet
Decree 238—that eased licensing and portfolio allocation requirements on foreign
banks, strengthened secrecy provisions, and allowed unrestricted movements of capi-
tal (Moreno, 1999). The goal of transforming Panama into an o¤shore banking cen-
Figure 14.4
Panama: Inﬂation and growth, 1990–1999.
Source: IFS, ECLAC.316 Chapter 14

ter was achieved fairly quickly. By 1987 there were more than 120 banks located in
the country, the majority foreign-owned, and broad money and private sector credit
as a share of GDP had risen by more than 15 percentage points (to 40% and 54%
respectively). Except for a banking crisis in 1988–1989 which occurred as a result of
economic sanctions imposed on Panama in 1988, including a freezing of the deposits
held in the United States by the Banco Nacional de Panama, the Panamanian bank-ing system has fared well. 3One result is that private sector borrowers in Panama
have access to international ﬁnancial markets and can borrow at low interest rates.
Indeed, Panamanian ﬁrms and banks do not face a ‘‘sovereign ceiling’’ and can often
borrow at lower rates than the government. However, the small spread between do-
mestic and foreign interest rates is probably more a reﬂection of Panama’s sound and
internationally-oriented banking system than the result of full dollarization.
The rest of Panama’s economy displays many of the maladies common to Latin
America. Until the late 1980s, Panama had a large and ine‰cient public sector that
spent more than 25% of GDP on public sector wages and other current outlays, rigid
labor markets that led to high unemployment (of more than 15%), a distorted trade
regime that thwarted the development of agriculture and manufacturing, and a weaksystem of property rights (Loayza and Palacios, 1997). Given these problems, Pan-
ama had a lackluster ﬁscal performance, with ﬁscal deﬁcits jumping from 2% of
GDP in the 1960s to over 7% in the 1970s, and averaging 5% in the 1980s. Like the
rest of Latin America, Panama ﬁnanced its large ﬁscal deﬁcits mainly with foreign
borrowing, and when the debt crisis of the 1980s hit the region, the country was not
spared. In fact, partly due to the political upheaval, the resolution of Panama’s exter-
nal debt problems was particularly di‰cult and protracted. A reﬂection of this and of
its ﬁscal proﬂigacy is the fact that Panama has needed continued support from the
IMF: from 1973 to 1997, Panama requested thirteen IMF programs, the greatestnumber for any country in Latin America during that period. Although the size of
the IMF loans was generally small, and many of the loans were not drawn, the recur-
rent need to solicit IMF support cast doubts on the claims about self-adjusting prop-
erties of Panama’s dollarized economy that have become popular in some circles.
14.2.2 Bottom Line
Our review of the advantages and disadvantages of hard pegs and of the experiencewith those regimes in Argentina and Panama suggests two main conclusions.
The ﬁrst one is that there are two necessary conditions for the success of a hard
peg: a solid banking and ﬁnancial system, and sound and sustainable ﬁscal policies.
The sole adoption of a hard peg does not ensure that these two conditions will be met,at least not rapidly or automatically. The weakness of Argentina’s banking system
almost brought down its (quasi-) currency board during the Tequila crisis of 1995,
whereas the strength of Panama’s banking system—badly shaken by the incidentsStrategies for Emerging Market Countries 317

of the late 1980s—seems to owe at least as much to the policies and regulations that
transformed Panama into an o¤shore ﬁnancial center for the region than to its hard
peg regime. On the ﬁscal requirements, small ﬁscal deﬁcits were key to the early suc-
cess of Argentina’s currency board but persistent ﬁscal imbalances in the second half
of the 1990s and early 2000s raised recurrent concerns about the sustainability of the
hard peg and eventually led to its demise. Furthermore, the ﬁscal crisis spilled overinto a banking crisis which has been very damaging to the Argentinian economy.
The ﬁscal problems of Panama, on the other hand, have been as entrenched and pro-
tracted as those of the typical (non-dollarized) Latin American country. The claim
that hard pegs ensure ﬁscal discipline and prevent ﬁscal dominance receives little sup-
port from these two experiences.
The second conclusion is that hard pegs remain subject to speculative attacks and
bank runs, and are ill-equipped to counter country-speciﬁc shocks. The spillovers of
the Tequila crisis on Argentina, its banking crisis in 2001–2002 and the runs on Pan-
ama’s banks in the late 1980s provide evidence of the ﬁrst point. The deepening re-
cession in Argentina after the devaluation of the Brazilian real in 1999 and the high
volatility of output in Panama are illustrations of the second.
Another problem of hard pegs is that they do not have an easy exit strategy. Not
even when changes in the country’s political and economic institutions make it possi-
ble and desirable to have a monetary policy able to focus on domestic considerations.
Exiting from a currency board is highly dangerous unless the currency is likely to ap-
preciate, but this is exactly when things are going well and so the political will to exit
is likely to be weak, or nonexistent. Exiting from a fully dollarized economy is even
more troublesome because the (new) monetary authorities, and the new currency, are
likely to encounter a serious problem of lack of credibility. The dire situation of Ar-
gentina in January 2002 provides the best possible illustration of the enormity of thechallenges involved.
Notwithstanding their shortcomings, hard pegs may be the only sustainable mone-
tary policy strategy in the medium term for those emerging market countries whose
political and economic institutions cannot support an independent central bank fo-
cused on preserving price stability. Countries that cannot ﬁnd ways of locking-in the
gains from their ﬁght against (high) inﬂation, or those that have not yet started that
ﬁght, may ﬁnd in hard pegs a reasonable second best strategy for monetary policy.
14.3 Monetary Targeting
A monetary targeting strategy focused on controlling inﬂation comprises three keyelements: 1) reliance on information conveyed by a monetary aggregate to conduct
monetary policy, 2) announcement of targets on a monetary aggregate to guide the
public’s inﬂation expectations, and 3) some accountability mechanism that precludes318 Chapter 14

large and systematic deviations from the monetary targets. In addition, the strategy
presupposes that monetary policy is not dictated by ﬁscal considerations—i.e., lack
of ﬁscal dominance—and that the exchange rate is ‘‘ﬂexible.’’
14.3.1 Lessons from the Recent Experience in Latin America
Despite what is often said, no central bank in Latin America has truly practiced
monetary targeting. In their relatively recent experience with low(er) inﬂation and
ﬂexible exchange rates, the monetary policy frameworks of many central banks in
Latin America, and in emerging markets in other regions, have contained the ﬁrst
of the three key elements mentioned earlier—i.e., using the information conveyed
by a monetary aggregate to conduct monetary policy. However, the other two ele-
ments (public announcements of the targets and some type of accountability mecha-
nism) rarely have been present at the same time—see Cottarelli and Giannini (1997).
The commonly held view that Latin American countries have pursued monetary
targeting is probably rooted on the observation that most central banks in the region
traditionally have used monetary aggregates for the internal design of their monetary
policy. In fact, they have followed this practice in ‘‘good’’ and ‘‘bad’’ times: in peri-ods of high inﬂation and complete ﬁscal dominance and in periods of low inﬂation
and high central bank independence; in periods when the exchange rate was ﬁxed
and when it was allowed to ﬂoat more or less freely; during episodes of stabilization,
both failed and successful; and as an integral part of the many IMF programs these
countries have had over the years. However, the fact that monetary aggregates have
played an important role in monetary policymaking in Latin America does not mean
that the central banks of the region have implemented a monetary targeting strategy.
Regimes where monetary targets are not announced, or are announced but not given
a chance to perform as the main nominal anchor, are not monetary targeting regimes.Instead these regimes are better characterized as ones where central banks make
vague references to monetary aggregates, while they retain a high degree of discre-
tion and instrument independence. A discussion of the experience in Mexico and
Peru in recent years illustrate this point.
Mexico From late 1987 to 1994 the inﬂation rate in Mexico fell from a record high
140% to 7% (see ﬁgure 14.5). The disinﬂation program comprised drastic cuts of gov-
ernment spending, a pegged exchange rate, and the periodic announcement of guide-
lines for public sector prices, the exchange rate and wages (see Aspe, 1993). Starting
in November 1991, when inﬂation was running at 20% in annual terms, Mexico
adopted a system of gradually widening exchange rate bands aimed at giving the cen-tral bank scope to strike a better balance between the ‘‘credibility’’ and ‘‘ﬂexibility’’
of its monetary regime (Helpman et al., 1994). In e¤ect, however, Mexico’s mone-
tary policy in the early 1990s was overburdened by multiple objectives: accumulatingStrategies for Emerging Market Countries 319

Figure 14.5
Mexico: Inﬂation, exchange rate and growth, 1990–1999.
Source: Bank of Mexico and INEGI.320 Chapter 14

international reserves, lowering interest rates, limiting exchange rate volatility, pre-
serving the exchange rate band, and reducing inﬂation. To achieve these, the central
bank conducted monetary policy guided by its internal forecasts of the demand for
base money, and relied heavily on sterilized intervention to prevent the massive cap-
ital inﬂows that ﬂooded Mexico in those years from fueling base money growth and
inﬂation. Hence, from 1991 to 1994, excluding the December spikes, Mexico’s mon-etary base hovered around a remarkably narrow range, while the central bank accu-
mulated more than $11 billion of reserves.
In 1994 the conﬂicting demands placed on monetary policy clashed. The cen-
tral bank reacted to the long string of adverse shocks hitting Mexico during the
year by sticking to its internal forecast for base money and sterilizing the out-
ﬂows of reserves. Instead of raising interest rates to arrest the reserve losses, the
authorities issued $40 billion of dollar-denominated short-term debt (the infamous
Tesobonos ) worsening the system’s vulnerability to a speculative attack. 4The end
came on December 20, when the central bank tried to undertake a ‘‘controlled’’
15% devaluation. The plan did not work, and two days later the peso was allowed
to ﬂoat.
In the ensuing panic Mexico’s central bank maintained its adherence to base
money targeting. In January 1995 the central bank released to the public, for the ﬁrst
time, its monetary program for the year. The program had an inﬂation objective of
19%, and projected a 10 billion pesos increase in base money, which was presented as
the main nominal anchor of the ‘‘new’’ regime. The program lacked credibility and
the free fall of the peso continued until late March, when Mexico secured a $52 bil-
lion support package arranged by the U.S. Treasury and the IMF. At that time, the
central bank announced a modiﬁed monetary program that maintained the projected
increase in base money at 10 billion pesos, revised the forecast of inﬂation to 42%,and, crucially, raised interest sharply and kept them high until May, when the peso
showed signs of stabilizing. For the remainder of the year, the central bank seemed
to gear its monetary policy to preventing ‘‘large’’ peso depreciations; every fall in the
peso of more than 2–3% was followed by a large increase in the interest rates of
Cetes (Mexico’s T-bills), both at the primary auction and in the secondary market
(see Edwards and Savastano, 1998). At the end of 1995, the central bank actually
complied with its announced target for base money (though with less foreign reserves
and more domestic credit than it had projected), but inﬂation, at 52%, exceeded the
program target by 10 percentage points (see ﬁgure 14.5).
The confusion about the instruments and targets of Mexico’s monetary policy con-
tinued for the following two years. The central bank maintained its (new) practice ofreleasing to the public its (quarterly) monetary program, which contained targets for
base money, domestic credit and international reserves at about the same time as the
government submitted to Congress a document containing the budget and the broadStrategies for Emerging Market Countries 321

economic objectives for the following year (including an end-point objective for the
rate of inﬂation). Starting in late 1996, the bank went one step further and released
(and posted on its website) its daily forecast of the monetary base for the following
year. However, it gave no indication of the expected path of inﬂation over the period
covered by the forecast. Moreover, the fact that the nominal exchange rate exhibited
remarkable stability from early 1996 to mid 1997 triggered suspicions that the centralbank, despite its repeated pronouncements to the contrary, was once again targeting
the peso/dollar exchange rate.
Assessing the stance of monetary policy in Mexico during this period, let alone un-
derstanding how the central bank conducted monetary policy, was a daunting task
for analysts and the general public. Although inﬂation fell steadily, albeit slowly,
throughout 1996–97, the Bank of Mexico had serious trouble communicating its
monetary strategy to the public and producing a nominal anchor that would help
lower inﬂation expectations. These problems became particularly acute in 1997 when
the monetary base, which had remained fairly close to its preannounced (quarterly)
path in 1996, started to show large and sustained deviations from its daily forecasts
early in the year. As a result, the Bank of Mexico went to great lengths trying to ex-plain to the public the reduced role that its own forecasts of the monetary base were
playing in guiding its monetary policy (see Bank of Mexico, 1998). Even though the
monetary base exceeded its target by 4.1%, inﬂation in 1997 fell to 15.7%, very close
to the year-end objective of 15%. The unreliability of the relationship between the
monetary base and inﬂation became apparent again in 1998 when inﬂation exceeded
the year-end objective of 12% by almost 7 percentage points even though base money
ended up 1.5% below its forecast. The opposite problem occurred in 1999, when the
inﬂation rate fell below the end-year inﬂation target (12.3% vs. 13%), while base
money exceeded its forecast by more than 21%.
Though it can hardly be argued that the instability of the monetary base-inﬂation
relationship produced terribly bad outcomes since the ﬂoating of the peso in late
1994 until 1997, it was fairly apparent that it had left the Bank of Mexico without a
useful nominal anchor to guide inﬂation expectations. Aware of this situation, the
central bank gradually backed o¤ from its ﬂirtation with monetary targeting. When
Guillermo Ortiz became Governor in 1998, the bank started to downplay publicly
the role that base money forecasts play in the setting of monetary policy, even
though it has maintained the practice of releasing its year-ahead daily forecast of
base money, and has allowed considerably more scope for exchange rate ﬂuctuations.
In fact, we will argue in the next section that the Bank of Mexico has been moving
gradually in the direction of inﬂation targeting.
Peru In August 1990, Peru launched an ambitious economic reform program aimed
at stopping hyperinﬂation and dismantling the numerous controls and distortions322 Chapter 14

prevailing in the economy. The central elements of the anti-inﬂation e¤ort were the
adoption of a freely ﬂoating and fully convertible exchange rate, the establishment of
a cash management committee to handle the ﬁnances of the public sector without
resorting to central bank credit, the de-facto elimination of interest rate ceilings, and
a once-o¤ large adjustment of administered prices—including a 3,000% increase
in the price of gasoline—that helped push the inﬂation rate that month to 400%(Paredes, 1991). The decision to refrain from using the exchange rate as the main
nominal anchor of the disinﬂation was probably the most distinctive feature of Peru’s
stabilization.
The stabilization program was highly successful (see ﬁgures 14.2 and 14.6). In its
ﬁrst phase, from August 1990 to late 1992, annual inﬂation fell steadily, though grad-
ually, from a high of a 12,000% rate in August 1990 to 57%. Key elements of the
program during this phase were the tight control over government spending exercised
by the cash management committee, the major reforms of the tax and tari¤ codes,
and a bold program of privatizations. The second phase of the stabilization started
in 1993, with the approval of a new charter for the central bank, and lasted until
late 1996. The new charter provided a strong institutional foundation for the conductof an independent monetary policy by making price stability the sole objective of the
central bank, by prohibiting the bank from lending to the public sector, from provid-
ing any type of subsidized credit or from creating multiple exchange rates, and by
making the central bank’s Board accountable to Congress in case those directives
were breached (de la Rocha, 1998). In addition, in 1994, Peru’s central bank started
to announce at the beginning of each year a target range for annual inﬂation at year
end (the December to December 12-month inﬂation rate) which had been agreed on
with the Minister of Finance and used in the preparation of the coming year’s ﬁscal
budget. These changes helped to consolidate the stabilization. Inﬂation fell from56.7% in 1992 to 11.8% in 1996, while output growth averaged 9% from 1993 to
1995. Importantly, the disinﬂation proceeded at a fairly steady pace and the rate of
inﬂation did not get ‘‘stuck’’ in the 20% range as had happened often in other stabi-
lization programs in the region. In the ﬁnal phase, from 1997 to the present, inﬂation
has fallen to the single digit level, an outcome Peruvians had not seen for almost
thirty years.
At least since 1993, Peru’s central bank has used estimates of the demand for base
money as its main intermediate target for monetary policy. However, and most cru-
cially , Peru’s central bank has not made its monetary targets public. Aware of the
uncertainties surrounding those forecasts in a dollarized economy (80% of bank
deposits and bank loans in Peru are dollar-denominated), the central bank hasretained considerable discretion to revise and update its base money demand esti-
mates, and to modify the setting of policy instruments whenever it has deemed
necessary (de la Rocha, 1998). By doing so, Peru avoided the type of problemsStrategies for Emerging Market Countries 323

Figure 14.6
Peru: Inﬂation, Exchange rate and growth, 1994–1999.
Source: Central Reserve Bank of Peru and IFS.324 Chapter 14

encountered by Mexico when it tried to employ base money forecasts as a nominal
anchor for inﬂation expectations.
Even though the Peruvian authorities did not announce targets for monetary
aggregates nor any type of money rule as an anchor for inﬂation expectations at any
point during the 1990s, Peru’s program has become the prime case of a ‘‘money-
based stabilization’’ in the large literature on inﬂation-stabilization strategies (e.g.,Calvo and Vegh, 1994, 1999). The ‘‘money-based stabilization’’ label has been
pushed further recently with Corbo (1999), who argues that Peru used a monetary
anchor as the central element of its stabilization program—see also Favaro, 1996.
These characterizations are misleading: In the 1990s Peru’s central bank did not pur-
sue a monetary targeting strategy with a money anchor but instead followed a con-
ventional two-step approach for the internal design of its monetary policy, using the
growth of base money as one of the elements guiding its decisions on instruments set-
tings. Peru’s strategy in the past decade should be seen as one of discretionary mone-
tary policy with an increasing focus on price stability, not too di¤erent from the
approach to monetary policy followed by many non-inﬂation targeting industrial
countries (including the U.S.).
14.3.2 Bottom Line
The recent experiences of Mexico and Peru illustrate the di‰culties that the instabil-
ity of the money-inﬂation relationship creates for monetary targeting as a strategy
for monetary policy in emerging market countries. This does not mean that mone-
tary aggregates have no role to play in the conduct of monetary policy in those coun-
tries. In many emerging market economies the signal-to-noise ratio of monetary
aggregates may be high, owing to their history of high inﬂation and large swings
in money growth. However, as inﬂation falls to single digit levels and remains there,money growth rates are likely to lose informational content and become less useful
indicators of monetary policy, as occurred in industrial countries (see Estrella and
Mishkin, 1997). As money aggregates become less reliable indicators of future inﬂa-
tion, central banks will be well advised to downplay the importance of monetary tar-
gets, and search for alternative nominal anchors and communication devices.
Central banks in emerging market economies are oftentimes regarded as monetary
targeters (e.g., Fry et al., 1999); almost always that characterization is inappropriate.
As in Mexico and Peru, the alleged monetary targeting is typically a disguise for a
highly discretionary monetary policy. Even when that approach proves to be success-
ful for a period of time, as has been the case especially in Peru, it is a highly dan-
gerous strategy. Two crippling shortcomings of the approach are that it depends toomuch on the preferences, skills and credibility of the individuals running the central
bank, and that it does not lend itself to make monetary policy transparent and
accountable. 5Strategies for Emerging Market Countries 325

In sum, our review of the evidence suggests that monetary targeting is a strategy
for monetary policy that has not been used by Latin American countries in the recent
past, and is probably not an advisable medium-term strategy for the future. This
is so because the problems that led to the abandonment of this strategy in indus-
trialized countries (Bernanke and Mishkin, 1992) are also likely to arise in emerging
market countries as low inﬂation becomes a more permanent feature. Indeed, evenGermany, the quintessential monetary targeter, encountered problems with the
money-inﬂation relationship which led the Bundesbank to miss the target ranges for
its monetary targets on the order of half the time. 6The secret to the Bundesbank’s
success was its long-term adherence to a ‘‘monetarist’’ framework to communicate
to the public its commitment to price stability, along with the credibility it earned
over the years which made its explanations of target misses believable to the public.
Germany’s relative success with monetary targeting is not a model for emerging mar-
ket countries, where central banks need to assert their credibility over the next few
years. In fact, the Bundesbank’s success may not even be a model for how the Euro-
pean Central Bank should conduct monetary policy.
14.4 Inflation Targeting
Inﬂation targeting is a monetary policy strategy that involves ﬁve main elements: 1)the public announcement of medium-term numerical targets for inﬂation; 2) an insti-
tutional commitment to price stability as the primary goal of monetary policy, to
which other goals are subordinated; 3) an information-inclusive strategy in which
many variables, and not just monetary aggregates or the exchange rate, are used for
deciding the setting of policy instruments; 4) a transparent monetary policy strategy
that ascribes a central role to communicating to the public and the markets the plans,objectives, and rationale for the decisions of the central bank; and 5) mechanisms
that make the central bank accountable for attaining its inﬂation objectives. The list
should clarify one crucial point about inﬂation targeting: it entails much more than a
public announcement of numerical targets for inﬂation for the year ahead. This is im-
portant in the emerging markets context, because many emerging market countries
have routinely reported numerical inﬂation targets or objectives as part of the gov-
ernment’s economic plan for the coming year (see Fry, et al., 1999) and yet they
have not been pursuing an inﬂation targeting strategy. The monetary policy strategy
must contain the other four elements listed above for it to be consistent with inﬂation
targeting and, hence, sustainable over the medium term.
14.4.1 Lessons from the Recent Experience in Latin America
Inﬂation targeting is often in the eyes of the beholder. The monetary policy frame-
works of several countries in Latin America contain some of the elements of inﬂation326 Chapter 14

targeting that we have outlined. However, this does not mean that those countries
should be regarded as having followed an inﬂation targeting strategy. To understand
why we examine the recent experience of ﬁve countries: Chile, Colombia, Peru, Mex-
ico and Brazil. 7
Chile The new central bank legislation of 1989, which took e¤ect in 1990, gave in-
dependence to the central bank and mandated price stability as one of its primary
objectives. However, the legislation also stipulated objectives of the central bank to
ensure equilibria in domestic and external payments. Over time, the central bank of
Chile gradually increased the weight it attached to its price stability objective. The
ﬁrst inﬂation objective under the new legislation was announced in September 1990
for the twelve-month inﬂation rate in 1991 and has been announced every year since
then in the ﬁrst ﬁfteen days of September for the following year (December to De-
cember). However, the inﬂation objective was initially interpreted by the public
more as o‰cial inﬂation projections rather than as formal or ‘‘hard’’ targets (Mor-
ande´and Schmidt-Hebbel, 1997). In fact, Chile’s central bank pursued a very gradu-
alist approach to lowering its inﬂation objectives, starting with targets of over 20%for 1991 and lowering them slowly to below 5% (see ﬁgure 14.7). Over time, as the
central bank experienced success in both disinﬂating and meeting its inﬂation objec-
tives, the public began to interpret those objectives as ‘‘hard’’ targets for which the
central bank could be made accountable. As part of this process, in September 1994
the central bank started to announce point targets rather than target ranges for
its inﬂation objective for the following year. However, it was only in 1999 that the
central bank explicitly announced a multi-year target for inﬂation—consisting of
a target of 3.5% for the year 2000, and a longer-term target of 2 to 4% for 2001
onwards.
The Chilean experience with inﬂation targeting looks quite successful. 8Inﬂation
has fallen from levels above 20% when inﬂation projections were ﬁrst introduced to
a level around 3% at present. Over the same period, output growth has been very
high, averaging over 8.5% per year from 1991 to 1997, a level comparable to those
exhibited by the (former) Asian tigers. Growth performance faltered in 1998–99;
output growth fell to 3.4% in 1998 and the economy experienced a mild recession in
1999 (see ﬁgure 14.7). In 1998 the Chilean central bank was reluctant to ease mone-
tary policy and let the exchange rate depreciate in order to cushion the e¤ects of a
substantial negative terms of trade shock. Instead, the central bank raised interest
rates sharply and even narrowed the exchange rate band. In hindsight, these deci-
sions appear to have been a mistake: the inﬂation target was undershot and the econ-omy entered a recession for the ﬁrst time under the inﬂation targeting regime. Not
surprisingly given these outcomes, the central bank came under strong criticism. 9
During 1999 the central bank reversed course, eased monetary policy by loweringStrategies for Emerging Market Countries 327

Figure 14.7
Chile: Inﬂation, exchange rate and growth, 1990–1999.
Source: Central Bank of Chile and IFS.328 Chapter 14

interest rates, and allowed the peso to depreciate, thus setting the stage for a strong
rebound of output growth in 2000.
As part of its monetary policy regime, from the mid-1980s until August 1999, Chile
had an exchange rate band around a crawling peg which was (loosely) tied to lagged
domestic inﬂation. The central bank stressed that the purpose of the exchange rate
band was not inﬂation control, and this was the reason why, for most of the period,
the rate of crawl was set on a backward-looking rather than a forward-looking basis.
Rather the central bank argued that the purpose of the exchange rate band was to
keep the real exchange rate in a range consistent with medium- and long-term exter-
nal equilibrium and, thus, preclude an ‘‘excessive’’ current account deﬁcit. Over time,
the central bank also made it clear through its actions that the inﬂation target would
take precedence over the exchange rate band when there was a potential conﬂict be-
tween the two objectives. Thus, for example, in various instances from 1992 to 1997
when large capital inﬂows pushed the exchange rate close to the appreciated edge of
the band, the central bank widened the band and even revalued the central parity
while keeping the inﬂation target unchanged, thus signaling to the public that it
attached a higher weight to lowering inﬂation than to resisting a real appreciationthat seemed warranted by the ‘‘fundamental’’ determinants of the real exchange rate.
A strong ﬁscal position and a sound ﬁnancial system are two key features of the
Chilean economy that have supported the inﬂation targeting regime. The ﬁscal bal-
ance ended in surplus every year from 1991 to 1998, and during 1991–97 the surplus
averaged 2.8% of GDP, clear indications that ﬁscal policy was kept under control. In
addition, due largely to the measures taken in the aftermath of the severe banking
crisis of the early 1980s, Chile’s standards and practices in the areas of banking reg-
ulation and supervision during the 1990s have been of a quality comparable to those
found in industrialized countries and far superior to those found in the rest of LatinAmerica (with the possible exception of Argentina from 1995 to 2000). The resulting
solidity of the Chilean ﬁnancial system has meant that the ability of the central bank
to take steps to defend the currency and the banks has never been in question, which
may have helped Chile experience less pressures on its currency than other countries
of the region at the time of the Tequila crisis (see IMF, 1996). The controls on short-
term capital inﬂows have also been cited often as another important factor behind
the low vulnerability and relative stability of the Chilean economy in the 1990s.
However, the controls are highly controversial and their contribution is di‰cult to
ascertain. 10Our reading of the evidence suggests that, from the perspective of mone-
tary policy and inﬂation control, strict prudential supervision was probably more
important.
The Chilean example suggests that inﬂation targeting can be used as a successful
strategy for gradual disinﬂation, even when inﬂation starts from levels of around
20%. It is important to emphasize that the success of inﬂation targeting cannot beStrategies for Emerging Market Countries 329

solely attributed to the actions of the Chilean central bank: supportive policies such
as sustained ﬁscal surpluses and rigorous regulation and supervision of the ﬁnancial
sector have been crucial to that outcome. Another important element of Chile’s strat-
egy has been the gradual hardening of the inﬂation targets and, most recently, the
announcement of multi-year targets. However, it was not until early 2000, when
the central bank began publishing an Inﬂation Report -type document that included
baseline inﬂation forecasts, that Chile arguably completed its transition to a full-
ﬂedged inﬂation targeting regime.
Colombia A decade ago, the prospects for Colombia’s monetary policy were quite
promising. The country had avoided the populist excesses that had ravaged many of
its neighbors, had not been much a¤ected by the debt crisis, and had not su¤ered a
hyperinﬂation (see Urrutia, 1991). Next to Chile, Colombia was seen by many as the
country in the region best positioned for economic take-o¤. Breaking double-digit in-
ﬂation, a feature of Colombia’s economy since the early 1970s, was considered a key
prerequisite for attaining that goal (see Dornbusch and Fischer, 1993). The Colom-
bian authorities seemed up to the challenge. The 1991 constitution—and the sup-portive legislation passed in 1992—made the central bank independent from the
government, made inﬂation control the overriding objective of monetary policy, pro-
hibited the central bank from ﬁnancing private sector activities, and placed tight lim-
its on the bank’s ﬁnancing of government deﬁcits (see Steiner, 1995). In addition,
since 1991 the central bank started to announce explicit numerical targets for the
one-year ahead inﬂation rate, as part of the authorities’ economic program—which
continued to be centered around the crawling peg system which had been a hallmark
of Colombia’s economic policy since the late 1960s (see Williamson, 1996).
The anti-inﬂation strategy was unsuccessful. Average annual inﬂation in the period
1991–1998 (22.7%) was essentially the same as the average for the 1980s (23.6%),
and from 1991 to 1996 the central bank consistently exceeded its always modest
inﬂation targets (see ﬁgure 14.8). The inﬂation target was met for the ﬁrst time in
1997—with inﬂation ending slightly below the 18% target—but the target was
breached again in 1998 (16.7% vs. 16%). In that year, investors’ concerns about
Colombia’s large ﬁscal and external deﬁcits (in the order of 4% and 5% of GDP, re-
spectively) and about its political situation led to a string of speculative attacks on
the peso. In response, the central bank ﬁrst raised interest rates to record-high levels
and then, in September 1998, depreciated both edges of the exchange rate band by
9%. The response did not arrest the speculative pressures and induced a sharp slow-
down in activity. In 1999 the pressures on the peso continued and Colombia su¤eredits ﬁrst recession in seven decades. By mid-year it was apparent that the inﬂation tar-
get of 15% would be undershot by a large margin, but it was also clear that this was
not a desired policy outcome. In late September the exchange rate band was aban-330 Chapter 14

Figure 14.8
Colombia: Inﬂation, exchange rate and growth, 1990–1999.
Source: DANE, Central Bank of Colombia and IFS.Strategies for Emerging Market Countries 331

doned, the peso was allowed to ﬂoat, and Colombia requested its ﬁrst IMF pro-
gram in more than 30 years in an attempt to allay investors’ concerns and end the
recession.
It is self-evident from Colombia’s inﬂation performances that reducing inﬂation
from the 20–25% range was not a priority of monetary policy for most of the 1990s.
Its increased independence notwithstanding, the central bank continued to give prior-ity to other objectives, especially output stability, whenever those goals seemed to be
put in jeopardy by the inﬂation target (see Cardenas and Partow, 1998). The central
bank seemed relatively content with its approach to monetary policy; indeed, in
1998, the (former) Vice-Governor of the bank stated boldly that: ‘‘the stance of eco-
nomic policy in Colombia has been deﬁned in the context of a global objective which
has been to maintain moderate inﬂation in the 20–30% range’’ (Carrasquilla, 1998,
p. 87). Interestingly, as had happened in Brazil a few months earlier (see below), the
failed defense of the exchange rate band in September 1999 prompted a reformula-
tion of Colombia’s monetary regime. As part of the policy response to the currency
crisis, the authorities let the peso ﬂoat and set an inﬂation target of 10% for 2000
which, in the event, was undershot by about 1%. Later, in October 2000, the Colom-bian authorities moved further in the direction of inﬂation targeting by announcing
targets for 2001 (8%) and 2002 (6%) and taking concrete actions to increase the ac-
countability and transparency of the central bank.
Peru As noted in the previous section, Peru’s central bank announced an inﬂation
target since 1994 and was quite successful in bringing down inﬂation. However,
from 1997 to 1999, the central bank consistently undershot its inﬂation targets. In
1997, the target range was 8–10% while the actual end-of-year rate of inﬂation closed
at 6.5%; in 1998 the target range was set at 7.5–9% and actual inﬂation was 6%; andin 1999 the range was 5–6% and inﬂation fell to 3.4%. Only in 2000 did the end-year
rate of inﬂation (3.7%) fall within the target range set by central bank at the end of
the previous year (3.5%–4%)—see ﬁgure 14.6.
In 1998 a series of adverse shocks (i.e., el Nin ˜o, low commodity prices, and the
Russian crisis) provoked a collapse in exports, a substantial depreciation of the sol,
and a sharp slowdown of bank credit. Those events brought the Peruvian economy
to the verge of its ﬁrst recession since 1992. Economic activity remained depressed in
1999–2000 despite an agriculture-led rebound of aggregate output. As a result, mon-
etary policy came under ﬁre from all fronts fueling a debate on whether there is a
need for an alternative monetary framework for Peru, including the option of full
dollarization. Thus, notwithstanding the successful disinﬂation, Peru’s monetaryauthorities continued to lack credibility.
Although the central bank announces inﬂation targets, Peru’s monetary policy
framework does not contain many crucial features of an inﬂation targeting regime,332 Chapter 14

such as the publication of inﬂation reports (and, hence, of the central bank’s inﬂation
forecasts), mechanisms for making the central bank accountable for attaining its in-
ﬂation targets, or the announcement of multi-year targets. However, probably the
most serious shortcoming of Peru’s monetary policy has been its lack of transpar-
ency. A main contributing factor has been the profusion of instruments of monetary
policy employed by the central bank: intervention in the money market (through theauction of certiﬁcates of deposits), intervention in the foreign exchange market
(through direct sales and purchases of foreign exchange), and several other secondary
instruments such as rediscounts, reserve requirements on the sizable foreign currency
deposits and the interest paid on those reserve requirements. The proliferation of sig-
nals, compounded by the apparent lack of a coherent framework to communicate
and evaluate monetary policy, has made it di‰cult for the public to decipher the cen-
tral bank’s actions, intentions and priorities, as well as to assess the stance of mone-
tary policy at any given point in time. Instances where these problems have arisen
abound, but they have been particularly acute and frequent with regard to two indi-
cators: the observed rate of growth of base money (which on many occasions has
been considered excessive and inconsistent with the inﬂation target—for exampleduring 1995–1996) and the intervention in the foreign exchange market (which is
often perceived as interfering excessively with equilibrium short-run movements in
the nominal exchange rate—especially with depreciations). Although the latter criti-
cism is probably warranted, Peru’s central bank has consistently, and in our view,
prudently, refrained from making any type of commitment, explicit or implicit, re-
garding the (expected or desired) level or path of the nominal exchange rate, and
has let the exchange rate depreciate at a faster rate when market pressures have
proved persistent—for example, in late 1998 and 1999. This ﬂexibility, added to
the desirable features already included in the central bank’s charter, bodes well fora smooth transition to a monetary policy regime more consistent with inﬂation
targeting.
One feature of the Peruvian experience that is of great interest is the high degree of
dollarization of the economy. As noted before, more than 70% of bank deposits and
bank loans in Peru are dollar-denominated; moreover, U.S. dollars circulate freely
and are widely accepted as means of payment. As in other countries of the region,
Peru’s dollarization has its roots in the high inﬂation of the 1970s and 1980s. The
process of remonetization that accompanied the successful stabilization of the early
1990s was driven by repatriation of ﬂight capital of domestic residents and was chan-
neled primarily to the fully convertible dollar deposits o¤ered by the banking system.
Thus, also as in other countries—i.e., Argentina, Bolivia, Uruguay—the bankingsystem has remained highly dollarized despite the success in ﬁghting inﬂation. 11As
noted earlier, partial dollarization has the potential to make an inﬂation targeting re-
gime, which requires some degree of exchange rate ﬂexibility, vulnerable to ﬁnancialStrategies for Emerging Market Countries 333

instability. However, this does not seem to have presented a severe problem in the
case of Peru. The country su¤ered no contagion whatsoever from the Tequila crisis
of December 1994 and weathered the crisis nicely, although this outcome was sub-
stantially helped by Peru’s limited access to short-term capital ﬂows at that time.
Similarly during the Russian crisis of 1998, when there was a substantial deprecia-
tion, Peru did not experience severe ﬁnancial instability, although bank credit andeconomic activity slowed down considerably. The overhaul of banking supervision
and prudential regulations undertaken since the mid-1990s are likely to have contrib-
uted to this outcome.
Mexico We noted in section 14.3 that Mexico’s attempt at using base money fore-
casts as a nominal anchor has not been too successful, and that the central bank has
started to back o¤ from that practice. In fact, senior central bank o‰cials have
recently characterized Mexico’s monetary policy framework as being in ‘‘a transition
period towards a clear-cut inﬂation targeting scheme’’ (Carstens and Werner, 1999).
We also noted earlier that for a number of years Mexico has made public an explicit
inﬂation objective at the time the Minister of Finance submitted to Congress the gov-ernment’s economic program for the following year. However, Mexico’s monetary
policy still lacks some important elements of an inﬂation targeting strategy such as
a transparent policy framework, and high accountability for meeting the inﬂation
target. It is true that the Bank of Mexico has increased the emphasis on the inﬂa-
tion goal as the central objective of its monetary policy and that, since 1998, has let
the exchange rate ﬂuctuate more freely. But those changes did not go far enough.
Mexico’s central bank has continued to release its year-ahead forecasts for the daily
monetary base, has insisted on explaining its monetary policy actions in terms of its
system of daily liquidity management (the ‘‘corto’’ and ‘‘largo’’), does not produce orrelease to the public mid-course inﬂation forecasts and, until recently, maintained the
one-year ahead horizon for the inﬂation target. These practices are not credibility-
enhancing and tend to create confusion, especially when there are (downward) pres-
sures on the exchange rate.
It is possible that the Bank of Mexico was waiting for the ‘‘right’’ time to move to
a more explicit inﬂation targeting regime. After all, up until 2000, inﬂation remained
in the (low) double digits, external ﬁnancing conditions were tight, and the pass-
through from exchange rate changes did not seem to have fallen much (see Bank of
Mexico, 1998). In addition, the inﬂation rate in 1998 overshot the announced target
by almost 7 percentage points, damaging the Bank of Mexico’s anti-inﬂation creden-
tials. As we have argued, there is a case to be made for central banks to wait untilthey have acquired some anti-inﬂation credibility before they ‘‘harden’’ their targets
for inﬂation. From this perspective, 1998 was probably not a good year for the Bank
of Mexico to push further in the direction of inﬂation targeting.334 Chapter 14

In 1999, however, things started to look di¤erent. Annual inﬂation, at 12.3%, fell
below the 13% target, the pass-through from exchange rate changes seemed to abate
slightly, and, unlike the other large countries of the region, the economy grew by
more than 3% (see ﬁgure 14.5). These outcomes helped enhance the credibility of
the Bank of Mexico. Appropriately, the central bank stepped up its commitment to
inﬂation targeting. For the ﬁrst time, the central bank announced the 10% inﬂationtarget for the year 2000 before the Ministry of Finance submitted to Congress the
economic program for the year. This (subtle) move contributed to raising the account-
ability of the central bank for complying with its inﬂation objectives. Also for the
ﬁrst time, the Bank of Mexico announced a multi-year target for inﬂation by stating
that it intends to lower inﬂation to ‘‘international levels,’’ (i.e., somewhere in the 2 to
3% range) by 2003. Starting in April 2000, the Bank of Mexico began issuing an In-
ﬂation Report . The report explains developments on the inﬂation front and discusses
their relationship with the policy actions taken by the bank, but it does not present
the bank’s inﬂation forecasts. Nonetheless, publication of the report was a welcome
step that augurs well for a rapid transition to full-ﬂedge inﬂation targeting. All in all,
starting in the late 1990s the Bank of Mexico followed a strategy quite similar to theone followed by the central bank of Chile a few years earlier, i.e., it ‘‘hardened’’
gradually the inﬂation targets as the bank’s credibility increased because of its dem-
onstrated success on the inﬂation front.
Brazil The exchange-rate based stabilization under the Real plan from 1994 until
January 1999 was extremely successful, reducing inﬂation from 2,500% in December
1993 to less than 2% by December 1998 (see ﬁgures 14.2 and 14.9). 12However, the
inability of the Brazilian government to put its ﬁscal house in order led to a gradual
build up of public debt that increased the regime’s vulnerability to speculative attacksand, following a costly defense in the fall of 1998, the realcollapsed in January 1999.
In the immediate aftermath of the currency crash, the (de-facto) resignation of two
central bank presidents and the lack of a clear strategy for monetary policy made
Brazilian prospects look bleak; doomsday predictions—such as: ‘‘ one caipirinha will
amount to ten tequilas ’’13—became common in the press and in market commentary.
However, soon after his appointment in early February, the new central bank presi-
dent, Arminio Fraga, took two crucial steps. First, as the British had done in the
fall of 1992, 14he recognized the need to rapidly put in place a nominal anchor and
announced that Brazil would be soon adopting an inﬂation targeting strategy.
And second, he decided to increase the interbank interest rate by 600 basis points,
to 45%, to arrest the plunge of the realand re-establish credibility in monetary policy.
On June 21, 1999 the President of Brazil issued a decree instituting an inﬂation
targeting framework for the conduct of monetary policy. The regime contemplated
in the decree contains all the key elements of an inﬂation targeting strategy, namely:Strategies for Emerging Market Countries 335

Figure 14.9
Brazil: Inﬂation, exchange rate and growth, 1995–1999.
Source: Central Bank of Brazil IFS.336 Chapter 14

1) the announcement of multi-year inﬂation targets (with explicit numerical targets
for the 12-month rate of inﬂation in the years 1999, 2000 and 2001, and a commit-
ment to announce the targets for 2002 onwards two years in advance); 2) assigning to
the National Monetary Council the responsibility for setting the inﬂation targets and
tolerance ranges based on a proposal by the Minister of Finance; 3) giving to the cen-
tral bank of Brazil full responsibility to implement the policies needed to attain theinﬂation targets; 4) establishing procedures to increase the central bank’s account-
ability (speciﬁcally, if the target range is breached, the central bank president would
have to issue an open letter to the Minister of Finance explaining the causes of the
deviation, the measures that will be taken to eliminate it, and the time it will take to
get inﬂation back inside the tolerance range); and 5) taking actions to improve the
transparency of monetary policy (concretely, the central bank was requested to issue
a quarterly Inﬂation Report modeled after that produced by the Bank of England).
In terms of its design, the framework set up by Brazil had all the ‘‘bells and whis-
tles’’ of an inﬂation targeting regime, and it clearly was the most comprehensive at-
tempt to establish a regime of this type in Latin America. What is especially striking
about Brazil’s move to inﬂation targeting is how fast it occurred. The ﬁrst inﬂationreport was issued in July 1999, just a few months after Fraga was conﬁrmed, with the
second, right on schedule in September. The reports not only discussed clearly
the conditions prevailing in the economy and the prospects for inﬂation, but also
provided the central bank’s inﬂation forecasts under di¤erent scenarios—including
through the use of ‘‘fan charts’’ depicting the probabilities of di¤erent inﬂation paths.
Many central bankers in emerging market countries have been concerned that it
might take them a long time to acquire the technical capability to issue an inﬂa-
tion report of this type. Brazil’s example suggests that those concerns may be a bit
overdone.
The initial inﬂation targets were set at 8% for 1999, 6% for 2000 and 4% for 2001,
with a tolerance range of G2%. To the surprise of many, the strategy worked well
from the start. There was a remarkably small pass-through from the large deprecia-
tion of the real(which fell by 45% on impact and thereafter stabilized at 30% below
its pre-devaluation level) for several months, the output contraction was contained
(in fact, annual GDP grew by almost 1 percent in 1999), Brazil was not cut-o¤ from
external ﬁnancing—though there was some ‘‘arm twisting’’ involved—and there were
no major bank runs. By March 1999, asset prices had started to recover, the real
appreciated and the central bank found room to lower interest rates—which it did,
quite aggressively (from a high of 45% to below 20% in a seven-month period). In-
ﬂation and the exchange rate remained subdued through October, when the monthlyinﬂation rate rose to 1.2%, the largest monthly increase since June 1996, and the ex-
change rate crossed, brieﬂy, the then ‘‘critical’’ mark of R$2.00 per U.S. dollar (see
ﬁgure 14.9). In the event, inﬂation in 1999 reached 8.9%, above the 8% target for theStrategies for Emerging Market Countries 337

year but well within the 2 percent tolerance range; during 2000 inﬂation continued
falling, and closed the year right at the 6% mid-point target set by the central bank
in mid-1999.
Its auspicious beginning notwithstanding, it is still too soon to tell whether Brazil’s
inﬂation targeting scheme will be successful. The two big question marks are, ﬁrst,
whether the central bank will be capable of enhancing and asserting its independencefrom the government and remain committed to controlling inﬂation, and second, the
perennial question in Brazil, whether the government will undertake the steps and
reforms needed to put ﬁscal policy on a sustainable path consistent with low inﬂa-
tion. If Brazil, yet again, cannot meet these challenges, monetary policy will become
increasingly overburdened and discretionary, ﬁscal dominance will reappear, and the
inﬂation targeting regime will blow up. Despite these risks, it is nonetheless useful to
identify the factors that may have contributed to Brazil’s initial success with inﬂation
targeting. In our view, the three that stand out are the relative strength of Brazil’s
banking system (which had undergone a major restructuring following the bank
crisis of 1994–1996—see Caprio and Klingebiel, 1999), the existence of substantial
‘‘slack’’ in the economy (partly a consequence of the prolonged interest rate defenseof the realplan), and, especially, the quick measures taken by Governor Fraga to
reestablish credibility in monetary policy. Other emerging market countries may
want to take note.
14.4.2 Bottom Line
Our review of the conduct and orientation of monetary policy in ﬁve Latin Americancountries in recent years suggests to us that inﬂation targeting can become a viable
medium-term strategy for monetary policy for many emerging market economies.
In fact, all the countries reviewed in this section seem to be moving in the directionof a full-ﬂedged inﬂation targeting regime. In terms of a demonstrated commitment
to lowering inﬂation in line with its target and of the general conduct of monetary
policy, Chile is far ahead of the rest of the group. In terms of setting up a frame-
work for monetary policy that contains all the key elements of inﬂation targeting,
Brazil has taken the lead in the region, showing that an inﬂation-targeting regime
can be implemented quite quickly. The other three countries reviewed lag behind in
both the commitment to inﬂation control and adoption of the other key elements of
inﬂation targeting. A key requirement for inﬂation-targeting regimes in emerging
market countries, as elsewhere, is the recognition that undershooting inﬂation tar-
gets, as occurred in Chile and Peru in the late 1990s, is just as costly as overshooting
the targets. Support for an independent central bank which is pursuing price stabilitycan erode if the central bank is perceived as focusing too narrowly on lowering inﬂa-
tion to the detriment of other objectives, especially output stability. By just as readily
admitting their mistakes when an inﬂation target is undershot as when it is overshot,338 Chapter 14

and continuously reﬁning their technical expertise to minimize the occurrence of such
events, central banks may increase support for their independence and for the inﬂa-
tion targeting regime.
Fiscal discipline and a sound and well-regulated banking system are crucial for the
viability and success of inﬂation targeting, just as they are for the success of hard
pegs. Again, Chile seems to be way ahead of the other countries reviewed in termsof broad compliance with these requirements. Lack of ﬁscal discipline is a particu-
larly serious concern in Brazil and Colombia, whereas weaknesses in the banking sys-
tem are the big question mark in Mexico, and, to a lesser extent, Peru. Inﬂation
targeting alone will not solve these problems; neither will hard pegs. Setting multi-
year inﬂation targets in coordination with the government (including on the issue of
government-controlled prices) may help reduce the risk of ﬁscal proﬂigacy, but it is
not a long-term solution. Setting up institutions that help keep ﬁscal policy in check
and others that promote and enforce sound banking practices seem to be the only
solutions that may prove lasting and workable for emerging market countries.
Then there is the di‰cult question of the role of the exchange rate in an inﬂation
targeting strategy for monetary policy in an emerging market country. The ﬁve casesreviewed provide only limited guidance for answering this question satisfactorily.
The countries’ reluctance to adopt an attitude of ‘‘benign neglect’’ of exchange rate
movements (i.e., a ‘‘pure ﬂoat’’) seems broadly appropriate—especially while they
were undertaking a disinﬂation—but all of them probably went too far for too long
in the direction of limiting exchange rate ﬂexibility. They did so not only through the
explicit use of exchange rate bands, employed by all countries, except Peru, for a
good part of the 1990s, but also through frequent direct and indirect intervention in
the foreign exchange market. The main problem with responding too heavily and too
frequently to movements in a ‘‘ﬂexible’’ exchange rate is, of course, that the strategyruns the risk of transforming the exchange rate into a nominal anchor for monetary
policy that takes precedence over the inﬂation target, at least in the eyes of the pub-
lic. With time, this practice may become observationally equivalent with a strategy of
nominal exchange rate targeting.
To mitigate the risk that the exchange rate might replace the inﬂation target as the
economy’s main nominal anchor, central banks in emerging market economies
would be well advised to be more transparent regarding the role they ascribe to the
exchange rate in their monetary policy framework. For example, they could express
a concern for the e¤ects that exchange rate ﬂuctuations may have on aggregate de-
mand and supply and indicate that those concerns would lead the central bank to
try to smooth large exchange rate ﬂuctuations, but it would not try to prevent theexchange rate from reaching its market-determined level over longer horizons. Ex-
change rate smoothing via foreign exchange market interventions might be necessary
at times to prevent or arrest large and abrupt exchange rate ﬂuctuations that areStrategies for Emerging Market Countries 339

clearly divorced from fundamentals. However, systematic exchange market interven-
tions, particularly sterilized ones, are likely to be counterproductive as they would
make it very di‰cult to signal that the inﬂation targets, rather than the exchange
rate, is the primary nominal anchor of the economy.
Central banks should also explain to the public the rationale for exchange rate in-
tervention in a manner analogous to that for interest-rate smoothing, i.e., as a policyaimed not at resisting market-determined movements in an asset price, but at miti-
gating potentially destabilizing e¤ects of abrupt and sustained changes in that price.
More generally, we think it is important that central banks understand that there are
no ‘‘good ﬂoats’’ or ‘‘bad ﬂoats,’’ but that there is such a thing as ‘‘good’’ and ‘‘bad’’
monetary policy under ﬂexible exchange rates. Letting the exchange rate become the
de-facto nominal anchor of the economy through excessive intervention in a quasi-
inﬂation targeting regime is an example of the latter.
It is also important for central banks to recognize that, as is the case for most eco-
nomic relationships, the pass-through from exchange rate changes to prices is likely
to be regime-dependent. After a sustained period of low inﬂation with e¤ective,
as opposed to ﬁctional, exchange rate ﬂexibility, the informational content of theexchange rate in the expectations-formation process and price-setting practices of
households and ﬁrms is likely to fall. Thus, the widespread view that a currently
high pass-through from exchange rate changes to prices is a barrier to successful in-
ﬂation targeting is probably exaggerated. Indeed, the low pass-through that occurred
after the Brazilian devaluation in 1999, which might have been reduced by the adop-
tion of an inﬂation targeting regime (as well as by the slack in the economy), suggests
that a high pass-through is not a permanent feature of emerging market economies.
A related problem of special relevance for emerging market countries is the extent
to which a high degree of dollarization may hinder inﬂation targeting. To a large ex-tent a transparent and well-designed policy of exchange-rate smoothing combined
with strong regulatory and supervision practices in the ﬁnancial system should miti-
gate potential inconsistencies. The recent experience of Peru is encouraging in this re-
gard. In fact, the argument can be turned on its head. The high dollarization of bank
loans and deposits and the widespread use of U.S. dollars as the unit of account and
medium of exchange (though not as legal tender) in countries like Peru, Bolivia
and Uruguay is probably irreversible, at least in the medium run. Yet all these coun-
tries have retained a domestic currency and have managed to reduce inﬂation to
very low levels.
Even Uruguay, the chronic inﬂation country par excellence has recently brought
inﬂation down to the single digits. Highly dollarized economies are therefore reapingone of the main beneﬁts of full dollarization (low inﬂation) while preserving some
scope to mitigate the e¤ects of other shocks through monetary policy. Because their
payments systems and transactions technology are already partially dollarized, it340 Chapter 14

would be relatively easy for these countries to switch unilaterally to full dollarization,
if they chose to. Designing a credible strategy that allows them to retain an addi-
tional margin of ﬂexibility without impairing their gains on the inﬂation front, which
is what inﬂation targeting is all about, is probably a more demanding task, but its net
beneﬁts over the medium term are also greater, and, we think, worth pursuing.
14.5 Conclusion
The case studies in this chapter suggest that one size does not ﬁt all when it comes todesigning monetary policy strategies for emerging market and transition countries.
The key to successful monetary policy is the ability to constrain discretion so that
monetary policy can focus on the long-run goal of price stability. How best to do
this depends on the insitutional environment in each country. There are some emerg-
ing market countries which may not have the political and other institutions to con-
strain monetary policy if it is allowed some discretion. In these countries there is a
strong argument for hard pegs, including full dollarization, which allow little or no
discretion to the monetary authorities. On the other hand, there are many emergingmarket countries that seem to have the ability to constrain discretion, with Chile
being the clearest example, and for these cases we believe that inﬂation targeting is
likely to produce a monetary policy which keeps inﬂation low and yet appropriately
copes with domestic and foreign shocks. As we have seen, monetary targeting as a
strategy for emerging market countries is not viable because of the likely instability
of the relationship between monetary aggregates and inﬂation.
Regardless of which monetary policy strategy is chosen, our case studies suggest
that a monetary policy strategy will not be successful in maintaining low inﬂation
over the medium term in emerging market countries unless government policies cre-ate the right institutional environment. Rigorous prudential supervision and sound
ﬁscal policy are essential to the success of any monetary policy strategy.
Notes
The views expressed in this chapter are exclusively those of the authors and not those of Columbia Univer-
sity, the National Bureau of Economic Research or the International Monetary Fund.
1. Although a soft peg may be appropriate as a tool in the initial phases of a stabilization program, this
strategy is not discussed here, because as has been amply demonstrated by recent experiences in industrial
and emerging market economies, it is not an appropriate medium-term strategy for monetary policy (see
Obstfeld and Rogo¤ (1995), Eichengreen and Masson (1998) and Mishkin (1998, 1999)).
2. See, for example, Eichengreen and Hausmann (1999), Moreno (1999), and Schuler (1999). Panama has
domestic currency coins (balboas) that co-circulate at parity with U.S. dollar coins. The balboas are issuedby the Banco Nacional de Panama, a government-owned commercial bank that acts as the ﬁnancial agentof the government but does not centralize o‰cial holdings of reserves nor acts as lender of last resort.
3. The U.S. economic warfare against Panama sparked a series of bank runs that nearly caused the col-
lapse of the Panamanian payments system (see Garber, 1999). When the standstill ended, after almostStrategies for Emerging Market Countries 341

two years, a number of small banks had disappeared, the money supply had shrunk by 30%, and real out-
put had fallen by 18%. This episode illustrates that a country with a hard peg is not exempt from bank runs
and panics, whatever their origin may be. The fact that the United States also had frequent bank panics inthe nineteenth and early twentieth century even when it had a hard peg (the gold standard) also illustratesthis point—e.g., see Mishkin (1991).
4. The role of monetary policy in precipitating the Tequila crisis of December 1994 remains a matter of
dispute. See, for example, the contrasting views presented in Gil-Diaz and Carstens (1996), Kamin andRogers (1996), Calvo and Mendoza (1996), and Edwards (1998).
5. One of us has argued elsewhere that even the discretionary monetary policy regime in the United States,
which has been so successful, may not produce desirable outcomes over the long run and needs to be modi-ﬁed, even though the environment for ‘‘good’’ discretion in the United States is far more favorable than in
emerging market economies (see Mishkin, 1999).
6. Partly because of this a number of researchers regard Germany’s monetary policy as being closer to an
inﬂation targeting regime than to a monetary targeting regime. See for example, Clarida and Gertler
(1998), Bernanke, et al. (1999) and Mishkin (1999).
7. A questionnaire-based assessment of monetary policy frameworks in emerging economies reported in
Masson et al. (1997), identiﬁed Chile, Colombia and Mexico as the countries in Latin America that, as ofend-1996, appeared to be good candidates for adopting an inﬂation targeting strategy. Brazil and Peruwere not proposed as candidates by the IMF desk o‰cers to whom the questionnaire was sent.
8. Corbo (1998) and Landerretche, et al. (1999) analyze the factors behind Chile’s successful disinﬂation of
the 1990s; see also Massad (1998). For a critical view of the disinﬂation, see Calvo and Mendoza (1999).
9. In contrast, during this same period, Australia eased monetary policy, thereby allowing the currency to
depreciate to cushion the e¤ects of its own negative terms of trade shock. This policy met with great suc-cess, resulting in an economy that remained strong while the inﬂation target continued to be met. One rea-
son why Chile’s central bank did not react in a similar manner to a comparable shock may have been its
(unwarranted) concern that a large peso depreciation would lead to inﬂation exceeding the target and,hence, erode its credibility.
10. For a recent overview of the debate surrounding Chile’s capital controls, see Edwards (1999).11. See Rodriguez (1993) and Savastano (1996) for evidence on the path of remonetization in these
economies.
12. For an overview of the main elements of the Real plan and of its initial results see Cardoso (1998), and
Lopes (1998).
13. A ‘‘caipirinha’’ is a popular alcoholic drink in Brazil, as is ‘‘tequila’’ in Mexico.14. See Mishkin and Posen (1997), and Bernanke et al. (1999).
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Press for the NBER.344 Chapter 14

15Inflation Targeting in Transition Economies: Experience and
Prospects
Jiri Jonas and Frederic S. Mishkin
15.1 Introduction
In the second half of the 1990s, several transition countries abandoned ﬁxed ex-
change rate regimes and instead introduced inﬂation targeting as framework for theconduct of monetary policy. In this chapter, we will analyze the experience of three
countries that moved to an inﬂation-targeting regime: the Czech Republic, Hungary,
and Poland.
It is worth studying inﬂation targeting in these transition countries for two reasons.
First, the transition countries are becoming an important part of Europe, and design-
ing the right monetary policy regime for their transition into successful European
economies is valuable in its own right. Second, these countries have three unique fea-
tures that make the study of inﬂation targeting in these countries particularly inter-
esting: (a) they are new democracies that are in the process of developing newgovernmental institutions; (b) their economies are undergoing radical restructuring
as part of the transition from socialism to capitalism; and (c) they are very likely to
enter the European Union (EU) and Economic and Monetary Union (EMU) in the
near future. These three unique features are emphasized in our discussion of their
inﬂation-targeting regimes.
In the next section of the chapter we discuss the reasons why these countries
moved to a more ﬂexible exchange rate regime and introduced inﬂation targeting.
In the third section, we examine in more detail the introduction of inﬂation targeting
in the three countries, and in the fourth section, we evaluate the preliminary experi-
ence with inﬂation targeting. In the ﬁfth section, we discuss a number of speciﬁc
issues for inﬂation targeting in transition economies: what inﬂation measure to tar-get, whether to target a point or a range, what should be the time horizon for the in-
ﬂation target, who should set the inﬂation target, what should be the response to
faster-than-targeted disinﬂation, how monetary policy should respond to deviations
of inﬂation from the target, how much the ﬂoor of the inﬂation target should be
emphasized relative to the ceiling, and what role the exchange rate should play in

an inﬂation-targeting regime. In the sixth section, we discuss the future prospects of
inﬂation targeting in transition economies in connection with the planned adoption
of the euro, focusing on inﬂation targeting within the ﬂuctuation band of exchange
rate mechanism 2 (ERM2) regime and on the potential conﬂict between the inﬂation
target and the exchange rate target. The ﬁnal section contains concluding remarks.
15.2 From Peg to Float
In economic history books, the 1990s will be probably remembered as a decade whenﬁxed exchange rate regimes lost much of their attraction as nominal anchors for
the conduct of monetary policy. As a result of devastating ﬁnancial crises, many
emerging-market countries were forced to abandon ﬁxed exchange rate regimes and
replace them with more ﬂexible exchange rate arrangements. Some countries—albeit
a signiﬁcant minority—even opted to introduce more ﬂexible exchange rate regimes
in an orderly way, without being forced to exit the peg as a result of ﬁnancial crisis or
market pressure on their currency.
This trend from more ﬁxed to more ﬂexible exchange rate regimes was also
observed in the transition economies of Central and Eastern Europe. In the early
years of transition, in the aftermath of price liberalization and exchange rate devalu-
ation, many transition economies have used the exchange rate peg as a nominal
anchor to achieve a rapid stabilization of price level. However, as with other
emerging-market economies, transition economies too have su¤ered the standard
problem of exchange rate–based stabilization programs: while inﬂation did decline
signiﬁcantly, it did not decline enough to prevent a large real appreciation that ulti-
mately created a balance-of-payment problem and forced the abandonment of the
ﬁxed exchange rate. While some countries opted for a hard version of a ﬁxedexchange rate—a currency board arrangement—others introduced managed ﬂoat:
ﬁrst the Czech Republic in 1997, then the Slovak Republic and Poland in 1998. Hun-
gary did not move to a fully ﬂoating currency regime, but in May 2001 it introduced
an exchange rate band, allowing the currency to move up and down within this band
by 15 percent.
When abandoning the exchange rate pegs, the authorities of these countries had to
decide what nominal anchor to use instead of the ﬁxed exchange rate. While the Slo-
vak Republic did not accompany the move to a ﬂoating exchange rate by an explicit
introduction of new monetary policy framework, the other three countries opted for
inﬂation targeting. Why did the authorities in these countries opt for inﬂation target-
ing, and why did they reject alternative policy frameworks? We can learn why byexamining the problems of other monetary policy regimes.
One alternative would be to use monetary aggregates as an intermediate target and
nominal anchor. However, targeting monetary aggregates does not have much at-346 Chapter 15

traction in transition economies. 1The traditional problem of instability of money de-
mand, and therefore the unstable relationship between the growth of money supply
and inﬂation, could be a particularly serious obstacle to targeting monetary aggre-
gates in transition economies. Economic transition is characterized by a sequence of
price shocks, including corrections in administered prices and tax reforms, that make
the relationship between money supply and price level very di‰cult to predict. Theinstability of money demand and money-price relationship is further exacerbated by
far-reaching changes in the ﬁnancial sector, including deep institutional changes, the
emergence of new types of ﬁnancial assets and players, and so on. Therefore, relying
solely on targeting money supply growth could be a quite ine¤ective approach to
conducting monetary policy.
Transition economies could have also applied a discretionary, ‘‘just-do-it’’
approach to monetary policy, as the Federal Reserve in the United States is doing,
in which there is no explicit nominal anchor. 2Given the di‰culty of establishing a
more stable relationship between some intermediate target and price level, some
may think that a less formal approach to monetary policy would be advisable. How-
ever, while this approach may work in countries whose central bank has well-established anti-inﬂationary credibility, and where inﬂation is low, it is doubtful that
it would work well in transition economies. Particularly in the Czech Republic where
inﬂation was relatively high and rising after the ﬁxed exchange rate regime was aban-
doned, the just-do-it approach to monetary policy was not seen as being potentially
e¤ective in bringing inﬂation expectations and actual inﬂation down. Without anti-
inﬂation credibility, the just-do-it approach would not su‰ciently anchor inﬂation
expectations and persuade economic agents that monetary policy would be actually
conducted to control inﬂation.
A third option would be to replace a ﬁxed exchange rate regime with a harder vari-
ant of exchange rate peg—that is, by introducing a currency board, or even unilater-
ally euroizing. This option has the advantage that it provides a nominal anchor that
helps keep inﬂation under control by tying the prices of domestically produced trad-
able goods to those in the anchor country, and making inﬂation expectations
converge to those prevailing in the anchor country. In addition, it provides an auto-
matic adjustment mechanism that helps mitigate the time-inconsistency problem of
monetary policy. Hard pegs also have the advantages of simplicity and clarity, which
make them easily understood by the public. However, the hard peg option has the
disadvantage that it leaves little scope for the country to conduct its own monetary
policy in order to react to domestic or foreign shocks.
For transition countries that wanted to retain some control over domestic mone-
tary policy and so opted to keep a ﬂexible exchange rate, the problems with
monetary targeting and the just-do-it approach led them to adopt a fourth op-
tion, inﬂation targeting. Inﬂation targeting has several advantages over a hard peg,Inflation Targeting in Transition Economies 347

monetary targeting, and the just-do-it approach. In contrast to a hard peg, inﬂation
targeting enables monetary policy to focus on domestic considerations and to re-
spond to shocks of both domestic and foreign origin. Inﬂation targeting also has the
advantage that stability in the relationship between money and inﬂation is not criti-
cal to its success because it does not depend on such a relationship. Inﬂation target-
ing, like a hard peg, also has the key advantage that it is easily understood by thepublic and thus highly transparent. In contrast, monetary targets, although visible,
are less likely to be well understood by the public, especially as the relationship be-
tween monetary aggregates and inﬂation becomes less stable and reliable. Because an
explicit numerical target for inﬂation increases the accountability of the central bank
relative to a discretionary regime, inﬂation targeting also has the potential to reduce
the likelihood that the central bank will fall into the time-inconsistency trap. More-
over, since the source of time inconsistency is often found in (covert or open) political
pressures on the central bank to engage in expansionary monetary policy, inﬂa-
tion targeting has the advantage of focusing the political debate on what a central
bank can do on a sustainable basis—that is, control inﬂation—rather than on what
it cannot do through monetary policy—for example, raise output growth, lowerunemployment, or increase external competitiveness.
How well were the transition economies prepared for the introduction of inﬂation
targeting? In the literature, a relatively long list of requirements has been identiﬁed
that countries should meet if inﬂation targeting regime is to operate successfully. 3
These requirements include (a) a strong ﬁscal position, (b) a well-understood trans-
mission mechanism between monetary policy instruments and inﬂation, (c) a well-
developed ﬁnancial system, (d) central-bank independence and a clear mandate for
price stability, (e) a reasonably well-developed ability to forecast inﬂation, (f ) ab-
sence of nominal anchors other than inﬂation, and (g) transparent and accountablemonetary policy.
It is not possible to say whether a country meets these requirements or not: it is
more a question of the degree to which these preconditions are met. On the whole,
it could be argued that the three transition countries that adopted inﬂation targeting,
the Czech Republic, Hungary, and Poland, met these requirements to a su‰cient de-
gree to make inﬂation targeting feasible and useful. 4
All three countries have an independent central bank with a clear mandate to pur-
sue price stability. In some cases, this independence and price stability mandate has
been strengthened just before the introduction of inﬂation targeting. There has also
been signiﬁcant progress in making monetary policy decisions more transparent and
central banks more accountable, although this is still to some extent a work in prog-ress in some countries. Financial markets in the three analyzed economies are rela-
tively well developed, allowing for a reasonably e¤ective transmission mechanism
between monetary policy instruments and inﬂation.348 Chapter 15

With respect to ﬁscal position, partly as a result of explicit recognition of hidden
transformation-related costs, ﬁscal deﬁcits have widened signiﬁcantly, particularly in
the Czech Republic and Hungary (see table 15.1). However, these deﬁcits have not
yet posed a direct problem to inﬂation targeting in the sense of ﬁscal dominance of
monetary policy, because they have been ﬁnanced by nonmonetary means at rela-tively favorable terms. 5The main reason why large ﬁscal deﬁcits in accession coun-
tries do not trigger adverse market reaction is that they are widely considered to be
temporary. In part this reﬂects the recognition of implicit public-sector liabilities
from the past. Moreover, as a result of EU/EMU accession, these countries will
adopt an institutional framework (the Stability and Growth Pact, or SGP) that
will require them to pursue disciplined ﬁscal policies. Still, before the constraint of
the SGP begins to operate, large ﬁscal deﬁcits can complicate monetary policy con-
duct in indirect ways, as we will see in our later discussion of these three countries’
experience with inﬂation targeting.
As for the absence of multiple nominal anchors, this condition is clearly met in the
Czech Republic and Poland. These countries have in place a regime of managed
ﬂoating, and inﬂation is the only nominal anchor in the economy. In Hungary, the
situation is more complicated because of the presence of the exchange rate band.
Theoretically, this could be incompatible with the requirement of the single nominal
anchor if the band is too narrow. We should note that the existence of the exchange
rate ﬂuctuation band is not only an issue of concern to Hungary today; it will be of
concern to all transition countries that join the ERM2 system, when they will have to
put in place the same ﬂuctuation band. We will discuss the issue of ﬂuctuation band
and inﬂation targeting in the section on monetary policy within the ERM2 system.
Perhaps the most serious objection raised against the adoption of inﬂation target-
ing in transition economies is the limited ability to forecast inﬂation accurately. This
is partly the result of the relatively frequent occurrence of shocks to which transition
economies are exposed, including price deregulation and catching up with the more
advanced economies, and also the result of a relatively large degree of openness of
these economies. Actual inﬂation is relatively unstable relative to the long-term inﬂa-
tion trend (Orlowski 2000). Under such circumstances, there are natural limits toTable 15.1
Inﬂation-Targeting Countries: General Government Balance (in % of GDP, Excluding Privatization
Revenues)
Country 1998 1999 2000 2001Czech Republic /C02.4 /C02.0 /C04.2 /C05.2
Hungary /C04.8 /C03.4 /C03.3 /C04.7
Poland /C03.2 /C03.7 /C03.2 /C06.0
Source: European Bank for Reconstruction and Development (2002).Inflation Targeting in Transition Economies 349

central banks’ ability to forecast inﬂation that cannot be quickly and substantially
improved by more sophisticated forecasting models. However, inﬂation-targeting
central banks are nevertheless making progress in improving their inﬂation-
forecasting capacity. One approach is to use alternative and less formal methods of
gauging future inﬂation. For example, in 1999 the Czech National Bank intro-
duced a survey of inﬂation forecasts by market participants to measure inﬂationexpectations.
15.3 Introduction of Inflation Targeting in Individual Countries
We will now turn in more detail to the introduction of inﬂation targeting in indi-
vidual countries. We will brieﬂy examine economic developments preceding the in-
troduction of inﬂation targeting, and the main operational characteristics of the
inﬂation-targeting regimes in the three countries.
15.3.1 The Czech Republic
The Czech Republic was the ﬁrst transition economy to introduce an inﬂation-
targeting regime, which it did after abandoning the ﬁxed exchange rate regime fol-
lowing currency turbulence in May 1997. 6
A ﬁxed exchange rate regime played an important role in the macroeconomic sta-
bilization package introduced in 1991. Several months after liberalization of prices
and devaluation of currency in 1991, the rate of inﬂation came down quickly, al-
though not quite to levels prevailing in advanced economies. Inﬂation remained
stuck at around 10 percent, and wages and other nominal variables soon adjusted to
this level. Higher domestic inﬂation and the ﬁxed nominal exchange rate produced a
real appreciation, which was not fully validated by higher productivity growth, andafter some time, erosion of competitiveness became a concern. The economy began
to overheat, political constraints prevented a su‰ciently vigorous and ﬂexible use of
ﬁscal policy to mitigate imbalances in the nonpublic sector, and tightening of mone-
tary policy alone could not cope with these rapidly growing imbalances. The mix of
tighter monetary policy and continued loose ﬁscal policy may have only made things
worse: it contributed to higher interest rates, which attracted more short-term foreign
capital, further fueling the growth of liquidity, keeping inﬂation high, and widening
the current account deﬁcit.
Ultimately, as the external deﬁcit continued to widen despite the visible decelera-
tion of economic growth later in 1996, the situation became unsustainable. It became
increasingly obvious that the policy adjustment that was feasible under the existingpolitical constraints would fall short of what was needed to reverse the unsustainable
deterioration of current account position. Uncertainties in ﬁnancial markets, trig-
gered initially by speculative attacks on the Thai baht, only accelerated the ﬂight of350 Chapter 15

foreign investors from koruna assets, which forced the authorities to stop defending a
ﬁxed exchange rate. On May 26, 1997, the government and the Czech National Bank
(CNB) decided to allow the koruna to ﬂoat freely. 7
Like many other emerging-market countries, the Czech Republic did not exit the
peg at a time of strong external position, doing so only when it was forced to do so
by market pressure. However, unlike other central banks that were ultimately forcedto abandon the defense of a ﬁxed parity, the CNB did not wait too long after the
pressure on the koruna intensiﬁed. Even though it ﬁrst tried to fend o¤ the pressure
by raising interest rates, it did not waste a large amount of foreign reserves in foreign
exchange market intervention. In the week before the decision to ﬂoat, the CNB’s
foreign reserves declined by about $2.5 billion, to $10 billion. Given the unsatisfac-
tory experience with interventions as a tool to prevent the exit from a pegged ex-
change rate regime, this was a correct decision.
Possible inﬂationary e¤ects of currency depreciation after the exit from the peg, to-
gether with the absence of an alternative nominal anchor to guide inﬂation expecta-
tions, created a risk that inﬂation would increase signiﬁcantly in the coming months.
Therefore, the CNB began to work on a new monetary policy framework, and in themeantime it tried to guide inﬂation expectations by its public pronouncements. After
the koruna (CZK) was allowed to ﬂoat, the CNB issued a public statement that it
expected the average koruna exchange rate to stabilize within months at roughly
CZK 17 to 19.50 per 1 deutsche mark (DM) (Czech National Bank 1997). Further-
more, the CNB made it clear that in the future, monetary policy would be un-
ambiguously focused on domestic price-level stability and reduction of potential
inﬂationary e¤ects of the koruna’s exchange rate movements (Czech National Bank
1997). The ﬁrst sentence may seem to have been somewhat at odds with the managed
ﬂoat. The reason for announcing a band in which the CNB expected the CZK/DMexchange rate to settle was to prevent overshooting at a time when there was no
other nominal anchor to tie down exchange rate and inﬂation expectations, and to
limit to the extent possible any pass-through of currency depreciation to domestic
inﬂation.
However, the CNB felt that this approach to monetary policy conduct was not sat-
isfactory and could not continue for much longer. Therefore, on December 21, the
CNB Bank Board decided that in the future, monetary programs would be formu-
lated on the basis of inﬂation targeting. The stated purpose of inﬂation targeting
was to provide a nominal anchor in the form of an inﬂation target, to use monetary
policy tools directly to achieve the inﬂation target, and to regularly inform the public
about the conduct of monetary policy. 8
In deciding what measure of inﬂation to target, the CNB faced a trade-o¤ between
transparency and the ability to control inﬂation, an issue that we will look at in detail
later. The CNB opted for a compromise that it considered most appropriate for anInflation Targeting in Transition Economies 351

economy in transition. For the purpose of inﬂation targeting, it introduced a new
concept, so-called net inﬂation. Net inﬂation measures changes in the consumer price
index (CPI), excluding the movement in regulated prices, and is further adjusted for
the impact on the remaining items of changes in indirect taxes or subsidy elimina-
tion. 9Unlike many other inﬂation-targeting countries, the Czech Republic did not
exclude from net inﬂation changes in the prices of energy and agricultural products.Such an exclusion would have narrowed the targeted price index too much and
would have made it too detached from the headline inﬂation. Instead, the CNB sub-
sequently introduced so-called exceptions to deal with this problem (see below).
In choosing whether to target a range or a single numerical value of inﬂation, the
CNB opted for a range. Initially, in 1998 and 1999, it was targeting a band 1 percent-
age point wide, but from 2000, it widened the band to 2 percentage points. The
CNB’s decision about the width of the band was guided mainly by its assessment of
the accuracy with which it thought it could hit net inﬂation targets, as well as the
past volatility of net inﬂation.
At the end of 1998, the CNB made some modiﬁcations to its inﬂation-targeting
strategy. First, the CNB introduced the ‘‘exceptions’’ that could justify missing an in-ﬂation target. Exceptions refer to exceptional and unpredictable factors that cause
actual inﬂation to deviate from the inﬂation target and for which the CNB cannot
bear responsibility. These factors include the following: signiﬁcant di¤erences be-
tween actual and predicted world prices of commodities; signiﬁcant di¤erences
between actual and predicted exchange rate that do not reﬂect developments of do-
mestic economic fundamentals and monetary policy; signiﬁcant changes of condi-
tions in agriculture that a¤ect agriculture producer prices; and natural disasters and
other extraordinary events that produce demand-led and cost-pushed price shocks
(Czech National Bank 1999, 57).
Second, the CNB decided to take a more active role in a¤ecting inﬂation expec-
tations. It realized that a much more rapid than originally expected decline in inﬂa-
tion in the second half of 1998, together with a large degree of rigidity in nominal
variables, could produce undesirable developments in real variables—most impor-
tantly, real wages. The CNB therefore initiated an informative meeting with the rep-
resentatives of trade unions and employees in order to explain what inﬂation it
expected in 1999 and, in this way, to help reduce inﬂation expectations. 10
In December 1999, the CNB approved Long-Term Monetary Strategy , which
speciﬁed the long-term inﬂation target for 2005. The objective was to make the
inﬂation-targeting strategy more forward looking. Importantly, the CNB made an ef-
fort to involve the public and the government in discussion of the long-term mone-tary policy target. No doubt this outreach e¤ort reﬂected the criticism by some
politicians that the process of disinﬂation was too fast and too costly in 1998 and
1999. The CNB did not wish to announce the quantiﬁed long-term target corre-352 Chapter 15

sponding to price stability and the speed with which this ultimate objective was to be
achieved without acquiring the support of the government. The CNB seems to have
acknowledged implicitly that the decision on the speed of disinﬂation is ultimately a
political one and that it had to be taken by a body with political mandate.
Another modiﬁcation of the inﬂation-targeting framework took place in April
2001. At that time, the CNB decided that the main reasons for favoring net inﬂationtargeting rather than headline inﬂation targeting had disappeared, and it decided that
from 2002 on, it would target headline inﬂation measured by the CPI. 11The CNB
explained that headline inﬂation covers more comprehensively price developments
in the economy and that it is more relevant for decisions of economic agents. For
these reasons, by targeting headline inﬂation, monetary policy should also be better
able to a¤ect inﬂation expectations. Headline inﬂation targets for the period 2002–
2005 were derived from the trajectory of net inﬂation speciﬁed in the December
1999 Long-Term Monetary Strategy . The CNB realized that targeting headline inﬂa-
tion has its risks as well, the most important one being the uncertainty regarding the
development of regulated prices and e¤ects of changes in administered prices. For ex-
ample, the need to achieve a stronger adjustment of ﬁscal imbalances could require alarger-than-expected increase in administered prices, with consequently larger impact
on headline inﬂation. Another complication could arise from the harmonization
of indirect taxes with the EU ahead of the EU entry. But these unexpected e¤ects of
changes in regulated prices or administrative measures on headline inﬂation were
included in the exceptions that allowed actual inﬂation to deviate from the inﬂation
target without necessitating a monetary policy response. After the April 2001 modiﬁ-
cation, the list of the exceptions included the following:
/C15Major deviations in world prices of raw materials, energy-producing materials, and
other commodities
/C15Major deviations of the koruna’s exchange rate that are not connected with domes-
tic economic fundamentals and domestic monetary policy
/C15Major changes in the conditions for agricultural production having an impact on
agriculture producer prices
/C15Natural disasters and other extraordinary events having cost and demand impacts
on prices
/C15Changes in regulated prices whose e¤ects on headline inﬂation would exceed 1–1.5
percentage points
/C15Step changes in indirect taxes
The CNB has also announced that the list of exceptions could be further widened
in the future to include one-time price shocks resulting from the adoption of EU
standards.Inflation Targeting in Transition Economies 353

15.3.2 Poland
After the Czech Republic, Poland was the second transition country to introduce in-
ﬂation targeting. Its approach to inﬂation targeting di¤ers in some important aspectsfrom that of the Czech Republic.
As a part of Poland’s big-bang approach to macroeconomic stabilization, the zloty
was pegged to a basket of currencies in 1990. But inﬂation did not decline su‰ciently
rapidly, and a ﬁxed nominal exchange rate resulted in rapid real appreciation and
erosion of competitiveness. Therefore, a preannounced crawling peg was introduced
in October 1991. Capital account liberalization led in 1994 and 1995 to large capital
inﬂows, which forced the authorities to widen the crawling exchange rate band in
May 1995 to G7 percent. Upward pressure on the currency continued, and in De-
cember 1995 the central rate was revalued by 6.4 percent in order to be aligned with
the prevailing market rate. In early 1998, the National Bank of Poland (NBP) began
to widen the band again: to G10 percent in February 1998, to G12.5 percent in Oc-
tober 1998, and ﬁnally to G15 percent in March 1999. At the same time, the rate of
crawl was reduced from an initial 1.8 percent per month in 1991 to 0.3 percent per
month. The main reason for the gradual widening of the band was the e¤ort of the
NBP to be better able to accommodate large capital inﬂows.
Poland’s transition to an inﬂation-targeting regime began during 1998. As in Hun-
gary, the introduction of inﬂation targeting was preceded by the amendment of the
Act on the NBP. This Act speciﬁed that the primary objective of the NBP is to main-
tain a stable price level and simultaneously support economic policy of the govern-
ment, provided that this does not constrain the execution of the primary target.The Act also established the Monetary Policy Council (MPC) of the NBP, which
replaced the NBP Management Board as the decision-making body. In April 1998,
the MPC updated the Assumptions of Monetary Policy for 1998 , prepared originally
by the NBP Management Board in September 1997, and conﬁrmed that the 1998
NBP inﬂation target of 9.5 percent remained unchanged. 12In June 1998, the MPC
deﬁned a target for monetary policy in 1999, which was to reduce inﬂation to 8–8.5
percent, and began to work on Assumptions of Monetary Policy for 1999 , as well as
onMedium-Term Monetary Policy Strategy for 1999–2003 . These documents were
approved in September 1998, and at the same time the NBP o‰cially announced
the introduction of inﬂation targeting. The NBP also announced at that time the
medium-term inﬂation target for 2003: reduction of inﬂation to less than 4 percent.The NBP also indicated that from that time on, annual inﬂation targets would be
announced in Assumptions of Monetary Policy .
It should be noted that at the time of announcement to implement inﬂation target-
ing, Poland still maintained an exchange rate band, which at the time of announce-
ment was widened from G10 percent to G12.5 percent, and later to G15 percent.354 Chapter 15

Only in April 2000 did Poland abandon the exchange rate band and switch to a man-
aged ﬂoat.
Poland has decided to target the broad CPI. The NBP explained that the CPI has
been used extensively in Poland since the beginning of transition, and that it is deeply
rooted in public perceptions as the measure of inﬂation. The CPI provides accurate
information about changes in price levels of consumer goods and services. Applica-tion of some measure of core inﬂation would require eliminating from the targeted
index some prices of goods and services that strongly a¤ect public perception of in-
ﬂation developments. However, the NBP has started preparatory work for calculat-
ing the core inﬂation index, and it did not exclude the possibility that it would start
targeting core inﬂation in the future. 13
Like the Czech Republic, Poland has chosen to target a band rather than a point.
Initially, it chose a quite narrow target range, just one-half of a percentage point,
which was subsequently widened to 1.2 points. The NBP explains that before the in-
troduction of inﬂation targeting, monetary targets in Poland were deﬁned as ﬁxed
points, and a wider band could possibly signal to the public a weaker commitment
to reducing inﬂation. It could be argued that under such circumstances a ﬁxed pointcould be better than a narrow band, as both are unlikely to be hit, and the damage of
missing a point could be less serious than the damage of missing a band. However,
the NBP did not exclude the possibility that it may widen the band in the future.
Unlike the Czech National Bank, the NBP did not explicitly deﬁne exceptions that
would allow missing the inﬂation target without requiring the monetary policy re-
sponse. However, the NBP subsequently analyzed in depth the process of inﬂation
in Poland and the role of monetary and nonmonetary factors (National Bank of Po-
land 2001, appendix 2). Speciﬁcally, the NBP calculates and analyzes di¤erent mea-
sures of the core inﬂation. It explains that even though core inﬂation rates do notreplace the headline consumer price index, they provide input for research and anal-
ysis and for decisions on monetary policy.
15.3.3 Hungary
The introduction of inﬂation targeting in the Czech Republic could be characterizedas a ‘‘big bang’’ approach. There was a clear break with the past ﬁxed exchange rate
regime, and after a few months of technical preparation, a full-ﬂedged inﬂation-
targeting regime was put in place. In contrast, Hungary’s introduction of inﬂa-
tion targeting could be characterized as ‘‘gradualist,’’ even more so than for
Poland. 14
Like other transition economies, Hungary adopted early in its transition an ex-
change rate peg of the forint against the basket of currencies. However, the peg was
adjusted downward quite often to maintain external competitiveness. The ﬂuctuationInflation Targeting in Transition Economies 355

band was gradually widened from G0.5 percent to G2.25 percent, to reduce specula-
tive pressures ahead of the predictable adjustments of the parity. But this mechanism
did not prevent large short-term capital inﬂows in late 1994, and in March 1995,
after a devaluation of 8.3 percent, the regime of ad hoc adjustment was replaced
with a crawling band. The monthly rate of crawl was initially set at 1.9 percent but
was gradually reduced to 0.4 percent after October 1999. This regime succeeded inbringing inﬂation down from about 30 percent in 1995 to below 10 percent in 1999.
Even at the time when the Czech Republic and Poland were abandoning ﬁxed ex-
change rate regimes, the Hungarian authorities continued to view this narrow ﬂuctu-
ation band as a useful nominal anchor. The band helped reduce inﬂation and anchor
inﬂation expectations, while at the same time avoiding excessive real appreciation
and erosion of competitiveness. However, like other emerging-market countries with
a ﬁxed exchange rate, Hungary too was ultimately forced to deal with the problems
caused by large capital inﬂows. For some time, Hungary was able to avoid pressure
on the narrow exchange rate band because of the presence of controls on short-term
capital ﬂows. These controls were e¤ective in introducing a wedge between onshore
and o¤shore interest rates, providing some degree of independence to monetary pol-icy. But it was clear that as capital controls were relaxed in line with progression to
EU accession a narrow-band regime would become more di‰cult to sustain.
The problems with the narrow exchange rate band began to intensify in the course
of 2000. Inﬂation, which declined signiﬁcantly in the period 1995–99, began to creep
up again. While this increase in inﬂation was initially triggered by external shocks,
like higher world oil prices, domestic factors began to play a role as well, including
the exchange rate regime. The constraints of the narrow band and increasing capital
inﬂows in 2000 began to make it more di‰cult for the central bank to simultaneously
pursue disinﬂation and nominal exchange rate stability. Early in 2000, the centralbank acted to reduce the pressure on the exchange rate band by cutting interest rates,
and it also threatened to introduce capital controls. This strategy worked, and the
exchange rate depreciated. However, in a situation of strong economic growth, ro-
bust domestic demand, and tight labor markets, reducing interest rates did not help
much in ﬁghting inﬂation, which remained relatively high. Periodically, speculative
pressures for appreciation and widening of the band appeared, forcing the central
bank to cut interest rates and/or intervene in the foreign exchange market. It opted
to do mainly the latter, and it sterilized the liquidity created as a result of these
interventions.
However, as the sterilization costs were increasing, it was becoming clear that the
narrow exchange rate band had outlived its usefulness and that Hungary needed tointroduce more exchange rate ﬂexibility if it was to succeed in reducing inﬂation fur-
ther. 15In May 2001, the authorities ﬁnally decided to widen the ﬂuctuation band
around the forint parity against the euro to G15 percent. 16The crawling regime356 Chapter 15

was maintained, with the rate of crawl reduced to 0.2 percent monthly, and remain-
ing controls on short-term capital ﬂows were phased out. In October 2001, the crawl-
ing peg was completely abolished.
While a wider exchange rate band should allow the government to attach more
priority to ﬁghting inﬂation, as we will discuss below, a conﬂict between the inﬂation
target and exchange rate target could still arise and complicate the conduct of mone-tary policy. However, the change in the monetary policy regime has been somewhat
confused. At the time when the authorities decided to widen the ﬂuctuation band,
they did not immediately announce a shift to a new monetary policy regime. Even
though the new exchange rate band was too wide to serve as a useful nominal an-
chor, the authorities were moving to inﬂation targeting only gradually. But on July
13, 2001, the new Act on the National Bank of Hungary (NBH) was enacted by
Parliament, which deﬁned the achievement and maintenance of price stability as the
prime objective of the NBH. The Act also sought to reinforce NBH independence, in
accordance with the EU requirement.
In its August 2001 Quarterly Inﬂation report, the NBH explained that for the next
couple of years it would be using the inﬂation-targeting system to achieve a gradualreduction of inﬂation to a level corresponding to price stability (National Bank of
Hungary 2001, 35–36). The NBH objective is to meet the Maastricht criterion on in-
ﬂation in 2004–2005, so that it can adopt the euro in 2006–2007. Speciﬁcally, the
NBH states that it will seek to bring inﬂation down to around 2 percent. In agree-
ment with the government, the NBH set an inﬂation target of 7 percent for Decem-
ber 2001, 4.5 percent for 2002, and 3.5 percent for 2003 and 2004. In recognition of
the fact that the NBH cannot instantly o¤set unexpected inﬂationary shocks, it has
also established a G1 percent tolerance band around the announced disinﬂation path.
The primary instrument that the NBH uses to attain its inﬂation targets is changes
in its benchmark interest rates. The NBH has particularly emphasized the important
role of changes in exchange rate on inﬂation. It argues that in Hungary, the exchange
rate channel is the central bank’s fastest and most powerful means of inﬂuencing do-
mestic prices. (However, we will see later in section 15.5 that this reasoning may be
dangerous.) While the exchange rate will not have the same prominent role as during
the narrow-band regime, and the NBH will be less able to control its short-term
movements, it will continue to play an important role. The NBH has indicated that
it will try to inﬂuence the exchange rate in order to achieve the desired inﬂation out-
come. In order to achieve the changes in exchange rate, it will use mainly changes
in interest rates, while direct intervention in the foreign exchange market will be
used only exceptionally, to deal with emergency situations. The NBH recognizesthat in the short term, the actual exchange rate could deviate from an exchange
rate path that would be consistent with the disinﬂation path. All in all, exchange
rate movements seem to play a much more important role in Hungary than in otherInflation Targeting in Transition Economies 357

inﬂation-targeting countries. Such explicit emphasis on the role of exchange rate
movements in achieving inﬂation targets as seen in Hungary is quite unique.
The NBH estimates that it takes up to one and a half years for changes in interest
rates to have a full impact on inﬂation. It argues that if it tried to keep inﬂation in
line with the targeted path over the short-term horizon, the result could be excessive
volatility of output (and arguably also excessive instrument volatility). Therefore, itwill conﬁne policy responses only to deviation of forecasted inﬂation from targeted
inﬂation over the horizon of one to one and a half years.
The transparency of this new system should be enhanced by the publication of
NBH’s inﬂation projections every quarter for the following six quarters. Moreover,
the NBH will also publish the considerations that were behind its monetary policy
decisions, and its analysis of the achievement of inﬂation target. The Quarterly Re-
port on Inﬂation also contains the projection of inﬂation using a fan chart.
Unlike the CNB, the NBH began to target headline inﬂation immediately. But
there is no discussion in NBH o‰cial documents about the reasons for choosing to
target headline inﬂation rather than adjusted or underlying inﬂation. The NBH also
did not specify any exceptions that would justify a deviation of actual inﬂation fromits inﬂation target, although there is some discussion in its inﬂation reports about the
possible extent of price deregulation and its e¤ects on headline inﬂation. When
announcing the introduction of inﬂation targeting, the NBH was also silent about
the possible conﬂict between the exchange rate band and the inﬂation target.
Overall, the impression is that the NBH has focused less on operational aspects of
the inﬂation-targeting regime than has the CNB or even the NBP. Perhaps this
reﬂects the fact that NBH o‰cials still attach importance to the nominal exchange
rate band as an important anchor of the economy. They seem to believe that moving
the exchange rate within the band will help them to achieve a long-term inﬂation tar-get that will allow them to qualify for euro adoption. In a sense, this strategy could
be understood: why invest heavily in a detailed design for a policy framework that
will be removed in a few years anyway after Hungary adopts the euro? The Czech
Republic and Poland introduced inﬂation targeting much earlier, and they may also
be less eager to adopt the euro as soon as possible. This means that inﬂation target-
ing could be in place for a longer time and that a well-designed inﬂation-targeting
framework may be more necessary.
15.4 Preliminary Experience with Inflation Targeting
In view of the relatively short period during which inﬂation targeting has been imple-mented in the transition economies, it is too early to make a deﬁnitive judgment
about the experience of the operation of this new policy framework. Nevertheless,358 Chapter 15

some preliminary observations can be made. There are two ways in which we can
evaluate the experience with inﬂation targeting in transition economies.
First, we can look at how successful inﬂation-targeting central banks were in
achieving inﬂation rates close to their inﬂation targets. Here the answer is ‘‘not all
that successful.’’ Initially, the CNB signiﬁcantly undershot its inﬂation target several
times, while the NBP ﬁrst overshot it and subsequently undershot it. The NBH hit itstargets in 2001 and 2002, but its short experience with inﬂation targeting does not tell
us much yet. But even this short-term experience makes one thing clear: namely, the
problems of simultaneously targeting inﬂation and exchange rate in a world of free
capital ﬂows.
Second, we can examine the success of inﬂation targeting in reducing inﬂation.
Looking only at these countries’ success in hitting their inﬂation targets could be
too narrow a perspective for assessing the performance of inﬂation targeting. All cen-
tral banks in inﬂation-targeting transition economies have emphasized that the main
purpose of the inﬂation-targeting framework is to allow these countries to bring in-
ﬂation down to a level that would qualify them for euro adoption. When we evaluate
inﬂation targeting from this perspective, the preliminary experience with this regimeshould be judged more positively: all these countries are proceeding well with disin-
ﬂation, and there is a good chance that in a few years they will be able to reach price
stability, as deﬁned for the purpose of euro adoption. However, the process of disin-
ﬂation is not a smooth one, and there are quite large variations in inﬂation.
Let us now look in more detail at the record of implementation of inﬂation target-
ing in the three analyzed countries. First we will discuss the speed of disinﬂation
implied by announced inﬂation targets, and then we will examine how successful the
inﬂation-targeting countries were in hitting these targets.
15.4.1 Inflation Targets and the Speed of Disinflation
In many advanced economies that pursue inﬂation targeting, this regime has been
introduced only after price stability has been reached (Bernanke et al. 1999). But
this was not the case in the transition economies, where, at the time of introduction
of inﬂation targeting, inﬂation was still running well above the level considered
consistent with price stability. Therefore, the authorities in these countries had to
make two decisions: (a) to quantify an inﬂation target that would be compatible
with the long-term objective of price stability, and (b) to decide on the time horizon
within which this ultimate objective was to be met—that is, to decide on the speed of
disinﬂation.
There is extensive literature discussing how to quantify price stability. In the liter-
ature, we can ﬁnd several arguments why central banks should not quantify price sta-
bility as inﬂation at zero or near zero (in the range of 0–1 percent). One reasonInflation Targeting in Transition Economies 359

relates to downward nominal wage rigidity. If the inﬂation rate were to approach
zero under the condition of downward wage rigidity, it would be di‰cult to achieve
real wage adjustment in response to changed market conditions, such as a negative
demand shock. The result could be higher-than-desirable real wages, higher unem-
ployment, and lower economic growth. 17A second reason relates to the impossibility
of reducing nominal interest rates below zero, which means that if inﬂation is close tozero, real interest rates cannot be pushed below zero when this might be necessary in
order to stimulate economic activity. 18Furthermore, a zero inﬂation target may lead
to periods of deﬂation, which could promote ﬁnancial instability and make it harder
to conduct monetary policy because interest rates would no longer provide a useful
guide to the stance of monetary policy (Mishkin and Schmidt-Hebbel 2002).
In the literature, one can observe a convergence of views that an inﬂation rate of
1–3 percent corresponds to price stability (see table 15.2). If we look at how central
banks quantify price stability in practice, we see that there is not much di¤erence be-
tween the theoretical conclusions and what the central banks actually do. This is the
case for all economies—developed, developing, and transition.
However, some have raised the question of whether the speciﬁc conditions of
transition economies would not justify targeting somewhat higher inﬂation than in
developed economies. High-growth countries typically experience real exchange rate
Table 15.2
Inﬂation Targets
Country Targeted inﬂation (%) Period
Czech Republic 1–3 (2–4) a 2005
Australia 2–3 Average during a business cycle
Brazil b 2–6 2001
Chile 2–4 2001Poland <4 2003
Hungary Around 2004–2005Mexico 3 2003Izrael 3–4 2001New Zealand 0–3 From 1996Canada 1–3 From 1995
Euro area <2 From 1999
United Kingdom 2.5 From 1996
Source: Schaechder, Stone, and Zelmer (2000); web sites of Banco de Me ´xico (http://www.banxico
.org.mx/), National Bank of Hungary (http://www.mnb.hu/), and European Central Bank (http://www.ecb.int/).a1–3 percent is for net inﬂation, 2–4 percent for headline inﬂation.
bFor 2002, the target was subsequently set at 2.5–4.5 percent, but as a result of the debt crisis and sharp
currency depreciation, inﬂation in 2002 reached 12.5 percent. In response to higher inﬂation, the centralbank also raised its 2003 and 2004 targets.360 Chapter 15

appreciation by an amount proportional to the relative di¤erence of traded to non-
traded sector productivity growth relative to the rest of the world (the Harrod-
Balassa-Samuelson e¤ect). If it is appropriate for these countries to aim at traded
goods inﬂation similar to that of industrialized countries in the long run, then trend
real appreciation requires a domestic nontraded goods inﬂation that is somewhat
higher, and so the inﬂation rate should be slightly higher than would be desirablefor average-growth countries. S ˇkreb (1998) notes that in the transition economies it
is particularly di‰cult to measure precisely the improvements in the quality of goods.
As a result, actual inﬂation could be much lower than measured inﬂation. Because of
these measurement problems, as well as other reasons, S ˇkreb argues that in transition
economies inﬂation in the range of 4–5 percent would correspond to price stability.
Other authors argue, however, that during the convergence with the developed
economies, transition economies should be expected to experience a rapid growth of
labor productivity from implementation of economic reforms, which should produce
lower inﬂation (Deppler 1998). Clinton (2000) argues that rapid productivity growth
in transition economies weakens the traditional arguments in favor of a notably
higher-than-zero inﬂation rate. Given the rapid growth of labor productivity, a de-cline in nominal wages would rarely be needed. 19Similarly, given the high real re-
turn on capital and high trend toward economic growth, it is not very likely that a
situation would arise in which a central bank would have to stimulate an economy
in recession with the help of negative real interest rates.
What can be said about the speed of disinﬂation? Theoretically, disinﬂation could
be too quick, resulting in excessively large (although arguably temporary) loss of out-
put and higher unemployment, or it could be too slow; inﬂation expectations could
become more entrenched at a high level, and this would make it more costly to re-
duce inﬂation later. 20Therefore, it could be argued that there exists an optimal speed
of disinﬂation that would minimize the sacriﬁce ratio (the ratio of loss of output to
disinﬂation). 21However, the determination of this optimal speed of disinﬂation is
less a matter of exact science and more a matter of judgment.
In the literature, a number of factors have been identiﬁed that a¤ect the sacriﬁce
ratio—that is, the output e¤ect of disinﬂation. These include the structure of the
economy, the degree and the means of indexation of wages and other nominal vari-
ables, past history of inﬂation and stabilization, credibility of monetary policy, the
degree of openness of the economy, and so on. Furthermore, as has been shown in
the case of other countries, change in inﬂation is positively correlated with the level
of economic activity (Stock and Watson 1999). Given the fact that economic reason-
ing does not provide a hard conclusion about the optimal speed of disinﬂation, andin view of the important consequences of the decision about the speed of disinﬂa-
tion for the economy and for di¤erent population groups, societies pay particular at-
tention to the mechanism through which this decision is reached. By its nature, theInflation Targeting in Transition Economies 361

decision about the speed of disinﬂation is not a purely technocratic decision that
could be put solely in the hands of professional economists or central bankers. Be-
cause di¤erent speeds of disinﬂation will have di¤erent consequences for di¤erent
population groups, this decision is by nature a political one, and thus an argument
can be made for entrusting it to a political body that has the political legitimacy to
make such political choices. This has implications for the debate on the optimal de-
gree of central bank independence that is discussed in section 15.5.
However, for transition countries in Central and Eastern Europe, the desire to
adopt the euro at some point in the future is of more practical relevance for mone-
tary policy than the theoretical arguments about the appropriate quantiﬁcation of
price stability and the optimal speed of disinﬂation. Eventual euro adoption will de-
pend on the ability to meet the Maastricht criteria, including low inﬂation, and the
decision to adopt the euro at a certain date will thus implicitly contain a decision on
how quickly and how far disinﬂation will have to go.
All three countries that we examine will have to adopt the euro at some point after
entering the EU, even though they may choose a di¤erent speed with which to do so.
But notwithstanding this possible di¤erent speed, all three countries are committed to
a relatively fast disinﬂation. Table 15.3 summarizes the speed of disinﬂation impliedby the level of inﬂation at the time of the introduction of inﬂation targets and by the
long-term inﬂation objective.
As we can see, the ultimate objective is deﬁned in each country in a di¤erent way:
as a range in the Czech Republic (both upper and lower band are speciﬁed); as a
maximum ceiling in Poland (only an upper band is speciﬁed), and as a ‘‘soft’’ point
target in Hungary (no lower and upper bound are speciﬁed, but inﬂation should meet
the Maastricht criterion). This also means that one single inﬂation rate could meet all
these constraints at the same time.
Even though the Czech Republic did not reveal a ﬁrm intention to choose the fast-
est possible strategy to adopt the euro, the CNB still opted for a relatively quick dis-
inﬂation so that it would be able to meet the Maastricht criterion and eventually
move quickly to adopt the euro if it chooses to. Figure 15.1 shows the CNB’s actualTable 15.3
The Speed of Disinﬂation
CountryEnd-
1997inﬂationIntroduction
of inﬂationtargetingInﬂation
at thattimeDirection
of inﬂationUltimate
objectiveYear
to beachieved
Czech Republic 10.0 December 97 10.0 Rising 2–4 2005
Hungary 18.4 August 01 8.7 Falling Around 2 2004–5Poland 13.2 June 98 12.2 Falling <4 2003
Note: All inﬂation ﬁgures refer to CPI.362 Chapter 15

Figure 15.1
Czech Republic, annual inﬂation and inﬂation targets, year-over-year.
Source: Czech Statistical O‰ce.Inflation Targeting in Transition Economies 363

and targeted inﬂation. When the inﬂation-targeting framework was adopted in De-
cember 1997, inﬂation was 10 percent, and it continued to rise, to about 13 percent
in early 1998 (in CPI terms; net inﬂation approached 8 percent). The CNB decided
that at the end of 1998 net inﬂation should decline to 5.5–6.5 percent and, at the
end of year 2000, to 3.5–5.5 percent. In December 1999, the CNB quantiﬁed its
long-term objective of price stability: net inﬂation in the range of 1–3 percent in2005, which was subsequently complemented by setting the 2005 CPI target in the
range of 2–4 percent. Given the inﬂation target for the year 2000 in the range of
3.5–5.5 percent, this implied an average annual reduction in net inﬂation by 0.5 per-
centage points. The CNB explained that this long-term target would basically imply
a continuation of the existing pace of disinﬂation. However, in December 2002, CPI
inﬂation fell to 0.6 percent, which already brought it well below the long-term target
range.
In Poland, the NBP ﬁrst set a short-term inﬂation target in June 1998 for end-1999
in the range of 8–8.5 percent (see ﬁgure 15.2). At the time of the announcement of
the inﬂation target, inﬂation was above 12 percent and declining. In September
1999, the NBP also announced the medium-term target of CPI inﬂation of less than4 percent at the end of 2003. Subsequently, inﬂation continued to fall faster
than expected, and in March 1999, when it fell to around 6 percent, the NBP modi-
ﬁed the end-1999 CPI target to 6.6–7.8 percent. In September 1999, in Monetary
Guidelines for the Year 2000 , the NBP set the end-2000 inﬂation target in the range
of 5.4–6.8 percent. However, the process of disinﬂation in Poland was interrupted, as
inﬂation increased from 5.6 percent in February 1999 to 11.6 percent in July 2000.
Therefore, the 2001 inﬂation target was set higher than in 2000, 6–8 percent, but
the targeted inﬂation range for end-2002 was reduced to 4–6 percent. As inﬂation
at the end of 2001 fell to 3.6 percent, meeting this target would have required anothermild pickup in inﬂation. Instead, inﬂation in 2002 fell rapidly and in December 2002
reached 0.8 percent, resulting in another signiﬁcant undershooting of the target. Dur-
ing 2003, inﬂation in Poland remained below the NBP long-term objective.
Hungary launched o‰cial inﬂation targeting only in mid-2001. 22At that time, in-
ﬂation was already declining: from a peak of 10.8 percent in May 2001, it fell to 8.7
percent in August when details of the new inﬂation-targeting regime were published
in the Quarterly Inﬂation Report (see ﬁgure 15.3). For 2001, the inﬂation target was
set in the range of 6–8 percent. For 2002, the inﬂation target was set at 3.5–5.5 per-
cent, and for 2003 the target was set at 2.5–4.5 percent. 23The NBH’s long-term ob-
jective is that Hungary meet the Maastricht criterion on inﬂation in 2004–2005,
which should be possible with inﬂation even slightly higher than the 2 percent thatthe NBH seeks to achieve in the long term. Unlike the Czech Republic and Poland,
Hungary also speciﬁed its long-term inﬂation target qualitatively, in terms of meeting
the Maastricht criterion for inﬂation, thus underscoring its preference to adopt the364 Chapter 15

Figure 15.2
Poland, actual inﬂation and inﬂation target, year-over-year.
Note: In June 1998, the NBP deﬁned the end-1999 inﬂation target. However, the NBP o‰cially announced the introduction of inﬂa-
tion targeting only in September.
Source: Central Statistical O‰ce Poland.Inflation Targeting in Transition Economies 365

Figure 15.3
Hungary, actual inﬂation and inﬂation targets, year-over-year.
Source: Hungarian Central Statistical O‰ce.366 Chapter 15

euro sooner rather than later. As inﬂation in late 2003 approached 6 percent, meeting
the long-term inﬂation target would require bringing inﬂation below present level, in
contrast to the Czech Republic and Poland, where inﬂation is likely to pick up some-
what from present unsustainable low levels.
15.4.2 Hitting and Missing Inflation Targets
In the previous section, we examined experience with inﬂation targeting from theperspective of disinﬂation. In this section, we look at how successful the three coun-
tries were in meeting their inﬂation targets. In this respect, we should keep in mind
that countries can be quite successful, in the longer term, in bringing inﬂation down,
but if a successful disinﬂation is accompanied by a signiﬁcant instability of inﬂation
(as evidenced by repeated large undershooting or overshooting of inﬂation targets),this can be costly for the economy as well.
There is not yet much we can read from the history of inﬂation targeting in Hun-
gary because it is so recent (see ﬁgure 15.3). The 2001 target was announced only in
August 2001, and it therefore was more of a short-term inﬂation forecast than an
actual inﬂation target. Therefore, the fact that Hungary met this target and the 2002
target does not tell much about the operation of its inﬂation-targeting framework.
The inﬂation target for 2002 implied a fairly rapid disinﬂation, alongside the trend
started in mid-2001. In 2001 and 2002, disinﬂation was helped by the appreciation
of the forint. However, since the forint has reached the upper end of the ﬂuctuationband and the government seems to resist the revaluation of parity, there is no room
for further nominal appreciation that would assist in further disinﬂation.
Table 15.4 and ﬁgures 15.1 and 15.2, which show the history of inﬂation targeting
in the Czech Republic and Poland, tell a very di¤erent story. In the Czech Republic,
the CNB signiﬁcantly undershot its inﬂation targets, particularly in 1998 and 1999,Table 15.4
Targeted and Actual Inﬂation in the Czech Republic and Poland
Czech Republic (net inﬂation) Poland (headline inﬂation)Target Actual Target Actual
1998 5.5–6.5 1.7 n.a. 8.6
1999 4–5 1.5 6.4–7.8 (8–8.5) a 9.8
2000 3.5–5.5 3 5.4–6.8 8.52001 2–4 2.4 6–8 3.62002 2.75–4.75 b 0.5 4–6 0.8
Source: Czech National Bank, National Bank of Poland, various documents.
Note: n.a. ¼not applicable.
aInitial target in parentheses.
bHeadline inﬂation.Inflation Targeting in Transition Economies 367

and less in 2000. Net inﬂation fell to 1.7 percent at the end of 1998 and to 1.5 percent
at the end of 1999, well below the CNB’s targets. Only in 2001, in the fourth year of
inﬂation targeting, did the CNB succeed in achieving its inﬂation target, but it under-
shot its target again in 2002.
As we can see in ﬁgure 15.2, in Poland there was an opposite problem, as the NBP
signiﬁcantly overshot its targets in 1999 and 2000. In the course of 1998, inﬂation inPoland was falling rapidly, and at the end of the year it fell to 8.6 percent, less than
the 9.5 percent projected. A more-rapid-than-expected decline in inﬂation prompted
the NBP to reduce early in 1999 its target for end-1999, from 8–8.5 percent to 6.4–
7.8 percent, a step that in retrospect may seem to have been somewhat premature. If
the NBP had maintained its original target, 8–8.5 percent, it would have missed it by
only a very small margin. But in the course of 1999, inﬂation began to increase
again, and the 1999 target was missed by a signiﬁcant margin, as was the 2000 target.
Very tight monetary policy and slowing economic activity helped to bring inﬂation
down sharply in 2001, and subsequently the 2001 and 2002 targets were undershot
quite sizably.
These repeated large deviations of actual inﬂation from the inﬂation target would
seem to suggest that inﬂation targeting was not very successful in the Czech Republic
and Poland. But before we make any deﬁnitive judgments about the success or fail-
ure of inﬂation targeting in these two countries, it is important to understand the rea-
sons for such signiﬁcant deviations of actual from targeted inﬂation. We have to
examine more closely both the domestic and the external economic circumstances
that prevailed during this period and that a¤ected actual inﬂation.
At the time when the CNB launched inﬂation targeting, inﬂation was rising quite
rapidly, but at the same time the economy was already slipping into a prolonged re-
cession. The 1998 and 2000 inﬂation targets were speciﬁed at the time when the CNB(and other public and private forecasters) expected much stronger economic growth
than actually materialized. 24However, with the onset of a major banking crisis in
1997–98, economic activity fell and contributed to a much faster disinﬂation than
was envisaged by the CNB’s inﬂation targets. 25Moreover, the 1997–98 ﬁnancial
crises and weak global economic activity contributed to falling commodity prices,
including energy prices. 26The CNB calculations suggest that these external factors
had a sizeable e¤ect on net inﬂation: in 1998, these factors reduced net inﬂation by
2–3 percentage points (C ˇapek 1999, 9). In the absence of these shocks, net inﬂation
at the end of 1998 would probably have been close to the bottom of the target range.
There were also other structural shocks that contributed to lower-than-projected in-
ﬂation. Among the more important was the continuing unexpected decline in food-stu¤ prices in 1998 and 1999. Ex post, the decline in foodstu¤ prices was ascribed to
the struggle of the retail distributors for market share in the Czech market. Weak do-
mestic demand, together with strong koruna and strong competitive pressure in the368 Chapter 15

domestic economy resulting from penetration on the Czech market of foreign distrib-
utors, continued to keep inﬂation low even after the e¤ects of external price shocks
began to disappear. In addition, the decision not to exclude energy prices and to ex-
clude adjustment of regulated prices from the targeted price index did not achieve its
objective of encouraging the government to pursue a ‘‘courageous policy of price
deregulation,’’ as the CNB initially hoped.
When inﬂation targeting was introduced, Poland was facing very di¤erent eco-
nomic circumstances from those of the Czech Republic. First, the implications of
global developments for domestic inﬂation were better known to the NBP at that
time and could be incorporated into the inﬂation target. As in the Czech Republic,
inﬂation in Poland declined signiﬁcantly during 1998 and 1999, but this decline was
less dramatic and did not last as long. Already in the second half of 1999, inﬂation in
Poland had begun to exceed by an increasingly wider margin inﬂation in the Czech
Republic. Relatively rapid growth of domestic demand, increase in import prices,
and the monopolistic structure of some industries together resulted in the reversal of
disinﬂation in Poland in the course of 1999. Fiscal policy was also much more expan-
sionary than the NBP had expected, and this expansionary stance further fueled do-mestic demand.
The NBP responded to these developments with a signiﬁcant tightening of mone-
tary policy, and it continued to keep monetary conditions very tight even when inﬂa-
tion began to fall sharply later in 2000 and in 2001. This (to some excessively) tight
monetary policy also brought economic growth nearly to a halt by the end of 2001,
and contributed to increased tension between the NBP and the government, which
even led by the end of 2001 to threats of reduction of NBP independence. It appears
that the NBP tried to use a tight monetary policy stance as an instrument to force the
government to strengthen structural ﬁscal balance, even at the cost of signiﬁcant un-dershooting of its inﬂation target.
Judging by its success in meeting its inﬂation target, the NBP has not been very
successful thus far. In the ﬁrst two years, inﬂation targets were overshot, and in the
third and fourth years there was signiﬁcant undershooting. Recent years saw a signif-
icant instability of inﬂation, which fell rapidly from 17.8 percent in the beginning of
1997 to 5.6 percent in February 1999, then rose to 11.6 percent in July 2000, and fell
again to 0.8 percent in December 2002. In Poland, external factors may have been of
less importance in explaining the failure to meet inﬂation targets than in the Czech
Republic, while the conduct of macroeconomic policy probably mattered more.
First, unexpected ﬁscal expansion, combined with easy monetary policy, contributed
to the acceleration of inﬂation and overshooting of inﬂation targets; subsequently,sharp tightening of monetary policy, in the absence of further easing of ﬁscal policy,
reduced inﬂation sharply down and produced a signiﬁcant undershooting of the
target.Inflation Targeting in Transition Economies 369

15.4.3 Comparison of Inflation and Output Performance of Inflation Targeters with Other
Transition Countries
We have seen that hitting inﬂation targets has not been an easy exercise. However,
this may have been unavoidable given the shocks the inﬂation targeters were sub-
jected to. To assess the success of inﬂation targeting in transition countries, we have
to ask how well the inﬂation targeters have done relative to the nontargeters.
There are two alternative monetary policy regimes to inﬂation targeting that tran-
sition countries have chosen:
1. Exchange rate peg: a crawling peg for Hungary until August 2001, a standard peg
for Latvia (peg to SDR), and a hard peg of the currency board type for Bulgaria,
Estonia, and Latvia
2. Float without an inﬂation target: Slovakia, Slovenia, and Romania 27
Figures 15.4 and 15.5 compare inﬂation rates (year over year) in the Czech Repub-
lic and Poland with those of the other transition countries. A relevant starting date
for comparing the di¤erent monetary regimes is December 1998 (marked in the ﬁg-
ures), which corresponds to the ﬁrst date that inﬂation targets were to be met in the
Czech Republic. As we can see in ﬁgure 15.4, which has a comparison with the non-
inﬂation-targeting ﬂoaters, the Czech Republic and Poland experienced lower levels
of inﬂation for most of the 1999–2002 period than did the non-inﬂation-targetingﬂoaters. On the other hand, ﬁgure 15.5, which has a comparison with the exchange
rate peggers, does not display a clear dominance of inﬂation targeting over pegging.
Hungary, with its soft peg, and Bulgaria, with its currency board, have typically had
higher inﬂation rates than the Czech Republic and Poland; but Lithuania, with its
currency board, and Latvia, with its standard peg, have experienced lower inﬂation
rates. Estonia has had inﬂation rates comparable to those in the Czech Republic, but
up until the last half of 2002 had lower inﬂation than Poland.
Clearly a low level of inﬂation is only one measure of success of monetary
regimes—equally important is the variability of inﬂation and output. Table 15.5 pro-vides the standard deviation of both inﬂation and output for the period 1999–2002.
Here we see that the Czech Republic and Poland are in the middle of the pack on
both criteria. The Czech Republic and Poland have higher standard deviations of in-
ﬂation than the hard-pegging Baltic countries, while they have lower variability than
Hungary, a soft pegger, Bulgaria, a hard pegger, and Slovakia and Romania, non-
inﬂation-targeting ﬂoaters. Slovenia, a non-inﬂation-targeting ﬂoater, has equal inﬂa-
tion variability to the Czech Republic but has lower variability than Poland.
Although we should not make too much of the data in ﬁgures 15.4 and 15.5 and
table 15.5 because they cover such a short period and because these countries have
been subjected to di¤erent shocks, it is worth noting that in terms of inﬂation con-370 Chapter 15

Figure 15.4
Inﬂation in Czech Republic, Poland, and the non-inﬂation-targeting ﬂoaters, year-over-year.
Note: aIndicates the date of the ﬁrst inﬂation target.
Source: Czech Statistical O‰ce, Central Statistical O‰ce of Poland, Statistical O‰ce of the Republic of Slovenia, Statistical O‰ce of the Slovak
Republic, and National Statistical O‰ce of Romania.Inflation Targeting in Transition Economies 371

Figure 15.5
Inﬂation in the Czech Republic, Poland, and countries with peg, year-over-year.
Note: aIndicates the date of the ﬁrst inﬂation target.
Sources: Czech Statistical O‰ce, Central Statistical O‰ce of Poland, NBP, National Statistical O‰ce of Bulgaria, Statistical O‰ce of Estonia, Stat is-
tical O‰ce of the Republic of Slovenia, Statistical O‰ce of the Slovak Republic, Statistics Lithuania, and Central Statistical Bureau of Latvia.372 Chapter 15

trol, inﬂation targeting does not clearly dominate the other monetary policy regimes
chosen by transition countries.
We reach a similar conclusion in terms of output variability as seen by the stan-
dard deviations of output growth reported in table 15.5. 28The Czech Republic and
Poland have had lower standard deviations than the hard peggers, Bulgaria and the
Baltic states, but have had higher standard deviations than Slovakia and Slovenia,
non-inﬂation-targeting ﬂoaters. Hungary, a soft pegger for most of the period, had
the lowest standard deviation of output growth of all the countries in the table. How-
ever, even less should be made of these comparisons, because real shocks have dif-
fered dramatically across the transition countries. For example, as we can see in
ﬁgure 15.6, the Baltic countries, which have a higher proportion of their trade with
Russia as a result of their having been part of the former Soviet Union, su¤ered very
dramatic output declines in 1999 in the aftermath of the Russian ﬁnancial crisis inthe fall of 1998. The contraction of the Russian economy at that time had a far
smaller impact on transition countries that were less integrated with Russia and
whose trade was mostly with Western Europe.
15.5 Lessons and Problems of Inflation Targeting in Transition Economies
Even though the experience of the implementation of inﬂation targeting in transition
economies is relatively short, it has nevertheless brought out several speciﬁc issues,
which deserve discussion. First, how should the standard operational aspects of inﬂa-tion targeting be speciﬁed—that is, what price index should be targeted? Should the
inﬂation target be a point or a range? And what should the horizon for the target
be? Second, given the fact that transition economies began inﬂation targeting in aTable 15.5
Inﬂation and Output Growth Volatility: 1998–2002
CountryInﬂation
volatilityOutput
volatility
Czech Republic 3.49 2.00
Poland 3.6 1.82Hungary 3.08 0.72Estonia 3.08 3.07Latvia 1.34 2.52
Lithuania 2.18 3.5
Bulgaria 49.7 3.97Slovakia 3.88 1.39Slovenia 1.34 0.82Romania 18.37 4.83Inflation Targeting in Transition Economies 373

Figure 15.6
Transition economies: Real GDP (1997 ¼100).
Sources: Czech Statistical O‰ce, Central Statistical O‰ce of Polan d, National Statistical O‰ce of Bulgaria, Statistical O‰ce of
Estonia, Statistical O‰ce of the Republic of Slovenia, Statistical O‰ce of the Slovak Republic, Statistics Lithuania, and Central
Statistical Bureau of Latvia.374 Chapter 15

situation of higher inﬂation than the long-term objective, how should the speed of
disinﬂation be determined, and in a closely related question, how should the govern-
ment be involved in setting inﬂation targets? Third, how should monetary policy
respond to the deviation of the actual inﬂation from the targeted disinﬂation path,
and how much should the ﬂoor of an inﬂation target be emphasized relative to the
ceiling? Fourth, how should the exchange rate be incorporated into the inﬂation-targeting framework?
15.5.1 Operational Aspects of Inflation Targeting
What Measure of Inflation to Target? In deciding what measure of inﬂation to target,
central banks face a trade-o¤ between transparency and the ability to control inﬂa-
tion. The advantage of a broadly deﬁned headline inﬂation (i.e., the consumer price
index) is that it is better understood by the public. However, the problem is that
headline movements could reﬂect factors other than monetary policy measures. A
more narrowly deﬁned measure of inﬂation that excludes possible e¤ects of transi-
tory shocks could be better controlled by a central bank, but at the same time itcould be more di‰cult for the public to assess the conduct of monetary policy on
the basis of such measure. Given the emphasis on central banks’ accountability and
transparency in a regime of inﬂation targeting, this could potentially be a serious
handicap, particularly for a central bank that still has to earn its credibility.
The CNB opted for a compromise that it considered most appropriate for an econ-
omy in transition. For the purpose of inﬂation targeting, it introduced a new con-
cept, so-called net inﬂation, which excluded regulated prices (see section 15.3.1).
Speciﬁc conditions of economic transition have played an important role in selecting
net inﬂation as the targeted measure of inﬂation. Unlike in industrial countries, manyprices were still regulated in the Czech Republic in late 1997. The CNB knew that
substantial changes in these regulated prices, including rents, would be needed before
they reached a market-clearing level. As a result, a given monetary policy stance
could produce di¤erent future paths of headline inﬂation, depending on the pace of
price deregulation or the size of adjustment of administered prices. At the same time,
this approach was supposed to avoid a situation in which the government would be
hesitant to pursue a faster adjustment of regulated prices out of concern that the in-
ﬂationary e¤ects of such policy would force the CNB to tighten monetary policy,
with adverse e¤ects on economic growth, thus exacerbating the political cost of
deregulation. Indeed, the former acting governor of the CNB, Pavel Kysilka, stated
that ‘‘by targeting net inﬂation, we have provided a room to the government to pur-sue a courageous policy of price deregulation’’ (Kysilka 1998, 10–12). Obviously, a
high share of regulated prices in total CPI does not make it easier for the central bank
to deal with this trade-o¤ between transparency and ability to control inﬂation. 29Inflation Targeting in Transition Economies 375

Subsequently, the pace of price deregulation and increase in administered prices
was less than the CNB had hoped, and so use of the net inﬂation construct did not
produce the desirable outcome the CNB expected. In addition, the net inﬂation con-
struct turned out to be more volatile than headline inﬂation, helping to contribute to
larger misses of the target. When it decided to target net inﬂation, the CNB did not
exclude the possibility that in the future it could modify the measure of targeted in-ﬂation. The problems with the net inﬂation measure thus led the CNB to abandon it
in April 2001, and it subsequently moved to targeting headline inﬂation as has been
discussed in section 15.3.1.
Target a Point or a Range? As in other aspects of design of the operational frame-
work, there is a trade-o¤ involved in deciding about the width of the band. A wider
band increases the chance that monetary policy will be successful in keeping targeted
inﬂation inside. But a too-large band could reduce the ability of inﬂation targeting
to anchor inﬂation expectations, and it could be of less help in establishing the anti-
inﬂationary credibility. Some argue that a band that is narrow enough to anchor in-
ﬂationary expectations is likely to be frequently missed, and that it is preferable totarget a point and explain the deviations of actual inﬂation from that point target
(Bernanke et al. 1999; Mishkin 2001).
In a sense, one can argue that a higher degree of uncertainty in projecting inﬂation
and a correspondingly higher probability that even a target range would be missed
makes the issue of point versus range less of an issue than in more advanced
inﬂation-targeting economies. By setting a range, the central bank may indicate
what is its estimate of uncertainty of reaching the inﬂation target. This is how the
CNB has explained its decision regarding the width of the targeted range. Missing a
target range then carries a larger risk of credibility loss than missing a target point.Targeting a reasonably narrow band (that is, narrow enough so that it provides a
su‰cient nominal anchor) does not make much sense when the probability that it
would be missed is not signiﬁcantly less than the probability of missing a point.
Time Horizon of Inflation Targeting Monetary policy a¤ects the economy and particu-
larly inﬂation with long lags. In industrialized countries, lags from monetary policy
to inﬂation are typically estimated to be on the order of two years. Shorter time hori-
zons, such as one year, can be highly problematic. The ﬁrst problem with too short a
horizon is that it can lead to a controllability problem: too-frequent misses of the in-
ﬂation target, even when monetary policy is being conducted optimally. The second
problem is that it can lead to instrument instability, in which policy instruments aremoved around too much in order to try to get inﬂation to hit its targets over the
shorter horizon. A third problem is that too short a horizon implies that not enough
weight is put on output ﬂuctuations in the central bank’s loss function. 30376 Chapter 15

The experience with inﬂation targeting in New Zealand documented in Bernanke
et al. (1999) illustrates these problems. In 1995, the Reserve Bank of New Zealand
overshot its one-year-horizon inﬂation target range, making the governor subject to
dismissal under the central-banking law. It was recognized in the Reserve Bank that
the overshoot was likely to be short-lived and inﬂation was likely to fall, indicating
that monetary policy had not been overly expansionary. Fortunately, this view wasaccepted outside the Bank, and the governor, Don Brash, whose performance was
excellent, retained his job. Attempting to hit the annual target did, however, have
the unfortunate consequence of producing excessive swings in the monetary policy
instruments, especially the exchange rate. In a small, open economy, like New Zea-
land, exchange rate movements have a faster impact on inﬂation than interest rates.
Thus, trying to achieve annual inﬂation targets required heavier reliance on manipu-
lating exchange rates, which led to its having large swings. By trying to hit the short-
horizon target, the Reserve Bank also may have induced greater output ﬂuctuations.
For example, the Reserve Bank pursued overly tight monetary policy at the end of
1996 with the overnight cash rate going to 10 percent because of fears that inﬂation
would rise above the target range in 1997, and this led to an undesirable decline inoutput. The Reserve Bank has recognized the problems it had with a too-short target
horizon and now emphasizes a horizon of six to eight quarters in their discussions
of monetary policy (Sherwin 1999; Drew and Orr 1999). Furthermore, the Policy
Target Agreement between the central bank and the government has recently been
amended to be more ﬂexible in order to support the longer policy horizon (Reserve
Bank of New Zealand 2000).
The solution to avoiding too short a horizon for the inﬂation target is to set inﬂa-
tion targets for periods two years ahead (or longer). This automatically implies that
the central bank will have multiyear inﬂation targets. The target for the current cal-endar year will have been set two years previously, while there will also be a target
for the following year. With multiyear targets, the target from one year to the next
could vary over time. The inﬂation target would vary in response to shocks to the
economy, especially to supply shocks, which might need to be accommodated in
order to keep output ﬂuctuations from becoming excessive. Also, putting a weight
on output ﬂuctuations in a central bank’s objectives, as is sensible, means that the
approach of the inﬂation target to the long-run goal needs to be gradual (Svennson
1997). This also suggests the need for multiyear targets in which the inﬂation target,
even one for two years ahead, may di¤er from the long-run target if shocks to the
economy have driven inﬂation away from the long-run goal.
Initially, the horizons for inﬂation targets in the transition countries studied here
were short, being on the order of a year, and this may have contributed to the con-
trollability problem and the frequent target misses. Possibly in response to these
problems, the CNB was the ﬁrst to specify a long-term inﬂation target for a horizonInflation Targeting in Transition Economies 377

of ﬁve years, and the NBH and the NBP have also speciﬁed medium-term inﬂation
targets (see table 15.2).
15.5.2 Who Should Set the Inflation Target and Decide the Speed of Disinflation?
In the 1990s, there was a signiﬁcant shift worldwide toward more independent cen-tral banks, partly in response to a better understanding of economic costs of politicalinterference with monetary policy and high inﬂation. While not all central banks
were given complete freedom to set monetary policy targets, most of them gained in-
strument independence—that is, the freedom to conduct monetary policy without ex-
ternal interference to meet the objective. Among economists, there seems now to be a
consensus that central banks should have instrument independence—that is, inde-
pendence to conduct monetary policy so as to meet the inﬂation target or other mon-
etary policy objective. There also seems to be a consensus that central banks should
not have goal independence—independence to set inﬂation targets or other monetary
policy objectives (Fischer 1994).
From the early stages of economic transition, central banks in all three countries
have received a signiﬁcant degree of de jure independence, not only in the conductof monetary policy (instrument independence) but also in setting the objectives of
monetary policy (goal independence).
In the Czech Republic, the independence of the central bank was anchored in the
Constitution, which stated that the government might intervene in the CNB’s a¤airs
only for reasons clearly outlined in the Act on CNB. The Act on CNB (No. 6/1993
of Collection of Laws) speciﬁed that the primary objective of the CNB is to ensure
the stability of the Czech national currency (Article 2) and that the CNB Board
should set monetary policy and the instruments for the implementation of these pol-
icies (Article 5). Moreover, the Act explicitly states that in providing for its primaryobjective the CNB shall be independent of any instructions given by the government.
The governor, vice-governors, and members of the Board are appointed and recalled
by the president (Article 6). The Act was subsequently amended in 2002, and the
main objective of the CNB was changed to maintaining price stability, with the stan-
dard qualiﬁcation that without prejudice to its primary objective the CNB shall sup-
port economic policies of the government leading to sustainable economic growth.
The amended Act also states that ‘‘when providing for the primary objective of the
CNB and when carrying out their activities, neither the CNB nor the CNB Board
shall seek or take instructions from the President of the republics, from Parliament,
from the Government, from administrative authorities or from any other body’’ (Ar-
ticle 9). The appointment of the governor and other CNB o‰cials remains fully theresponsibility of the president.
In Hungary, the Act on NBH was passed in October 1991 and reinstated the inde-
pendence of the NBH. It has been amended several times since. The latest version,378 Chapter 15

from June 2001 (Act LVIII of 2001), states that the primary objective of the NBH
shall be to achieve and maintain price stability (Article 3) and that the NBH shall
deﬁne and implement monetary policy in the interest of maintaining the stability of
the national currency (Article 4). Article 6 states that ‘‘within the framework pro-
vided for by this Act, the NBH shall independently deﬁne its monetary policy and
the instruments for implementing such policy.’’ Article 38 stipulates that the govern-ment may not instruct the NBH in relation to its scope of tasks as set forth in the
Act. The president of the NBH is appointed for a period of six years by the president
of the Republic at the proposal of the prime minister. The president of the Republic
also appoints vice presidents and other members of the Monetary Council.
The legal position of the NBP is similar. The Act on the NBP of August 29, 1997,
stipulates that the basic objective of the NBP shall be to maintain price stability,
again with the addition that the NBP shall at the same time support government
economic policies, insofar as this does not constrain pursuit of the basic objective
(Article 3). The president of the NBP shall be appointed by the Sejm, at the request
of the president of the Republic, for a period of six years. The vice presidents and
other members of the NBP Management Board are appointed by the president ofthe Republic at the request of the president of the NBP. The nine members of the
Monetary Policy Council (MPC) are appointed in equal numbers by the president
of the Republics, the Sejm, and the Senate (Article 13). The responsibility of the
MPC is to draw annual monetary policy guidelines and submit them to the Sejm for
information (Article 12). Article 21 stipulates that in discharging its responsibilities
the NBP shall collaborate with the appropriate bodies of the central government in
developing and implementing national economic policy and strive to ensure proper
performance of monetary policy guidelines. It should submit monetary policy guide-
lines to the bodies of the central government and report on the performance of mon-etary policy.
However, de jure independence does not always imply a de facto independence.
While the NBP is not explicitly forbidden by the Act on NBP to seek instructions
from the government and other bodies in pursuing its responsibilities, de facto, it
decides alone on inﬂation targets. On the other hand, the NBH is de jure indepen-
dent and forbidden to seek instruction, but in practice, the governor of the NBH
seeks government endorsement for the NBH’s monetary policy objectives.
The e¤ort to make central banks legally independent reﬂected the belief of reform-
ist governments and parliaments that politics should not interfere with the conduct of
monetary policy. To a large extent, central-bank legislature in these countries was
modeled after the German Bundesbank, which itself—for historical reasons—enjoyed a high degree of independence. In the early years of transition, no one really
questioned the high degree of central-bank independence in the transition countries, as
governments had to deal with the more urgent tasks of liberalization, privatization,Inflation Targeting in Transition Economies 379

and so on. However, the high degree of central-bank independence eventually be-
came a source of tension.
These tensions appeared ﬁrst in the Czech Republic. As we have discussed, in the
early years of inﬂation targeting the CNB repeatedly undershot its inﬂation target,
while economic growth turned negative. In many countries, this would probably
have been su‰cient to create tensions between central bank and government. In theCzech Republic, these tensions were further aggravated by political developments.
To a large extent as a result of the poor state of the economy in the aftermath of
the currency turbulence of 1997, the main pro-reform party split and new elections
were called for mid-1998. In the meantime, a caretaker government was formed and
the CNB governor became a caretaker prime minister. When a new government was
formed after the election, he returned to the CNB. Inevitably, this drew the CNB fur-
ther into politics, exactly the opposite of what the high degree of de jure indepen-
dence was supposed to achieve.
The party that lost the election in 1998 criticized the CNB and the governor for
mishandling monetary policy, contributing to economic decline, and thus a¤ecting
the outcome of the elections. The CNB was considered to be too independent andunwilling to coordinate monetary policy with the economic policy of the govern-
ment. The speed of disinﬂation was considered as excessive, hurting economic
growth. This criticism eventually resulted in legislative e¤ort to curb the CNB’s inde-
pendence. When the CNB and the new government introduced jointly to Parliament
an amendment to the CNB Act to bring it in line with EU standards, members of
the party that lost the 1998 election submitted their own amendment that aimed at
signiﬁcantly reducing the CNB’s independence. They proposed for Parliament to
supervise and approve the operational budget, salaries of Board members to be cut,
monetary policy decisions to be made in consultation with the government, and po-litical parties to have more say in appointing the governor and Board members.
This proposal was strongly criticized by domestic and foreign ﬁnancial analysts, by
the International Monetary Fund, and—most importantly—by the EU and Euro-
pean Central Bank. Central-bank independence is a requirement for both EU and
EMU membership, and this argument ultimately carried the most weight because of
the planned accession of the Czech Republic into the EU/EMU. In the end, the CNB
retained its independence, and with the appointment of a new governor in 2000 the
relationship with the government improved as well.
Similar tensions between the central bank and the government emerged in Poland
during 2000 and 2001. As economic growth began to falter while interest rates
remained high, the NBP was blamed by some politicians for having set its monetarypolicy excessively tight and for contributing to subpar growth performance. Tensions
between the government and the NBP accelerated in October 2001, after the new
government took o‰ce. Contributing to the tensions was the fact that the president380 Chapter 15

of the NBP, Leszek Balcerowicz, was himself a former politician and main author of
the cold-turkey stabilization program that was criticized by the center-left politicians
who formed the government after the October 2001 elections.
The prime minister and other members of the cabinet have repeatedly attacked the
MPC for keeping interest rates too high. The pressure to reduce the NBP’s indepen-
dence rose, and some members of Parliament from the two governing parties drewlegal proposals to broaden the NBP’s objectives to include economic growth and em-
ployment, and to increase the number of members of the MPC. Even though the
government did not formally back these proposals, being well aware that this would
complicate the EU/EMU accession, it did not mind using them as a tool to put pres-
sure on the NBP to ease monetary policy. Because accession to EU/EMU is an im-
portant objective for Poland, it is not likely that these initiatives will succeed.
The Polish experience also illustrates the peril of a central-bank e¤ort to use mone-
tary policy as a tool to force the government to pursue a more disciplined ﬁscal
policy. The NBP tried to use tight monetary policy to pressure the government to im-
prove structural ﬁscal balance, and kept interest rates very high even as inﬂation was
falling below its target and growth came nearly to a halt. But instead of achievingthis objective, the NBP only antagonized the government and put its independence
under risk.
Even Hungary was not spared tensions between the central bank and the govern-
ment. Recently, the government put forward a bill that proposed to set up a Super-
visory Committee within the NBH. This committee would comprise delegates of
political parties and two persons appointed by the minister of ﬁnance. Such a com-
mittee already existed in the past but was abolished. The NBH argued that such a
step would infringe on NBH’s operational independence and would go against the
EU requirements on central-bank independence. Members of the government havealso pressured the NBH to reduce interest rates in order to support growth. They
argued that the NBH should not focus too much on inﬂation.
In Hungary, the reasons for this pressure on the central bank were mainly political
and personal. The new NBH president who was appointed in 2001 was a former
minister of ﬁnance, and from this position he had been exercising pressure on his pre-
decessor. However, the previous NBH president is in close contact with the present
prime minister and has used this relationship to put pressure on his successor. More
recently, the conﬂict between the inﬂation target and exchange rate target has further
increased these tensions.
Why do we see these tensions in all three inﬂation-targeting countries? There are
several reasons. First, at the beginning of transition, central banks were given a largedegree of both operational and goal independence. In a situation where inﬂation is
still higher than the long-term objective of price stability, this means that central
banks are given the freedom to decide on the speed of disinﬂation. As central bankersInflation Targeting in Transition Economies 381

tend to be more ambitious with respect to the speed of disinﬂation than politicians,
this creates the potential for tensions. These tensions tend to come into the open once
economic growth falters, particularly if this poor growth performance is perceived as
contributing to a loss of popularity of the governing party or parties. In our view,
this experience suggests the superiority of closer involvement with political author-
ities in setting monetary policy objectives. Particularly in the di‰cult period of eco-nomic transition, a goal of independence of central banks may complicate rather
than facilitate the conduct of monetary policy.
Second, the fact that politicians became central-bank governors, or that central-
bank governors stepped into politics, had the unwanted consequence of drawing
central banks more into the political arena. Finally, despite signiﬁcant progress in
economic and political reforms, the rule of law still remains less ﬁrmly established
even in the most advanced transition economies, making politically motivated
attacks on central banks more likely.
Public disputes between the central bank and the government of the kind that we
have seen in the Czech Republic, Poland, and Hungary are not desirable. They un-
dermine the credibility of the inﬂation-targeting framework and could increase thecosts of future disinﬂation. As we have already noted, the decision about the speed
of disinﬂation has a di¤erent impact on di¤erent groups in the society, and there is
thus a strong case for such a decision to be made by a politically responsible body
like the government. Clearly, it would better serve the credibility of monetary policy
if the speed of disinﬂation were the result of a joint decision by a central bank and
the government, although this is obviously not a practice in all inﬂation-targeting
countries. 31Such a joint decision would have several advantages. Most important,
it would be more credible. When a government decides (perhaps jointly with a cen-
tral bank) on the speed of disinﬂation, it is explicitly or implicitly committing itself topolicies supporting this disinﬂation objective. The speed of disinﬂation (co)decided
by government would be seen by markets as a political decision that takes into ac-
count possible short-term trade-o¤s, and it would reduce the probability that policies
supporting the achievement of targeted disinﬂation would be challenged on grounds
that they do not reﬂect the preferences of the society and that they are unduly costly.
Even in situations where the ultimate responsibility for deciding on the speed of
disinﬂation would rest with the government, the central bank could still provide im-
portant input into this decision by voicing (possibly publicly) its own views about the
desirable speed of disinﬂation. Of course, there is a risk that the government would
choose too slow a disinﬂation. However, it is not clear whether this would impose
higher costs on the economy than a unilateral decision by a central bank to pursuea more rapid disinﬂation that would subsequently be challenged by the government
as being too ambitious. Furthermore, a unilateral decision by the central bank to
pursue rapid disinﬂation is likely to weaken support for the central bank, as has382 Chapter 15

occurred in the Czech Republic and Poland. This increases the risk of loss of inde-
pendence and interferes with the ability of the central bank to control inﬂation in a
longer-run context.
The question of who should set inﬂation targets has a speciﬁc aspect in transition
economies that are expected soon to adopt the euro. One can argue that when the
political decision to adopt the euro is made, it e¤ectively speciﬁes both the disinﬂa-tion path and the ultimate inﬂation target. The inﬂation target is determined by the
need to meet the Maastricht criterion concerning maximum permissible inﬂation,
and the speed with which this inﬂation is to be achieved is determined by the timing
of the euro adoption. To the extent that there is a ﬁrm political commitment to adopt
the euro at a certain date, it becomes to a large extent irrelevant whether the inﬂation
target is set by a central bank or a government. The government does not have much
room to be more lenient on inﬂation than the central bank, because of the possibly
large economic and mainly political costs of not meeting the Maastricht criteria.
15.5.3 How Should a Bank Respond to Deviations of Inflation from the Target, and How
Much Should the Floor of an Inflation Target Be Emphasized Relative to the Ceiling?
The implementation of inﬂation targeting in the Czech Republic and Poland has
brought out an interesting problem that arises in other inﬂation-targeting economies
as well: how should a bank respond to a signiﬁcant deviation of inﬂation from the
inﬂation target? If the inﬂation rate overshoots the ceiling of the target range, then
the logic of inﬂation targeting clearly requires the central bank to bring the inﬂation
rate back into the target range. However, should an inﬂation-targeting central bank
try to lock in a lower-than-targeted inﬂation once actual inﬂation falls below the tar-
geted path if inﬂation is not yet at the long-run goal? Another way of asking this
question is to ask whether a central bank should emphasize the ﬂoor of the inﬂationtarget as much as the ceiling and thus work as hard to avoid undershoots of the tar-
get as overshoots.
As we have noted, the CNB signiﬁcantly undershot its inﬂation target in 1998 and
1999, and less so in 2000. Similarly, at the end of 2001, inﬂation in Poland fell well
below the NBP end-2001 target. What should central banks do in such situations?
Should they be upset at the undershoot and indicate that this was a serious mistake?
Alternatively, would it be appropriate for them to lock in the unexpectedly rapid dis-
inﬂation of the previous two years and focus monetary policy on maintaining price
stability from then on?
A case could be made for acting opportunistically and using faster-than-expected
disinﬂation to lock in this windfall beneﬁt of lower inﬂation (Haldane 1999). This iswhat Poland has tried to do by adjusting its original end-1999 inﬂation target after
actual inﬂation early in 1999 began to fall faster than projected. It would seem that
when inﬂation has been reduced to less than the central bank target but still remainsInflation Targeting in Transition Economies 383

above the level of inﬂation corresponding to price stability, it would make no sense
to let inﬂation go up again only to be forced to reduce it again later. Disinﬂation,
even at a moderate pace, could be costly, and if a country can avoid the need to dis-
inﬂate in the future, this should spare the economy some loss of output. Whether past
faster-than-planned disinﬂation was a result of luck or mistakenly tight monetary
policy may seem not to matter—bygones are bygones, past costs, if any, have beenincurred, and let’s just avoid any future costs of disinﬂation. 32
In practice, central banks have treated the ﬂoors of inﬂation-target ranges in di¤er-
ent ways (Clifton 1999). Some treat them as seriously as upper sides of a band and
have eased monetary policy to bring inﬂation back up inside the band (e.g., New
Zealand in 1991), while others preferred to consolidate the unexpected rapid disinﬂa-
tion (Israel in 1998).
The recent experience of Poland has shown the risks of trying to lock into inﬂation
that is lower than originally targeted. There are several problems with opportunistic
disinﬂation and with treating the bottom of the band leniently. First, there is a possi-
bility that opportunistic disinﬂation will not ﬁnd much sympathy with politicians.
Particularly if the disinﬂation that is faster than originally intended coincides with asigniﬁcant weakening of economic activity, there will be calls for a relaxation of
monetary policy, even if this should mean a return to somewhat higher inﬂation.
The NBP has exacerbated this problem because its inﬂation target is now stated to
be less than 4 percent, suggesting that they are not particularly disturbed by under-
shooting the inﬂation target. This may have contributed substantially to the poor
relations between the NBP and the government and the decrease in public support
for the NBP. The CNB was well aware of the danger from its undershoots of the in-
ﬂation target and did not even suggest that it could lock in the lower-than-targeted
inﬂation.
Second, if rapid disinﬂation is a result of temporary external shocks like large
declines in the price of commodities, it would be a mistake to assume that monetary
policy could lock in such disinﬂation forever without large future costs. Once these
shocks are over, prices of commodities usually do not stay low but rise again as
global demand recovers. Monetary policy that would try to prevent an accelerated
pace of disinﬂation in times of declining commodity prices or other positive supply
shocks would probably be too expansive. In the same vein, monetary policy would
risk being too restrictive if it tried to avoid any acceleration of inﬂation as positive
supply shocks are reversed. 33Like many other inﬂation-targeting central banks, the
CNB has explicitly recognized that monetary policy should not attempt to o¤set tem-
porary supply shocks that knock disinﬂation from its projected path.
Third, an opportunistic approach to disinﬂation could undermine the credibility of
an inﬂation-targeting framework. By setting medium-term inﬂation targets, central
banks attempt to establish a predictable environment that would allow economic384 Chapter 15

agents to plan for the future. Even though there could and will be deviations from
the target, credible inﬂation targeting would lead the agents to expect that a central
bank would do its best to return actual inﬂation to the targeted path. Attempts at
opportunistic disinﬂation could increase the uncertainty, because they would make
monetary policy less predictable. For example, economic agents could expect that
central banks would adjust an inﬂation target upward in case of a negative shock aswell.
However, a situation may arise where the path of disinﬂation has been set incor-
rectly. For example, competitive pressures in the economy due to liberalization, pri-
vatization, and a more open trade would produce a faster disinﬂation for a given
monetary policy stance than originally expected. These favorable supply shocks
would be likely to cause inﬂation to undershoot without leading to a decline in out-
put. In this case, maintaining the original disinﬂation target would require an overly
expansionary monetary policy, and it would seem to be more appropriate to accept
in such a case a disinﬂation that is faster than originally intended. This would also
likely be politically feasible because the undershoot of the inﬂation target would not
be accompanied by output losses.
15.5.4 Inflation Targets and the Exchange Rate
In the recent literature on inﬂation targeting, particularly on inﬂation targeting in
emerging-market countries, increased attention has been paid to the open-economy
aspect of inﬂation targeting (Mishkin 2000; Mishkin and Savastano 2001; Eichen-
green 2001). It has been recognized that the large degree of openness of some
emerging-market economies, in combination with speciﬁc characteristics of their ﬁ-
nancial systems, creates additional challenges for the implementation of inﬂation tar-
geting. Exchange rate movements directly a¤ect domestic inﬂation, both as a resultof external shocks and as a result of monetary policy measures. The open-economy
aspect of inﬂation targeting plays a prominent role in inﬂation-targeting transition
economies as well.
In the initial stage of transition, all three inﬂation-targeting countries analyzed in
this chapter used a ﬁxed exchange rate as a nominal anchor to import price stability
and bring domestic inﬂation quickly down. The currency peg-based stabilization was
quite e¤ective, because it allowed them to bring down inﬂation relatively quickly.
The initial monetary overhang was eliminated by a one-time increase in price level
rather than by a sustained growth in prices, and thus its elimination did not become
embedded in inﬂation expectations.
However, ﬁrst Poland, then the Czech Republic, and ﬁnally Hungary abandoned
the currency peg and moved to more ﬂexible exchange rate arrangements. This has
fundamentally changed the operation of monetary policy and the operation of the
monetary transmission mechanism.Inflation Targeting in Transition Economies 385

The importance of the exchange rate channel of monetary policy depends directly
on the degree of openness of the economy to trade ﬂows and on the degree of inte-
gration into international capital markets. The Czech Republic and Hungary are
very open economies with respect to trade ﬂows: the share of exports plus imports
in gross domestic product (GDP) exceeds 100 percent. Poland is a more closed econ-
omy: the share of exports plus imports reaches ‘‘only’’ about 50 percent. Therefore,exchange rate movements in the Czech Republic and Hungary will have a more
important e¤ect on domestic prices and inﬂation, and thus on inﬂation targeting. At
the same time, all three countries are very open to international capital ﬂows, be-
cause in preparation for EU membership they have largely completed capital ac-
count liberalization.
There are several reasons why exchange rate movements are important for inﬂa-
tion targeting in transition countries (Svensson 2000). First, exchange rate move-
ments provide an additional transmission channel of monetary policy. While in a
closed economy aggregate demand and expectation channels dominate, in an open
economy the exchange rate channel may be the most important one, particularly in
the short run. The exchange rate transmission channel operates both directly andindirectly. Changes in nominal exchange rate directly a¤ect the domestic prices of
imported ﬁnal goods and thus the targeted CPI index. 34Indirectly, the exchange
rate channel operates by a¤ecting domestic demand. Changes in real exchange rate
a¤ect domestic and foreign demand for domestic goods, thus enhancing the standard
aggregate-demand channel. Second, the exchange rate is one channel through which
foreign disturbances could be transmitted into the domestic economy. Third, transi-
tion countries also have a particular concern with their exchange rates because they
want to become part of the EU and the euro zone. Thus they must eventually ﬁx
their exchange rates to the euro as part of their planned entry into the EMU and sonaturally care more about the exchange rate at which they will convert their currency
into the euro upon accession.
Finally, it should be noted that emerging-market countries and transition econo-
mies are usually more vulnerable to large exchange rate movements. The reason is
the underdeveloped capital market in domestic currency and the need to borrow in
dollars or other foreign currency, except for very short-term borrowing. This results
in open foreign exchange positions of banks and/or corporations and thus increased
vulnerability of their balance sheets to large exchange rate movements. While large
appreciation can make domestic producers uncompetitive (both in foreign and do-
mestic markets), large depreciation could cause substantial damage to ﬁrms or banks
with large open foreign exchange positions and precipitate a ﬁnancial crisis of thetype described in Mishkin (1996, 1999).
While it is generally recognized that in such open economies as the Czech Republic
and Hungary the exchange rate represents both an important channel of monetary386 Chapter 15

transmission and an important channel of transmission of external disturbances, it is
less obvious what the implications are for the treatment of the exchange rate in the
regime of inﬂation targeting. We can distinguish two approaches to the exchange
rate: an active and a passive approach. In an active approach, the central bank cares
about the exchange rate over and above its e¤ects on inﬂation and actively tries to
inﬂuence the level of the exchange rate. In a passive approach, a central bank caresabout the exchange rate only to the extent that it a¤ects aggregate demand and the
inﬂation rate, and it does not try to directly manipulate the exchange rate, only react-
ing to changes in exchange rate that would threaten its inﬂation target. 35
As we have noted, the Czech Republic and Hungary are particularly open econo-
mies, and the exchange rate will therefore have an important e¤ect on inﬂation and
other variables. Poland is less open, and exchange rate movements seem to play a
less important role in monetary policy deliberations. It seems that the NBH is pursu-
ing this active approach, to judge from its statements on the role of the exchange rate
in a¤ecting inﬂation outcomes. As Orlowski (2000) argues, in Hungary, the central
bank has focused its monetary policy on exchange rate stability, and for this reason
changes in the exchange rates have a strong e¤ect on inﬂation. Such a strong e¤ectwas not observed in the Czech Republic and Poland. This may explain the relatively
larger emphasis put by the NBH on the exchange rate channel of monetary policy.
The problem is that too much reliance on the exchange rate channel of monetary
transmission carries the risk that a central bank would focus excessively on a short-
term horizon. In open economies, the exchange rate channel not only is important
but operates very fast, because changes in exchange rate directly a¤ect domestic
prices of imported ﬁnal goods, and with longer but still potentially quite short
lag prices of domestic goods containing imported inputs. This rapid transmission
may induce the inﬂation-targeting central bank into too much of a focus on a short-term horizon and into an e¤ort to keep actual inﬂation in line with the inﬂation tar-
get by orchestrating exchange rate changes. However, excessive use of the exchange
rate channel could have undesirable consequences. It could cause a problem of in-
strument 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. 36In addition, it runs the risk of transforming the exchange rate into a nom-
inal anchor that takes precedence over the inﬂation target. For example, as docu-
mented in Bernanke et al. (1999), Israel’s intermediate target of an exchange rate
around a crawling peg did slow the Bank of Israel’s e¤ort to win support for disinﬂa-
tion 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 induce the wrong pol-icy 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.Inflation Targeting in Transition Economies 387

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 inﬂation. By early 1997, the Re-
serve Bank institutionalized this focus by adopting as its primary indicator of mone-
tary policy a Monetary Conditions Index (MCI) similar to that developed by the
Bank of Canada. The idea behind the MCI, which is a weighted average of the ex-change rate and a short-term interest rate, is that both interest rates and exchange
rates on average have o¤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¤set the upward pressure on inﬂation. However, the o¤setting e¤ects of interest
rates and exchange rates on inﬂation depend on the nature of the shocks to the ex-
change rates. If the exchange rate depreciation comes from portfolio considerations,
then it does lead to higher inﬂation and needs to be o¤set by an interest rate rise.
However, if the reason for the exchange rate depreciation is a real shock, such as a
negative terms-of-trade shock, which decreases the demand for a country’s exports,
then the situation is entirely di¤erent. The negative terms-of-trade shock reduces ag-
gregate demand and is thus likely to be deﬂationary. The correct interest rate re-sponse is then a decline in interest rates, not a rise as the MCI suggests.
With the negative terms-of-trade shock in 1997, the adoption of the MCI in 1997
led to exactly the wrong monetary policy response to the East Asian crisis. With de-
preciation setting in after the crisis began in July 1997 after the devaluation of the
Thai baht, the MCI began a sharp decline, indicating that the Reserve Bank needed
to raise interest rates, which it did by over 200 basis points. The result was very tight
monetary policy, with the overnight cash rate exceeding 9 percent by June of 1998.
Because the depreciation was due to a substantial, negative terms-of-trade shock
that decreased aggregate demand, the tightening of monetary policy, not surpris-ingly, led to a severe recession and an undershoot of the inﬂation target range, with
actual deﬂation occurring in 1999. 37The Reserve Bank of New Zealand did eventu-
ally realize its mistake and reversed course, sharply lowering interest rates beginning
in July 1998 after the economy had entered a recession, but by then it was too late. It
also recognized the problems with using an MCI as an indicator of monetary policy
and abandoned it in 1999. Now the Reserve Bank operates monetary policy in a
more conventional way, using the overnight cash rate as its policy instrument, with
far less emphasis on the exchange rate in its monetary policy decisions.
Chile’s inﬂation-targeting regime also included a focus on limiting exchange rate
ﬂuctuations by having an exchange rate band with a crawling peg that was (loosely)
tied to lagged domestic inﬂation. This focus on the exchange rate induced a seriouspolicy mistake in 1998 because the central bank was afraid it might lose credibility in
the face of the ﬁnancial turmoil if it allowed the exchange rate to depreciate after
what had taken place in ﬁnancial markets after the East Asian crisis and the Russian388 Chapter 15

meltdown. Thus, instead of easing monetary policy in the face of the negative terms-
of-trade shock, the central bank raised interest rates sharply and even narrowed its
exchange rate band. In hindsight, these decisions were a mistake: the inﬂation target
was undershot and the economy entered a recession for the ﬁrst time in the 1990s. 38
With this outcome, the central bank came under strong criticism for the ﬁrst time
since it had adopted its inﬂation-targeting regime in 1990, which weakened supportfor the independence of the central bank and its inﬂation-targeting regime. During
1999, the central bank did reverse course, easing monetary policy by lowering inter-
est rates and allowing the peso to decline.
The contrast between the experience of New Zealand and Chile during this period
with that of Australia, another small open economy with an inﬂation-targeting re-
gime, is striking. Prior to adoption of their inﬂation-targeting regime in 1994, the
Reserve Bank of Australia had adopted a policy of allowing the exchange rate to
ﬂuctuate without interference, particularly if the source of the exchange rate change
was a real shock, like a terms-of-trade shock. Thus, when faced with the devaluation
in Thailand in July 1997, the Reserve Bank recognized that it would face a substan-
tial negative terms-of-trade shock because of the large component of its foreign tradeconducted with the Asian region and that it should not ﬁght the depreciation of the
Australian dollar that would inevitably result (McFarlane 1999; Stevens 1999). Thus,
in contrast to New Zealand, it immediately lowered the overnight cash rate by 50
basis points to 5 percent and kept it near this level until the end of 1998, when it
was lowered again by another 25 basis points.
Indeed, the adoption of the inﬂation-targeting regime probably helped the Reserve
Bank of Australia to be even more aggressive in its easing in response to the East
Asian crisis and helps explain why its response was so rapid. The Reserve Bank was
able to make clear that easing was exactly what inﬂation targeting called for in orderto prevent an undershooting of the target, so that the easing was unlikely to have an
adverse e¤ect on inﬂation expectations. The outcome of the Reserve Bank’s policy
actions was extremely favorable. In contrast to New Zealand and Chile, real output
growth remained strong throughout this period. Furthermore, there were no negative
consequences for inﬂation despite the substantial depreciation of the Australian
dollar against the U.S. dollar by close to 20 percent: inﬂation remained under con-
trol, actually falling during this period to end up slightly under the target range of 2
to 3 percent.
While it would not be desirable if a central bank tried to actively manipulate the
exchange rate, this does not imply that it should not respond to an exchange rate
shock. However, whether it should respond and how it should respond depend onthe nature of the shock. As illustrated above, the response to a real shock to the ex-
change rate such as a change in the terms of trade should be entirely di¤erent from
the reaction to a portfolio shock.Inflation Targeting in Transition Economies 389

The relevant question concerning the transition economies is this: what types of
shock are they likely to face in the period ahead of the EU/EMU membership? And
how vulnerable are they to large exchange rate movements? How much should they
be concerned about exchange rate movements for other reasons than the risk that the
inﬂation target will not be met?
Besides the standard shocks that all open emerging-market economies could face,
transition economies could face speciﬁc external shocks related to the euro adoption:
speciﬁcally, the convergence play. The convergence play refers to capital inﬂows to
accession countries stimulated by the expected behavior of interest rates and ex-
change rates ahead of the euro adoption. Countries that have joined the EMU in
the past have experienced a sizable decline in the currency risk premium of their
debt—that is, the premium to compensate the debt holders for the risk that their cur-
rency would lose value. The decline in the currency risk premium resulted in lower
interest rates on their debt instruments in local currency, and thus a higher price of
these instruments. Increased prices allowed holders of these instruments to realize
capital gains. Therefore, investors could reasonably expect that transition countries
that have joined the EU will soon adopt the euro as well, and from past experiencethey could expect a reduction in interest rates on debt instruments issued by these
countries that would allow them to reap capital gains. In other words, these investors
have incentive to play on the convergence of interest rates to euro area level and in-
vest in ﬁxed-income instruments issued by accession countries. The resulting increase
in capital inﬂows and currency appreciation could be viewed as a pure portfolio
shock that would require interest rate reduction. But reducing interest rates could
conﬂict with the inﬂation target, because it could stimulate domestic demand too
much and result in faster increase in domestic prices. On the other hand, if monetary
policy does not respond, the large capital inﬂow could lead to the standard problemsof excessive currency appreciation, balance-of-payments problems, and reversal of
capital ﬂow resulting in currency depreciation and higher inﬂation.
Complicating the problem even more is the exposure of accession countries to a
second shock—in this case a real shock. It has been well documented that as transi-
tion economies catch up with the more developed EU countries, they experience
rapid productivity growth, which produces real exchange rate appreciation, either
by means of nominal appreciation or by means of higher inﬂation. In this case, the
appreciation of the domestic currency should be seen as an equilibrium phenomenon,
which is sustainable and does not require a monetary policy response. In sum, in the
period ahead of the EU/EMU membership, accession countries could be exposed to
two simultaneous external shocks that would tend to produce exchange rate appreci-ation but that would call for a di¤erent policy response. In practice, it could be di‰-
cult to disentangle what part of the currency appreciation is the result of the porfolio
shock and what part results from the real shock. Balance-of-payments data on the390 Chapter 15

size and composition of capital ﬂows, and data on productivity growth, should pro-
vide some indication of the relative importance of these two types of shocks.
The recent experience of the Czech Republic illustrates yet another problem: cur-
rency appreciation caused by a large inﬂow of foreign direct investment (FDI) as a
result of the sale of state-owned enterprises to foreign owners. One can argue that
currency appreciation resulting from the inﬂow of FDI is the typical real shockthat does not call for a monetary policy response: the currency appreciates, but FDI
inﬂow results in more investment, better management, and ultimately in higher pro-
ductivity, which validates the appreciation of the currency. This argument has two
problems. First, while currency appreciation will always happen when there is a sale
of domestic assets to foreigners for foreign currency, it is less sure that the increase in
productivity validating the currency appreciation will follow. For example, a large
part of recent sales consisted of utilities where the potential for increasing the com-
petitiveness in export markets is limited. Second, there is a time discrepancy between
the timing of the currency appreciation (immediate) and the productivity increase
(later). And third, expectation of currency appreciation as a result of sales to foreign-
ers of state-owned assets could itself induce investors to take positions in the domes-tic currency, in order to beneﬁt from the expected appreciation once the privatization
payment materializes. This would produce a currency appreciation even before the
privatization-related capital inﬂow materializes.
All this complicates signiﬁcantly the task of the inﬂation-targeting central bank.
To the extent that currency appreciation reﬂects an equilibrium phenomenon, appre-
ciation of the real equilibrium exchange rate, there would be little reason for concern.
Such appreciation would not threaten economic growth and external equilibrium,
and if inﬂation is still above the long-term target, it should help the central bank to
bring inﬂation down. But how much should a central bank worry if this real appreci-ation is too fast and too large? It could result in a widening current account deﬁcit
and subsequent large exchange rate depreciation, with negative e¤ects on inﬂation.
And it could cause problems in the corporate sector, because adjustment to a fast
and large currency appreciation could be more di‰cult. The standard prescription
for a central bank dealing with large capital inﬂows and currency appreciation is
sterilized intervention: buy foreign currency in the foreign exchange market and neu-
tralize monetary e¤ects of this intervention by selling bonds. Eventually, this inter-
vention could be complemented by interest rate cuts, to reduce the incentive for
capital inﬂows.
But this prescription may be of little help in the circumstances like those in the
Czech Republic in 2001–2002. Large capital inﬂows are mainly in the form of FDI,and not attracted by a large interest rate di¤erential. Reducing interest is not going
to slow down FDI inﬂows. These are interest rate insensitive. Sterilized intervention
would be possible, but this policy has its own problems. In order to be e¤ective, itInflation Targeting in Transition Economies 391

would have to be of a very large amount (on the order of several billion dollars) and
it may not even be e¤ective at all. Sterilizing such intervention could be quite costly
for the central bank. 39
For these reasons, the CNB has pursued a pragmatic strategy of gradual interest
rate reduction, combined with occasional foreign exchange market intervention of
limited magnitude. This intervention has been subsequently sterilized. The CNB rec-ognized that in 2001–2002 currency appreciation reﬂected mainly the e¤ect of the
FDI inﬂow, and that it was therefore a real shock that the monetary policy had no
business of neutralizing. However, the speed of the appreciation could be occasion-
ally too fast, and at that point, the CNB felt that it could slow down the pace of
appreciation by intervening, so that the corporate sector would have more time to
adjust to the trend appreciation. In late 2002, capital inﬂows related to the conver-
gence play (the portfolio shock) were not a serious issue for the Czech Republic,
partly because the convergence play and the compression of yield spreads had
already taken place. 40Otherwise, the situation would have been even more
complicated.
Another reason for not having benign neglect of the exchange rate is emphasized
in Mishkin (2000) and Mishkin and Savastano (2001). For the reasons discussed ear-
lier, transition countries with a lot of foreign-denominated debt may not be able to
a¤ord large depreciations of their currencies, which can destroy balance sheets and
trigger a ﬁnancial crisis. Central banks in these countries may thus have to smooth
‘‘excessive’’ exchange rate ﬂuctuations, but not attempt to keep the exchange rate
from reaching its market-determined level over longer horizons. The stated rationale
for exchange rate smoothing would be similar to that for interest rate smoothing,
which is practiced by most central banks, even those engaged in inﬂation targeting:
the policy is not aimed at resisting market-determined movements in the exchangerate, but at mitigating potentially destabilizing e¤ects of abrupt changes in exchange
rates.
The challenges facing the central bank are somewhat di¤erent in Hungary. As was
noted, Hungary still maintains an exchange rate band of G15 percent. In the litera-
ture on inﬂation targeting, it is often emphasized that the absence of a second nomi-
nal anchor is one of the prerequisites of successful inﬂation targeting. Pursuing two
nominal objectives could result in a situation where one objective will need to be
given preference over the second objective, but without clear guidance as to how
such conﬂict would be resolved, this could make monetary policy less transparent. 41
The question arises: to what extent might the existence of the G15 percent exchange
rate band in Hungary be considered as a second nominal anchor whose attainmentcould eventually conﬂict with the inﬂation target? The answer has turned out to be
‘‘a lot.’’392 Chapter 15

In mid-February 2002, the exchange rate of the forint hovered some 12–13 percent
above parity, quickly approaching the upper part of the band. Partly as a result of
uncertainty related to parliamentary election, the currency weakened somewhat dur-
ing the spring and summer, but it began to appreciate again later in 2002. In January
2003, it approached the upper end of the band, and speculation about the revalua-
tion of parity resulted in a sharp acceleration of capital inﬂow that forced the NBHto respond by cutting interest rates by 2 percentage points and intervening heavily in
the foreign exchange market. The NBH is reported to have bought more than 5 bil-
lion euros, increasing international reserves by 50 percent and base money by 70 per-
cent. 42Even though the NBH subsequently began to sterilize this huge injection of
liquidity, market participants now assume that maintaining the exchange rate band
will have priority over the inﬂation target and expect inﬂation in 2003 to exceed the
NBH inﬂation target. 43
This conﬂict between the inﬂation target and exchange rate target need not be a
unique problem for Hungary. Other accession countries could face this problem
once they become members of the EU and once they decide to join the ERM2 mech-
anism that requires them to limit exchange rate ﬂuctuation in exactly the same wayas Hungary already does today—that is, to peg the currency against the euro and
allow maximum G15 percent ﬂuctuation around the established parity. Therefore,
we now turn to the issue of monetary policy implementation in the period after EU
accession and before EMU accession.
15.6 Monetary Policy within the ERM2 System
Participation in the ERM2 mechanism and subsequent adoption of the euro are
obligatory for all new EU members (no opt-out clause is available). But the new EUmembers do not have to join the ERM2 mechanism immediately after the EU entry.
Therefore, after joining the EU, the new members will have to decide how quickly to
join the ERM2 mechanism and adopt the euro, and whether ERM2 membership
would require a modiﬁcation of the inﬂation-targeting framework.
How would monetary policy in the accession countries operate under the ERM2
regime, and what would be the main nominal anchor of the economy? Formally,
the monetary policy framework after joining the ERM2 mechanism will be similar
to the monetary policy framework in Hungary today, where the G15 percent ﬂuctu-
ation band is already in place. But there will also be important di¤erences. First, the
adoption of the euro will be approaching, which could have important implications
for capital ﬂows (convergence play) and ﬁscal policy implementation (the need tomeet ﬁscal criteria). Second, breaching the target band (its lower side) would have
di¤erent consequences for Hungary today and for accession countries operatingInflation Targeting in Transition Economies 393

within the ERM2 regime. Third, unlike Hungary’s monetary policy today, the mon-
etary policy and exchange rate of an accession country within the ERM2 regime will
be of common interest to all EMU members, and the European Central Bank (ECB)
could intervene to help the accession country to keep the exchange rate within the
band.
The ERM2 ﬂuctuation band will allow rather large exchange rate movements, too
large to provide a su‰ciently ﬁrm nominal anchor. For this reason, the inﬂation tar-
get will likely need to continue to play the role of nominal anchor, as it did in Spain
before its entry into EMU (see Bernanke et al. 1999). Successful operation of inﬂa-
tion targeting after ERM2 entry should be facilitated by the fact that the process of
disinﬂation is likely to be largely completed. Low inﬂation could reduce, though not
fully eliminate, the probability that the inﬂation target would conﬂict with the com-
mitment to maintaining the currency within the ERM2. Still, the possibility of a con-
ﬂict between the inﬂation target and the ERM2 exchange rate band cannot be fully
excluded. But it is important to be clear about the nature of this risk and how it
could be mitigated.
Within the ERM2 framework, two situations could arise where monetary and
other policies may be constrained by the fact that the exchange rate is approaching
the lower or upper side of the band. One possibility is that the exchange rate would
approach the upper (appreciated) band, as was happening in Hungary. In order to
prevent breaching the permitted ﬂuctuation band, interest rates may need to be
reduced to moderate the pressure on the currency. But lower interest rates could in-
terfere with the inﬂation target, because they could stimulate domestic demand more
than the central bank considers prudent and could produce higher inﬂationary pres-
sures. However, a strongly appreciating currency would also simultaneously act as
a mechanism to dampen inﬂationary pressures, so it is not at all obvious that thisconﬂict with the inﬂation target would actually become serious. 44If reducing inter-
est rates would not help, and pressures on the currency to appreciate persisted,
another option would be to revalue the central parity. 45This would reduce the bur-
den of monetary policy and at the same time introduce a one-time deﬂationary
shock.
A di¤erent conﬂict between the inﬂation target and exchange rate band would
arise if there was downward pressure on the currency and if the exchange rate threat-
ened to break through the lower (more depreciated) end of the band. Breaching the
ERM2 lower target band would force the country to start the ERM2 two-year test
again, so it could be potentially costly. Central banks could react to such a situation
by tightening monetary policy and raising interest rates. But this response certainlyshould not conﬂict with the inﬂation target. On the contrary, it should be in line
with the inﬂation-targeting policy if the reason for downward pressure was too394 Chapter 15

relaxed a policy. And tighter monetary policy would also help to mitigate inﬂation-
ary pressures that may arise from currency depreciation. Tighter monetary policy
would also be appropriate in the case when the currency depreciates as a result of a
negative portfolio shock. Higher interest rates should help arrest capital outﬂow by
making domestic currency assets more attractive. But the situation could be more
complicated when the currency depreciates as a result of negative real shock whichat the same time reduced aggregate demand for domestic output (domestic or foreign
demand). Maintaining the currency within the ﬂuctuation band could require a
tighter policy stance than what would be required if monetary policy were guided
only by the inﬂation target. As a result, actual inﬂation would become lower than
the inﬂation target, and monetary policy would further weaken demand and eco-
nomic activity that was already a¤ected adversely by the negative real shock. Under
normal circumstances, this would not be desirable. But temporary lower economic
activity may be a price worth paying in a situation where the alternative would be
to violate the Maastricht criterion of two years of successful operation within the
ERM2 system, thus delaying euro adoption.
To some extent, ﬁscal policy could be used to reconcile eventual conﬂict between
the inﬂation target and the ERM2 band. First, maintaining a ﬁscal policy stance that
would clearly indicate authorities’ determination to meet Maastricht criteria of pub-
lic debt and ﬁscal deﬁcit would reduce the risk of downward pressure on the currency
as a result of a negative portfolio shock. It would also allow the maintenance of
lower interest rates than if ﬁscal policy were more expansionary, and thus reduce
short-term capital inﬂows. Second, a changing ﬁscal policy stance could be used as
a defense against large exchange rate movements threatening to breach the ERM2
band. Fiscal policy could be tightened even more than what is required by Maas-
tricht criteria in case of downward pressure on the currency that would threaten tobreak the lower side of the band, or—to the extent that meeting Maastricht criteria
is not threatened—it could be relaxed in case of upward pressure on the currency.
But in this case, using interest rate policy would be clearly preferable as a ﬁrst line
of defense.
The risk of conﬂict between the inﬂation target and exchange rate target will de-
pend importantly on market expectations of the conversion rate of the national cur-
rency into the euro. If market participants expect that the current market rate will be
also the conversion rate, there will be less risk of such conﬂict, as the behavior of
market participants should actually limit the ﬂuctuation of the actual exchange rate.
However, widespread market expectation that the future conversion rate will di¤er
signiﬁcantly from the current exchange rate could result in large and volatile capi-tal ﬂows and swings in actual exchange rate that could severely complicate the simul-
taneous achievement of the inﬂation target (su‰ciently low inﬂation to meet theInflation Targeting in Transition Economies 395

Maastricht criterion) and exchange rate target (keeping the currency within the ﬂuc-
tuation band).
How should inﬂation targets be set after the countries have joined the EU and
eventually the ERM2 mechanism? The obvious answer is to set the inﬂation target
in such way that it will converge to inﬂation rate estimated to be consistent with the
Maastricht criterion. Table 15.6 shows the annual inﬂation rate in three current EU
members with the lowest inﬂation rate in the period 1995–2001. If we add to the
average of inﬂation in three EU best performers the 1.5 percentage point margin
allowed by the Maastricht Treaty, we receive the maximum permissible inﬂation in
the accession countries that would be applied if they were to adopt the euro in thatparticular year.
If we take the period 1995–2001 as a benchmark, the inﬂation rate that the acces-
sion countries would have to reach in order to meet the Maastricht criterion was in
the range of 2.1 to 3.7 percent. In 1998 and 1999, inﬂation in the EU countries was
particularly low, and it would thus seem that reaching the Maastricht objective
would have been particularly challenging for accession countries at that time. How-
ever, we should note that to some extent exceptionally low inﬂation in the EU was a
part of the global tendency of falling inﬂation, which a¤ected the transition econo-
mies as well. To the extent that inﬂation in the EU and in the transition economieswaiting to adopt the euro moves jointly in response to common external shocks like
falling commodity prices and weak global economic activity, accompanied by large
excess production capacity and weak pricing power of producers, lower permissible
inﬂation does not make it necessarily more di‰cult (i.e., it does not require a tighter
monetary policy) to qualify for euro adoption.
We can also see that the range of maximum permissible inﬂation of 2.1–
3.7 percent is broadly in line with the long-term inﬂation targets in the Czech
Republic (2–4 percent), Hungary (around 2 percent), and Poland (less than 4
percent).Table 15.6
Lowest Inﬂation Rates in EU Countries, 1995–2000
1995 1996 1997 1998 1999 2000 2001
Country A 0.8 0.6 1.2 0.8 0.5 1.7 1.6
Country B 1.5 1.3 1.3 0.9 0.6 1.9 2.5Country C 1.7 1.4 1.4 0.9 0.6 2.3 2.5Average inﬂation 1.3 1.1 1.3 0.9 0.6 2.0 2.2
Maastrict criterion inﬂation a 2.8 2.6 2.8 2.4 2.1 3.5 3.7
Source: United Nations (2002).
aAverage inﬂation in three countries plus 1.5 percentage points. Average inﬂation rounded up.396 Chapter 15

15.7 Conclusion
In this chapter, we have discussed the experience with inﬂation targeting in the three
transition economies—the Czech Republic, Hungary, and Poland. We have exam-
ined the circumstances leading to the switch from exchange rate pegs to inﬂation tar-
geting and the modalities of inﬂation targeting in each of these countries. The short
history of inﬂation targeting in these three countries does not yet allow us to draw
any deﬁnitive conclusions about the success or failure of this regime. However, we
conclude that inﬂation targeting in transition economies could be implemented
reasonably successfully. While the examined countries have often missed inﬂation
targets by a large margin, they nevertheless progressed well with disinﬂation. Still,
increased uncertainty prevailing in transition economies makes it particularly di‰cult
to predict inﬂation su‰ciently far ahead, as required by the forward-looking nature
of the inﬂation-targeting approach. In view of that, and given the possibility thattransition countries will be more frequently hit by shocks that could divert inﬂation
from the targeted path, misses of inﬂation targets are more likely there than in the
more advanced economies.
This does not imply that monetary policy targeting other nominal variables like
monetary aggregates would make the task of controlling inﬂation easier. Even
though inﬂation targeting in transition economies is more di‰cult than in advanced
economies, it could still bring signiﬁcant beneﬁts. It should be clear, though, that too
much focus on hitting inﬂation targets at any price at all times could produce a sig-
niﬁcant instability of monetary policy instruments, damaging economic performance.The focus of inﬂation-targeting central banks should be on the medium-term horizon
to ensure that disinﬂation remains on track and that inﬂation converges to a level
deemed consistent with price stability. Alongside this trajectory, there will inevitably
be misses, possibly sizable ones. Thus, the onus is on central banks’ ability to clearly
communicate to the public what the limits and possibilities of inﬂation targeting in
transition economies are, and if it happens, to explain credibly and openly why inﬂa-
tion targets were missed.
A key lesson from the experience of the inﬂation-targeting transition countries is
that economic performance will improve and support for the central bank will be
higher if central banks emphasize avoiding undershoots of the inﬂation target as
much as avoiding overshoots. Undershoots of the inﬂation targets have resulted inserious economic downturns that have eroded support for the central bank in both
the Czech Republic and Poland. Also, economic performance will be enhanced if
inﬂation-targeting central banks in transition countries do not engage in active ma-
nipulation of the exchange rate. This seems to be less of an issue in the Czech Repub-
lic and Poland, but it is still a live issue in Hungary.Inflation Targeting in Transition Economies 397

A di‰cult problem for inﬂation targeting in transition countries is the often stormy
relationship between the central bank and the government. This can be alleviated by
having a direct government involvement in the setting of the inﬂation target and a
more active role of the central bank in communicating with both the government
and the public. In addition, having technocrats rather than politicians appointed as
the head of a central bank may help in depersonalizing the conduct of monetary pol-icy and increase support for the independence of the central bank.
We have also addressed the future perspective of monetary policy in the transition
economies. We concluded that even after EU accession, inﬂation targeting can re-
main the main pillar of monetary strategy in the three examined accession countries
during the time before they adopt the euro. Inﬂation targets would be guided toward
meeting the Maastricht criterion for inﬂation, which would require maintenance of
inﬂation at the level deﬁned in long-term inﬂation objectives.
In addition, an important advantage of the inﬂation-targeting regimes in transition
countries is that the central banks in the countries practicing inﬂation targeting have
been learning how to set monetary policy instruments to hit their inﬂation goals.
Since these central banks will have a role in setting monetary policy instruments atthe ECB when they adopt the euro, the monetary policy experience that they have
acquired by operating an inﬂation-targeting regime will help them play a more active
and positive role in deliberations at the ECB.
Notes
The views expressed in this chapter are exclusively those of the authors and not those of the International
Monetary Fund, Columbia University, or the National Bureau of Economic Research (NBER). We thankthe participants in the Macro Lunch at Columbia University and the NBER Inﬂation Targeting Confer-ence for their helpful comments.
1. Indeed, it is not at all clear that monetary targeting is a viable strategy, even in industrialized countries,
because the relationship between monetary aggregates and goal variables such as inﬂation and nominalspending is typically quite weak. For example, see Estrella and Mishkin (1997).
2. For a description of the just-do-it approach in the United States, see Bernanke et al. (1999). Some tran-
sition economies are pursuing a managed ﬂoat (Romania, the Slovak Republic, Slovenia) or free ﬂoat
(Albania) without a formal inﬂation-targeting framework in place, although Albania is now introducingfull-ﬂedged inﬂation targeting. It is interesting to compare the development of inﬂation in these countriesthat have similarly ﬂexible exchange rate regimes but no formal inﬂation-targeting regime in place (see sec-tion 15.4.3).
3. See Debelle (1997) and Schaechter, Stone, and Zelmer (2000).4. For a discussion of whether Hungary is ready for inﬂation targeting, see Siklos and A ´bel (2002).
5. Note that one can argue that a strong ﬁscal position is a requirement for successful conduct of monetary
policy under any policy framework, not just inﬂation targeting. See Eichengreen (1999) and Mishkin andSavastano (2001).
6. For an early analysis of inﬂation targeting in the Czech Republic see Hrnc ˇı´rˇand S ˇmidkova ´(1999) and
Mahadeva and S ˇmidkova ´(2000).
7. For a discussion of the Czech exchange rate crisis see Begg (1998). It is noteworthy that, unlike the case
of many other emerging-market countries that were forced to abandon the currency peg, the Czech koruna398 Chapter 15

depreciated only moderately, and it subsequently strengthened again. One reason for this limited deprecia-
tion was the relatively low degree of dollarization and currency mismatches in the Czech economy and
thus the limited e¤ect of the exit from the peg on companies’ and banks’ balance sheets.
8. The path to inﬂation targeting for the CNB has many similarities to the path followed by the Bank of
England and the Riksbank after the collapse of their exchange rate pegs in 1992. See Bernanke et al.(1999).
9. At the end of 1997, the CPI consisted of 754 items, 91 items had regulated price, and net inﬂation mea-
sured the movements of 663 items, which in terms of weights in the consumer basket represented aboutfour-ﬁfths of the total basket.
10. Trade unions agreed that it would not be desirable to aim for higher than zero growth in real wages in
1999. The catch was that trade unions’ economic experts projected that inﬂation in 1999 would reach 10percent, and trade unions therefore demanded a 10 percent increase in nominal wages, which in their viewwould be consistent with zero growth in real wages. As inﬂation in 1999 remained close to 2 percent, 10
percent nominal wage growth resulted in a large increase in real wages. At the end of 1999, when the CNB
was again discussing with the representatives of trade unions inﬂation prospects for 2000, they seemed tohave learned from their mistake and expressed more trust in CNB’s inﬂation forecast for 2000.
11. However, already in 2000, when it announced the net inﬂation target for end-2001, the CNB also began
publishing its projection of headline inﬂation.
12. This should be interpreted more as a forecast than as a full-ﬂedged inﬂation target.13. See National Bank of Poland (1998). It is noteworthy that the NBP intends to calculate the core inﬂa-
tion itself. Usually, central banks targeting a measure of underlying inﬂation do not calculate this index. Inorder to avoid a conﬂict of interest, they let other agencies, mainly statistical o‰ces, calculate and publishunderlying inﬂation.
14. Perhaps this is just another example of the gradualist approach of Hungary to economic reforms more
generally, unlike the ‘‘big bang’’ or ‘‘shock therapy’’ approach applied in the Czech Republic and Poland.
15. In 2000, inﬂation ended at 10.1 percent (December to December), much more than the government
had projected earlier. In 1999, the government projected that average annual inﬂation would be 6–7 per-cent in year 2000. In early 2001, inﬂation increased further, close to 11 percent. Hungary’s ambition to join
the EU and adopt the euro as soon as possible had probably contributed to the increasing emphasis on
further progress with disinﬂation that could be accomplished only with a higher degree of nominal ex-change rate ﬂexibility, and on the willingness to accept the consequences of a stronger currency for thecompetitiveness and external balance.
16. Israel also adopted an inﬂation-targeting regime with a narrow exchange rate band in 1991. Like Hun-
gary, it also found it necessary to widen the exchange rate band, doing so in 1995. Over time, the Israelishave further downplayed the exchange rate in their inﬂation-targeting regime. For a discussion of Israeliinﬂation targeting and the role of the exchange rate, see Leiderman and Bufman (2000) and Bernanke
et al. (1999).
17. This mechanism is described in Akerlof, Dickens, and Perry (1996), but it is highly controversial be-
cause the evidence that low inﬂation leads to a rise in unemployment is very mixed. In addition, as pointed
out in Groshen and Schweitzer (1996, 1999), inﬂation can not only put ‘‘grease’’ in the labor markets asAkerlof, Dickens, and Perry argue, but also put in ‘‘sand’’ that makes the labor markets less e‰cient.
18. This argument has been made in Summers (1991).19. One problem with this argument is that the rapid productivity growth applies economywide, but there
could still be ﬁrms or industries where productivity growth would be small or negative and where decline innominal wages would be called for if inﬂation was close to zero.
20. It could be argued that lower inﬂation usually means higher output growth, and therefore the sooner
lower inﬂation is reached, the sooner will the economy achieve a higher output growth. But there are alsocounterarguments. For example, due to a loss of marketable skills, persons that could be seen as temporar-ily unemployed during the period of rapid disinﬂation could become permanently unemployed, whichresults in an additional loss of output.
21. For a discussion of the costs of disinﬂation see Ball (1994). The author comes to the conclusion that
fast disinﬂation reduces the sacriﬁce ratio.Inflation Targeting in Transition Economies 399

22. The NBH was publishing inﬂation objectives based on government budgetary projections for 1998,
1999, and 2000 (12–13 percent, 9 percent, and 6–7 percent respectively), but these were not formal inﬂa-
tion targets and there was no formal requirement for the NBH to meet them (see Siklos and A ´bel 2002).
23. The long-term inﬂation target and the 2002 target were announced in the August 2001 Inﬂation Re-
port, while the 2003 target was announced in the press on December 2001, when the government agreedwith the NBH’s proposal.
24. For example, the May 1998 World Economic Outlook projected real GDP growth in 1998 of 2.2 per-
cent. This forecast was quite accurate, but with an opposite sign. Actual growth was /C02.2 percent.
25. Of course, the hotly debated question was whether and to what extent the CNB’s excessively tight
monetary itself contributed to slower-than-projected growth.
26. In U.S. dollar terms, oil prices fell by 31.2 percent, while nonfuel commodity prices fell by 14.7 percent
in 1998. See International Monetary Fund (1999). It should be noted that this e¤ect of ﬁnancial crises con-tributed to an unexpected fall in inﬂation worldwide. The May 1997 IMF World Economic Outlook pro-jected that in 1998 consumer prices in advanced economies would increase by 2.5 percent, while the actual
increase was only 1.5 percent.
27. The currency regimes of these countries are characterized as managed ﬂoats. In June 2001, Romania’s
currency regime was reclassiﬁed from a managed ﬂoat to a crawling band because the central bank inter-
venes to prevent currency appreciation.
28. The mixed results reported here on the performance of inﬂation-targeting regimes relative to other
monetary policy regimes is not very surprising. As argued by Calvo and Mishkin (2003), the choice ofmonetary policy regime is likely to be less important to the macroeconomic performance of emerging-market and transition countries than deeper institutions.
29. The Czech economy is very open, with imports representing about 50 percent of GDP, and changes in
import prices of oil and gas have a large impact on domestic prices. However, at the time of the introduc-tion of inﬂation targeting, the CNB had considered isolating the e¤ects of price deregulation as more im-portant than isolating the e¤ects of terms-of-trade shocks or exchange rate e¤ects.
30. As demonstrated by Svensson (1997), a faster target path of inﬂation to the long-run inﬂation goal
implies a smaller weight on output variability in the central bank’s loss function.
31. Such arrangement need not necessarily imply a formal subordination of the central bank to the gov-
ernment in setting inﬂation targets. For example, in Australia, the inﬂation target is set by a central bank
alone, and the government subsequently publicly endorses this target.
32. Of course, such an argument could be made only if inﬂation does not fall below the long-term inﬂation
target corresponding to price stability.
33. If a positive price shock was permanent, perhaps as a result of a sudden increase in productivity, it
would be appropriate to accommodate the e¤ect of such shocks on inﬂation.
34. The CPI includes prices of both domestic and imported goods. Consequently, it represents a combined
measure of domestic inﬂation and imported inﬂation. Domestic inﬂation is also a¤ected indirectly bychanges in prices of imported goods. Changing the price of imported input used for the production of do-mestic goods would a¤ect costs and—depending on the extent of the pass-through—domestic prices.
35. Again, we can distinguish a more or less active use of this passive approach, depending on the time
horizon during which the central bank would try to meet the inﬂation target by responding to exogenousexchange rate changes.
36. This risk seems to be well recognized by the NBH. See National Bank of Hungary (2001, 35–36).37. The terms-of-trade shock, however, was not the only negative shock the New Zealand economy faced
during that period. Its farm sector experienced a severe drought, which also hurt the economy. Thus, amistake in monetary policy was not the only source of the recession. Bad luck played a role too. SeeDrew and Orr (1999) and Brash (2000).
38. Because, given its location in Latin America, Chile’s central bank did have to worry more about loss
of credibility and also because Chile encountered a sudden stop of capital inﬂows at the time, the ability of
the Chilean central bank to pursue countercyclical policy was more limited than that of the Australian cen-
tral bank. However, although lowering interest rates in 1998 may not have been as attractive an option,the sharp rise in the policy interest rate in 1998 was clearly a policy mistake.400 Chapter 15

39. Of course, with falling interest rate di¤erential, the costs of sterilization decline as well.
40. In fact, at the end of 2002, spreads on domestic-currency sovereign bonds compared to the benchmark
German bonds were negative for all maturities. See Ceska Sporitelna/Erste bank (2002). Of course, the
question is whether such dramatic compression of yield spreads is sustainable.
41. On the experience with inﬂation targeting in the presence of nominal exchange rate band in Israel, see
Leiderman and Bufman (2000).
42. See JPMorgan (2002).
43. Analysts have interpreted this as evidence that the NBH is determined to maintain the currency band
even at the cost of temporary higher inﬂation. See IMF (2002).
44. The direct e¤ect of the appreciated exchange rate on inﬂation will be felt sooner than the indirect e¤ect
of reduced interest rates on aggregate demand and demand-induced acceleration of inﬂation.
45. For countries in the ERM2 framework, the ECB would also be expected to help a national central
bank sustain the currency inside the ﬂuctuation band, of course, to the extent that this does not interferewith the ECB’s price stability objective.
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16A Decade of Inflation Targeting in the World: What Do We
Know and What Do We Need to Know?
Frederic S. Mishkin and Klaus Schmidt-Hebbel
The emergence of inﬂation targeting over the last ten years represents an exciting de-
velopment in central banks’ approach to the conduct of monetary policy. After initial
adoption by New Zealand in 1990, a growing number of central banks in industrial
and emerging economies have opted for inﬂation targeting, and many more are con-
sidering future adoption of this new monetary framework.
A full decade of inﬂation targeting in the world o¤ers lessons on the design and
implementation of inﬂation-targeting regimes, the conduct of monetary policy,and country performance under inﬂation targeting. In section 1, this chapter brieﬂy
reviews the main design features of eighteen inﬂation targeting experiences, statisti-
cally analyzes whether countries under inﬂation targeting are structurally di¤erent
from industrialized countries that do not target inﬂation, and considers the existing
evidence on the success of inﬂation targeting. The interaction of inﬂation targeting
design features and the conduct of monetary policy during the transition to low inﬂa-
tion are tackled in section 2. The chapter then focuses on unresolved issues in the de-
sign and implementation of inﬂation targeting and their relation to the conduct of
monetary policy (section 3). Brief conclusions close the chapter.
16.1 What Do We Know about Inflation Targeting after a Decade of World Experience?
To discuss what we know about the inﬂation-targeting experience, we address threequestions: (1) who targets inﬂation and how? (2) are inﬂation targeters di¤erent? and
(3) is inﬂation targeting a success?
16.1.1 Who Targets Inflation and How?
Inﬂation targeting started a decade ago, with public announcements of inﬂation tar-gets in New Zealand and Chile. According to our count, nineteen countries have
implemented inﬂation targeting as of November 2000. They include industrial andemerging economies, transition and steady-state inﬂation targeters, semi and full-
ﬂedged targeters, early and recent starters, and current and former targeters. 1Figure

16.1 depicts adoption dates and initial inﬂation rates (at year of adoption) for the
nineteen-country sample. 2
We introduce two country groups as the basis for our empirical analysis conducted
in the 1990s, a sample of inﬂation targeters and a control group of non-targeters (see
table 16.1). The ﬁrst sample, inﬂation targeters, comprises a heterogeneous group of
eighteen industrial and emerging economies: Australia, Brazil, Canada, Chile, Co-
lombia, the Czech Republic, Finland, Israel, Korea, Mexico, New Zealand, Peru,
Poland, South Africa, Spain, Sweden, Thailand, and the United Kingdom. (Finland
and Spain dropped out of this group when they relinquished monetary policy on
adopting the euro in 1999. 3The second sample is a control group of nine industrial
economies that were not inﬂation targeters during the 1990s: Denmark, France, Ger-
many, Italy, Japan, Norway, Portugal, Switzerland, and the United States. Among
these, Germany and Switzerland had explicit monetary targets in place throughout
most of the 1990s and could thus be classiﬁed as implicit inﬂation targeters (as
argued by Bernanke and others, 1999). 4Japan and the United States had no explicit
Figure 16.1
Inﬂation at adoption of inﬂation targeting in nineteen countries, 1988–2000 a.
Note: aAnnual inﬂation rates are those observed one quarter before adopting inﬂation targeting.
Source: Authors’ calculations, based on data from IMF, International Financial Statistics , various issues;
country sources; Schaechter, Stone, and other (2000).406 Chapter 16

targets, and the remaining ﬁve European countries targeted their exchange rate to the
deutsche mark before adopting the euro in 1999. 5
Inﬂation targeters exhibit some commonalities and many di¤erences in the precon-
ditions, target design, and operational features of their inﬂation-targeting regimes.
Four stylized facts emerge from country experiences and features, as summarized in
table 16.A1 in the appendix. First, full-ﬂedged inﬂation targeting is based on ﬁve
pillars: absence of other nominal anchors, an institutional commitment to price sta-
bility, absence of ﬁscal dominance, policy instrument independence, and policy trans-
parency and accountability. While the second through the ﬁfth of these pillars are
necessary for e¤ective conduct of monetary policy under any regime, they are partic-
ularly important prerequisites for e¤ective policy under inﬂation targeting. The suc-cess of inﬂation targeting depends strongly on high market credibility in the central
bank’s resolve and ability to put into place policies geared at meeting the target, and
credibility is fostered by the ﬁve institutional pillars.
Second, the adoption of inﬂation targeting ranges from evolutionary to revolution-
ary. Many countries adopted inﬂation targeting without satisfying one or more of the
above conditions. For example, Chile and Israel targeted the exchange rate during
most of the 1990s (as Israel still does today). The Bank of England started inﬂation
targeting well before attaining instrument independence. Most countries adopted in-
ﬂation targeting before achieving high levels of policy transparency (including the
publication of inﬂation reports, inﬂation projections, and monetary policy meeting
minutes) and full accountability, and some countries, including Colombia, Israel,Korea, Mexico, Peru, and South Africa, still do not publish inﬂation forecasts.
On the other extreme is Brazil, who adopted full-ﬂedged inﬂation targeting right
from the start.
Country experience suggests that the adoption of inﬂation targeting in the 1990s
represented a monetary policy learning process. There is now a broad consensusTable 16.1
Inﬂation Targeters and Nontargeters
Inﬂation targeters NontargetersAustralia Mexico Denmark
Brazil New Zealand FranceCanada Peru GermanyChile Poland Italy
Colombia South Africa Japan
Czech Republic Spain NorwayFinland Sweden PortugalIsrael Thailand SwitzerlandKorea United Kingdom United StatesA Decade of Inflation Targeting in the World 407

about the conditions that should be in place for e¤ective full-ﬂedged inﬂation target-
ing. These prerequisites were less obvious in the ﬁrst half of the 1990s, however,
when early inﬂation targeters perfected their frameworks by learning from their own
and the other inﬂation targeters’ cumulative experience.
Third, inﬂation at the moment of adopting an inﬂation targeting framework ranges
from moderately high to very low. Some countries adopted inﬂation targeting whentheir inﬂation rates were well above steady-state levels, using inﬂation targeting as
the main device to build up credibility, bring down inﬂation expectations, and pursue
a path of convergence to low, stationary inﬂation. This is the case of early inﬂation
targeters in emerging countries that started at initial inﬂation rates of 15 to 45 per-
cent (Chile, Israel, Peru) and subsequent emerging countries that adopted inﬂation
targeting when initial inﬂation was in the range of 7 to 20 percent (the Czech Repub-
lic, Colombia, Mexico, Poland). This stands in contrast to all industrialized and
some emerging inﬂation targeters that started at initial inﬂation close to stationary
low levels.
Multi-year transitions toward steady-state inﬂation pose serious challenges and
di‰culties to inﬂation targeting, including the need for announcing annual inﬂationtargets (that are much harder to meet) under conditions of high inﬂation expectations
and limited policy credibility. We discuss the issues related to transition to low inﬂa-
tion in section 16.2.2 below.
Fourth, inﬂation targeters vary widely with regard to implementation features,
including the target price index, target width, target horizon, escape clauses,
accountability of target misses, goal independence, and overall transparency and ac-
countability of the conduct of policy. Some of these di¤erences can be attributed to
country variation in institutions and history; others reﬂect the di¤erences between in-
ﬂation targeting in transition to low inﬂation versus inﬂation targeting at low inﬂa-tionary levels. Additional di¤erences in the design features of inﬂation targeting
stem from divergent views among policymakers and academics about how monetary
policy under inﬂation targeting should be conducted in conditions of low inﬂation.
16.1.2 Are Inflation Targeters Different?
Are the structural conditions and macroeconomic performance of countries thatadopt inﬂation targeting di¤erent from those of industrial countries that do not tar-
get inﬂation? To tackle this question we compare the sample of eighteen inﬂation
targeters to the control group of nine industrialized nontargeters, focusing on the re-
lation between having an inﬂation-targeting framework in place and exhibiting a set
of structural, institutional, and macroeconomic features. The empirical analysis pre-sented here is necessarily preliminary because (as discussed in note 1) it is not al-
ways easy to decide whether a country should be classiﬁed as engaging in inﬂation
targeting. 6Furthermore, determining the exact date at which an inﬂation-targeting408 Chapter 16

regime was adopted is often quite di‰cult. O‰cials at many of the central banks we
consulted give adoption dates that are earlier than those given by outsiders (see, for
example, Bernanke and others, 1999). The uncertainty of dating often follows from
the fact that inﬂation targeting is adopted gradually, making the exact date of adop-
tion di‰cult to determine.
Our data set consists of annual variables for twenty-seven countries over ten years
(1990–99). The focus is on a discrete variable for an inﬂation-targeting regime, which
takes a value of 1 when an inﬂation-targeting regime is in place or 0 when an alter-
native monetary regime is in place, together with a set of variables that could be
associated with the choice of an inﬂation-targeting regime. 7The latter variables in-
clude measures of the use of alternative nominal anchors (a measure of exchange
rate band width and a monetary target dummy), structural conditions (trade open-
ness), measures of central bank independence (formal independence, instrument inde-
pendence, and goal independence), and macroeconomic variables (the inﬂation rate
and the ﬁscal surplus ratio to GDP).
Table 16.2 reports cross-country and panel statistics and correlations for inﬂation
targeting and related variables. The data reﬂect large variation in all variable catego-
Table 16.2
Descriptive Statistics and Simple Correlations for Cross-Section and Panel Samples, 1990–99 a
Statistic IT Inf Open Fiscal BW MT CBFI CBGI CBII
Cross-section statistics
Mean 0.29 0.11 0.50 /C00.02 0.56 0.25 0.30 0.30 0.59
Standard deviation 0.46 0.37 0.19 0.04 0.45 0.43 0.46 0.46 0.49Maximum 1.00 5.55 0.85 0.06 1.00 1.00 1.00 1.00 1.00Minimum 0.00 0.00 0.03 /C00.16 0.00 0.00 0.00 0.00 0.00
Panel statistics
Mean 1.00 0.97 0.85 0.06 1.00 1.00 1.00 1.00 1.00
Standard deviation 0.00 0.00 0.03 /C00.16 0.00 0.00 0.00 0.00 0.00
Maximum 0.30 0.08 0.50 /C00.02 0.58 0.26 0.31 0.30 0.61
Minimum 0.46 0.15 0.19 0.04 0.45 0.44 0.46 0.46 0.49
Variable correlations: panel/cross-section
IT 1.00 /C00.11 0.35 0.10 0.24 /C00.29 /C00.03 /C00.07 0.23
Inf /C00.20 1.00 /C00.10 /C00.17 /C00.01 /C00.04 /C00.10 /C00.12 /C00.18
Open 0.25 /C00.42 1.00 0.16 /C00.08 /C00.13 /C00.11 0.08 /C00.03
Fiscal 0.21 /C00.22 0.27 1.00 /C00.01 0.11 0.12 0.15 0.19
BW 0.02 /C00.07 /C00.32 0.16 1.00 0.08 /C00.01 0.01 0.14
MT /C00.45 0.22 0.07 0.19 0.26 1.00 0.04 0.02 /C00.01
CBFI /C00.22 /C00.08 /C00.09 0.25 /C00.22 0.09 1.00 0.68 0.51
CBGI /C00.13 /C00.23 /C00.01 0.22 /C00.35 /C00.18 0.79 1.00 0.50
CBII 0.30 /C00.15 0.18 0.35 /C00.06 /C00.03 0.40 0.52 1.00
Source: Authors’ calculations.
aThe panel sample comprises ten years of data (1990–99) for each of the twenty-seven countries identiﬁed
in the text. Panel sample correlations are reported in the upper-half matrix triangle, while cross-sectioncorrelations are reported in the lower-half matrix triangle. Standard errors are 0.06 for the panel sampleand 0.19 for the cross section.A Decade of Inflation Targeting in the World 409

ries across countries and over time in our sample of twenty-seven countries. Panel
correlations are sometimes very di¤erent from cross-country correlations, including
cases changing signs. This is likely the result of the noise encountered in annual coun-
try data; we therefore focus on cross-country correlations.
Having inﬂation targeting in place is positively and signiﬁcantly correlated with no
individual variable and negatively and signiﬁcantly correlated only with monetarygrowth targets ( MT). Inﬂation targeting is positively and not signiﬁcantly correlated
with trade openness ( Open ), the ratio of the ﬁscal surplus to GDP ( Fiscal ), the width
of the exchange rate band ( BW), and instrument independence of the central bank
(CBII ). It is negatively and not signiﬁcantly correlated with normalized inﬂation
(Inf), formal independence of the central bank ( CBFI ), and goal independence of
the central bank ( CBGI ).8
Next we introduce a multivariate probit model for the likelihood of having an
inﬂation-targeting regime in place, based on the observation of the variables identi-
ﬁed above. The model speciﬁes the probability of having an inﬂation-targeting re-
gime in place Pr ðITj…Țas a function of these variables:
PrðITj…Ț¼fðInf;Open ;Fiscal ;BW;MT;CBFI ;CBGI ;CBII Ț
Expected coe‰cient signs are positive for Fiscal ,BW, and the three measures of
central bank independence, negative for MT, and ambiguous for InfandOpen .
Before turning to the results, we note that caution should be exercised in the causal
interpretation of this equation. While certain structural features may be exogenous to
the choice of inﬂation targeting, it is very likely that adoption of inﬂation targeting
requires—and thus contributes to—renouncing the use of other nominal targets,
improving macroeconomic performance (such as reducing inﬂation and improving
the ﬁscal stance), and strengthening central bank independence. Potential reverse
causation means that the empirical results should be interpreted carefully.
The full-panel probit regression produced noisy results. We therefore report cross-
country results only, based on country decade-averages for each variable, includingthe dependent variable, that is, the choice of an inﬂation-targeting regime. We start
by discussing the full-sample results in the ﬁrst column of table 16.3.
Inﬂation targeting is positively and signiﬁcantly associated with the level of nor-
malized inﬂation. This result reﬂects the fact that inﬂation targeting has been
adopted by countries that, on average, exhibited higher levels of inﬂation than have
industrial nontargeters. Indeed, most emerging countries adopted inﬂation targeting
as a device for bringing inﬂation down to low, single-digit levels, and most inﬂation
targeters—both emerging and industrial countries—made major progress in reduc-
ing inﬂation either during or shortly before or after adopting inﬂation targeting (Ber-nanke and others, 1999; Corbo, Landerretche, and Schmidt-Hebbel, 2002). Countries
that trade relatively more (because they are more open or smaller than nontargeters)410 Chapter 16

are signiﬁcantly more likely to adopt inﬂation targeting, while most large industrial
countries are not inﬂation targeters.
Inﬂation targeting is negatively associated with the ratio of ﬁscal surplus to GDP.
This result again follows from having a control group of nontargeters comprised by
nine industrial countries that, on average, show a stronger ﬁscal position than the
eighteen inﬂation targeters. This association does not attain conventional signiﬁcance
levels, however.
Inﬂation targeting is positively but not signiﬁcantly associated with the width of
the exchange rate band. As expected, inﬂation targeting is negatively and signiﬁcantlyTable 16.3
Empirical Results for the Likelihood of Implementing an Inﬂation-Targeting Regime
Full sample a
(27 countries)Restricted sample 1 b
(24 countries)Restricted sample 2 c
(24 countries)
Variable (1) (2) (3) (4) (5) (6)Cons. /C09.7
(8.2)/C05.8*
(2.2)/C013.4***
(7.5)/C05.7*
(2.0)/C012.5
(8.2)/C04.7**
(2.1)
Inf 45.2***
(25.2)33.6*
(12.3)69.2**
(28.5)43.7*
(13.5)69.1**
(27.8)46.9*
(15.7)
Open 11.5***
(6.7)7.6**
(3.0)11.4**
(5.0)7.1*
(2.7)10.5***
(6.0)5.3***
(3.1)
Fiscal /C020.4
(45.1)/C049.7
(45.7)/C046.7
(46.8)
BW 0.3
(3.0)3.4
(3.2)3.2
(3.3)
MT /C012.9**
(5.7)/C09.3*
(3.0)/C013.4*
(4.3)/C09.6*
(2.8)/C012.5**
(5.3)/C07.9*
(3.0)
CBFI 2.2
(1.9)1.3
(1.7)1.0
(2.0)
CBGI /C014.7*
(5.4)/C09.6*
(3.2)/C011.3*
(2.6)/C09.8*
(2.8)/C010.5*
(3.8)/C08.2*
(3.1)
CBII 12.0**
(6.0)8.5*
(2.7)11.9*
(4.2)8.4*
(2.3)11.0**
(5.1)6.7**
(2.7)
Wald chi-squared 9.8 10.8 23.0 13.7 18.3 11.9
Pseudo R
20.61 0.57 0.63 0.57 0.63 0.58
No. observations 27 27 24 24 24 24
Source: Authors’ calculations.
*Statistically signiﬁcant at the 1 percent level.
**Statistically signiﬁcant at the 5 percent level.***Statistically signiﬁcant at the 10 percent level.aProbit regressions for 1990–99 cross-country sample. Standard errors for the full and restricted samples
are reported in parentheses.bRestricted sample 1 excludes three countries with very high inﬂation in the early 1990s (Brazil, Peru, and
Poland).
cRestricted sample 2 excludes three countries that may not be classiﬁed as inﬂation targeters (Colombia,
Korea, and Peru).A Decade of Inflation Targeting in the World 411

associated with the adoption of monetary growth targets, reﬂecting the incompatibil-
ity of having explicit monetary and inﬂation targets in place at the same time.
Finally, the likelihood of having inﬂation targeting in place is associated positively
with the formal independence of the central bank (although its coe‰cient is not sig-
niﬁcant at conventional levels) and signiﬁcantly with instrument independence. How-
ever, inﬂation targeting is negatively and signiﬁcantly associated with central bankgoal independence. The latter result suggests that when central banks have the free-
dom to determine their target levels, they are more likely to be operating under
exchange rate or monetary-growth anchors than under inﬂation targets. Inﬂation tar-
geting is thus associated with surrendering goal independence to governments. The
second column of table 16.3 reports a regression that drops the less signiﬁcant vari-
ables. All ﬁve remaining regressors become more signiﬁcant.
The preceding results are based on the full sample of twenty-seven countries, which
includes three countries with very high inﬂation rates in the early 1990s, namely Bra-
zil, Peru, and Poland. Dropping the three from the sample yields regression results
for a restricted sample (reported in columns 3 and 4 of table 16.3). Coe‰cient signs,
values, and signiﬁcance levels change little from those reported for the full sample.Thus our results are robust to exclusion of high-inﬂation outliers. We perform one
more robustness test by dropping Colombia, Korea, and Peru from the sample. As
discussed in note 5, there are some questions about whether these three countries
should be classiﬁed as inﬂation targeters. The regression results for this alternative
restricted sample, reported in columns 5 and 6 of table 16.3, also conﬁrm our full-
sample results.
16.1.3 Is Inflation Targeting a Success?
Many analysts argue that the structural features and macroeconomic performance of
inﬂation-targeting countries di¤er in some respects from those of countries that have
adopted alternative monetary frameworks. 9Others ﬁnd that some industrial coun-
tries without formal inﬂation targets (such as Germany before the euro, Switzerland
before 2000, and the United States) pursue a monetary policy that is close to explicit
inﬂation targeting (Mishkin, 1999a). This raises the question of whether inﬂation tar-
geting is observationally equivalent to alternative monetary frameworks with regard
to the conduct of policy and its results. To address this issue, we review the recent
empirical literature evaluating a decade of worldwide experience with inﬂation tar-
geting. Far from attempting a comprehensive evaluation, we identify a few tentative
conclusions that provide a partial view of the relative success of inﬂation targeting. 10
Central bank independence and inﬂation targeting are mutually reinforcing. Coun-
try experience in the 1990s suggests that extending larger degrees of independence to
central banks often supports the adoption of inﬂation targeting. In some countries
inﬂation targeting was adopted after granting formal and instrument independence412 Chapter 16

to central banks, as was the case in New Zealand and Chile. In other countries, like
the United Kingdom, instrument independence came after inﬂation targeting. Our
empirical results conﬁrm the positive association for formal and instrument indepen-
dence, but not for goal independence.
Communication, transparency, and accountability are improved under inﬂation
targeting. Adoption of inﬂation targeting has typically been followed (and sometimespreceded) by major improvement in central bank communication with the public and
markets and by signiﬁcant upgrade in monetary policy transparency. Most inﬂation
targeters publish inﬂation reports, monetary policy statements, the minutes of central
bank board meetings, central bank models, and inﬂation forecasts (see table 16.A1).
This major communication e¤ort on the part of central banks is arguably more im-
portant under inﬂation targeting than under alternative monetary regimes, consider-
ing the central role played by policy credibility and inﬂation expectations in attaining
inﬂation targets (Bernanke and others, 1999).
Inﬂation targeting helps countries reduce inﬂation below the levels they would
have attained in the absence of inﬂation targeting. However, it does not yield in-
ﬂation below the levels attained by industrial countries that have adopted othermonetary regimes, as shown by Bernanke and others (1999) and our own results
above. The adoption of inﬂation targeting is typically associated with a major up-
front investment in inﬂation reduction (Corbo, Landerretche, and Schmidt-Hebbel,
2002).
Inﬂation targeting has been tested favorably by adverse shocks. With the exception
of the emerging country ﬁnancial crises of 1997–99, the 1990s were very favorable to
the world economy, led by the largest U.S. expansion in the post–World War II era.
Many observers therefore argue that inﬂation targeting is as yet untested, since no
major adverse shocks have strained the achievement of low, stable inﬂation in manyinﬂation targeters. This is incorrect, however. Many inﬂation targeters are small,
open economies that were subject to severe shocks in the aftermath of the 1997 Asian
crisis, in contrast to the large industrial nontargeters that were una¤ected by these
shocks. The combined adverse ﬁnancial and terms-of-trade shocks su¤ered by Aus-
tralia, Chile, Israel, and New Zealand, among other inﬂation targeters, led to major
exchange rate devaluation in these countries and thus signiﬁcantly tested the attain-
ment of their inﬂation targets. They weathered this storm successfully, by recording
little pass-through from devaluation to inﬂation. The 1999–2000 oil price shock rep-
resented the second test for oil-importing inﬂation targeters, including the countries
mentioned above as well as Brazil, the Czech Republic, and Poland. Signiﬁcant
increases in imported inﬂation—through both energy prices and exchange ratedevaluation—could put these countries’ targets in jeopardy. The e¤ects of the oil
shock on core inﬂation appear to have been minor, however, and only temporary
and modest increases in headline inﬂation have been observed.A Decade of Inflation Targeting in the World 413

Inﬂation targeting has helped reduce sacriﬁce ratios and output volatility in coun-
tries that have adopted inﬂation targeting, bringing them to levels close to those in
industrial nontargeters. Bernanke and others (1999) ﬁnd that inﬂation targeting does
not make disinﬂation less costly in industrialized countries, as it does not alter sacri-
ﬁce ratios and Phillips curves. Corbo, Landerretche, and Schmidt-Hebbel (2002),
however, examine new evidence for a larger sample of inﬂation targeters and non-targeters. They conclude that sacriﬁce ratios have declined in emerging countries
after the adoption of inﬂation targeting and that output volatility has fallen in both
emerging and industrialized economies after adopting inﬂation targeting, reaching
levels that are similar to (and sometimes lower than) those observed in industrial
countries that do not target inﬂation.
Inﬂation targeting may help bring down and guide inﬂation expectations and deal
better with inﬂation shocks. According to Almeida and Goodhart (1998) and Ber-
nanke and others (1999), inﬂation targeting does not reduce inﬂation expectations
quickly, but rather does so gradually over time. Corbo, Landerretche, and Schmidt-
Hebbel (2002) report that inﬂation forecast errors, based on country vector auto-
regression (VAR) models, fall consistently with the adoption of inﬂation targeting,approaching the low levels prevalent in nontargeting industrial countries. They also
ﬁnd that inﬂation persistence declined strongly among targeters in the 1990s, which
suggests that inﬂation targets strengthen forward-looking expectations on inﬂation
and thus weaken the weight of past inﬂation.
Monetary policy under inﬂation targeting is ﬂexible inasmuch as it responds sym-
metrically to inﬂation shocks and accommodates temporary inﬂation shocks that do
not a¤ect the medium-term attainment of the target. Inﬂation targeters are not inﬂa-
tion nuts, as King (1996) holds, because they typically react symmetrically to positive
and negative shocks, pursue disinﬂation gradually, and react to temporary outputshocks. Cecchetti and Ehrmann (2000) show that output deviations have a positive
weight in all objective functions of inﬂation targeters.
Monetary policy is more clearly focused on inﬂation under inﬂation targeting and
may be toughened by inﬂation targeting. Central bank mandates to focus on price
stability tend to be strengthened by inﬂation targeting (Bernanke and others, 1999).
Cecchetti and Ehrmann (2000) provide evidence that central banks’ aversion to in-
ﬂation shocks (relative to output shocks) is toughened with the adoption of inﬂa-
tion targeting, a conclusion that is partly conﬁrmed by Corbo, Landerretche, and
Schmidt-Hebbel (2002).
We conclude that inﬂation targeting has proved to be a very successful new
monetary framework, both in comparison to inﬂation targeters’ preceding experienceand relative to alternative monetary regimes adopted by a control group of highly
successful industrial countries that pursued other monetary arrangements in the
1990s.414 Chapter 16

16.2 Revisiting Operational Design Issues
The previous section outlined some elements of the operational design of inﬂation-
targeting regimes. Four design issues deserve detailed discussion: the interaction of
the length of the target horizon, the width of the target range, and the use of escape
clauses; inﬂation targeting during the transition from high to low inﬂation; the desig-
nation of who should set the medium-term inﬂation target; and the role of the ex-
change rate and other asset prices. We discuss each of these in turn.
16.2.1 Interaction of the Target Horizon, Width of Target Range, Escape Clauses, and
Choice of Core Inflation Targets
A central problem for the design of inﬂation-targeting regimes is that monetary pol-
icy a¤ects the economy and inﬂation with long lags. For countries that have already
achieved low inﬂation, the lags are estimated to be quite extended, at two years oreven longer. Shorter time horizons are quite common in inﬂation-targeting regimes,
however, which frequently specify annual inﬂation targets.
Using a time horizon that is too short can lead to a controllability problem, partic-
ularly when combined with a narrow target range of an inﬂation. The result may be
frequent misses of the inﬂation target even when monetary policy is being conducted
optimally. This occurred in New Zealand in 1995, when the Reserve Bank overshot
its inﬂation target range of 0 to 2 percent by a few tenths of a percentage point in the
one year horizon. This overshoot made the governor subject to dismissal under
the central banking law, even though it was widely recognized that the overshootwas likely to be short-lived and that inﬂation would soon fall, as it later did. Al-
though the breach of the inﬂation target range did not result in a substantial loss of
credibility in the New Zealand case, under other circumstances or in an emerging
market country, such an event could result in a serious loss of credibility for the cen-
tral bank.
Combining too short a horizon with a narrow target range can also lead to instru-
ment instability, in which excessive swings in the monetary policy instruments occur
when the central bank tries to hit the inﬂation target. This problem can be especially
serious in a small, open economy, where it results in greater reliance on manipulating
the exchange rate to achieve the inﬂation target because exchange rate movements
have a faster impact on inﬂation than do interest rates. The annual target in NewZealand and the 2 percentage point range for the inﬂation target were important fac-
tors in the Reserve Bank emphasis on exchange rates in the conduct of monetary pol-
icy. This resulted in overly tight monetary policy at the end of 1996—the overnight
cash rate reached 10 percent because of fears that inﬂation would rise above the tar-
get range in 1997. Another consequence of New Zealand’s overly tight monetary
policy was that it contributed to the recession in 1997 and 1998, which was madeA Decade of Inflation Targeting in the World 415

worse by the negative terms-of-trade shock resulting from the East Asian crisis. Too
short a horizon and too narrow a range can thus induce undesired output ﬂuctua-
tions, as well.
Central banks can take four routes to avoid controllability and instrument instabil-
ity problems in an inﬂation-targeting regime. First, they can build in formal escape
clauses in their inﬂation-targeting regime to allow for misses of the inﬂation targetunder particular circumstances. Second, they can target core inﬂation rather than
headline inﬂation. Third, they can widen the range of the inﬂation target. Fourth,
they can set inﬂation targets for several years ahead.
Only New Zealand has incorporated formal escape clauses into its inﬂation-
targeting regime by allowing for misses of the inﬂation target range when there are
signiﬁcant changes in the terms of trade, changes in indirect taxes that a¤ect the price
level, or supply shocks such as a major livestock epidemic. Note that the New Zea-
land escape clauses are designed to deal exclusively with supply shocks because they
are the only shocks that can be readily identiﬁed as being exogenous. Aggregate de-
mand shocks may be exogenous, but they are just as likely to be induced by mone-
tary policy. Allowing central banks to use them to justify misses of an inﬂation targetwould likely destroy central bank credibility and undermine the inﬂation-targeting
regime. Thus formal escape clauses, although providing some increased ﬂexibility,
are only able to partially cope with the controllability and instrument instability
problems from too short a horizon and too narrow a target range.
The second alternative for coping with supply shocks is to target a core inﬂation
measure that excludes items such as food and energy from the price index, as they
are especially subject to supply shocks. Using a core inﬂation measure has the advan-
tage that it involves no discretion after a supply shock occurs. The use of such discre-
tion, as in the case of escape clauses, can lead the public to question the centralbank’s honest commitment to achieving the inﬂation targets. Instead, which items
are to be excluded from the construction of the inﬂation measure are decided ex
ante. This is probably why targeting core measures of inﬂation has been used more
widely than the speciﬁcation of escape clauses.
Like escape clauses, however, targeting core inﬂation measures has the disadvan-
tage of dealing only with instrument instability and controllability problems arising
from supply shocks, and not those stemming from aggregate demand shocks. Fur-
thermore, core inﬂation measures are not as well understood by the public as
headline inﬂation measures, thus making core inﬂation targets a somewhat weaker
communication vehicle than headline inﬂation targets. Core inﬂation measures also
exclude items that consumers care a lot about, particularly poorer consumers forwhom food and energy form a larger share of their budget. If these items are
excluded from the targeted inﬂation measure, the central bank may be subjected to
criticisms that it does not care su‰ciently about poorer members of society.416 Chapter 16

The third option, widening the target range, is similarly not, by itself, a solution to
controllability and instrument instability problems. Estimates of the irreducible un-
certainty around an inﬂation target with a one-year horizon are on the order of 5
percentage points, although over time, success with inﬂation targeting might decrease
the volatility of inﬂation expectations and hence inﬂation. 11Choosing such a wide
range for the inﬂation target is highly problematic because it will likely confuse thepublic about the central bank’s intentions. The resulting high ceiling for the range is
likely to make the commitment to low inﬂation less clear-cut, thereby reducing the
credibility of monetary policy. This type of problem occurred in the United Kingdom
in 1995, when inﬂation exceeded the target midpoint of 2.5 percent by over one per-
centage point, but without breaching the 4 percent ceiling. This gave the Chancellor
of the Exchequer cover to resist the Bank of England’s recommendation for tighten-
ing of monetary policy (see Bernanke and others, 1999).
Finally, lengthening the target horizon to correspond more closely to the lags in
the e¤ect of monetary policy on inﬂation would seem to be the best solution to the
problems of controllability and instrument instability. Given the problems encoun-
tered in New Zealand 1997 and 1998, the Reserve Bank of New Zealand nowemphasizes a target horizon of six to eight quarters in their discussion of monetary
policy (see Sherwin, 1999; Drew and Orr, 1999). Other central banks, including the
Bank of Canada and the Bank of England, have for a long time emphasized a target
horizon of closer to two years; this has recently become a feature of the Chilean tar-
geting regime, as well (Central Bank of Chile, 2000b).
As Svensson (1997) emphasizes, however, if central banks are concerned about
output ﬂuctuations and include a weight on output ﬂuctuations in their loss function,
then the inﬂation forecast should approach the long-run inﬂation target gradually.
This implies that a horizon even longer than the policy lags might be appropriatefor the inﬂation target. Such a long horizon for the inﬂation target may create prob-
lems for an inﬂation-targeting regime in that the long period before there is veriﬁca-
tion of hitting the target may weaken credibility, particularly if credibility of the
central bank is not high to begin with. One possible way to deal with this is to recog-
nize that the optimal horizon and the target range interact: the target horizon could
be kept relatively short, say two years, if the target range is widened. The Reserve
Bank of New Zealand, for example, now acknowledges that widening the target
range from 2 to 3 percentage points improved the inﬂation-targeting regime, even
though the Bank initially did not support this change. Widening the target range
is not without its problems, however, because it can also increase confusion and
weaken the credibility of the targeting regime. 12
Another way to allow for longer horizons is to use multi-year annual targets, such
that the path of the inﬂation target can approach the long-run inﬂation goal more
gradually. Both Brazil and Mexico recently adopted this strategy (Central Bank ofA Decade of Inflation Targeting in the World 417

Brazil, 1999; Bank of Mexico, 2000). An alternative approach is for the central bank
to continue to announce only one medium-term inﬂation target while also announc-
ing a long-run target with a speciﬁc date as to when it should be achieved. A third
alternative for the central bank is to announce only one long-term inﬂation target
and to publish inﬂation forecasts for future years, thus describing the expected path
of inﬂation toward the long-run target. Chile recently adopted this approach, follow-ing other industrial countries (Central Bank of Chile, 2000a).
16.2.2 Inflation Targeting during the Transition from High to Low Inflation
The credibility of the central bank is likely to be low when inﬂation starts out wellabove the long-run inﬂation goal consistent with price stability. In addition, with ini-
tially high inﬂation rates (say, over 10 percent), the monetary authorities cannot eas-
ily control inﬂation. Inﬂation targeting faces extra challenges to achieve a disinﬂation
from a high inﬂation rate.
One way to address the complications arising from an initially high inﬂation rate is
to phase in inﬂation targeting gradually, making it more formal in line with increas-
ing success on the disinﬂation front, as suggested by Masson, Savastano, and Sharma(1997). This is exactly the strategy that emerging market countries with initially high
inﬂation have pursued (Mishkin, 2000b; Mishkin and Savastano, 2000). 13For exam-
ple, when Chile adopted inﬂation targeting in 1991, inﬂation exceeded 20 percent,
and the inﬂation target was treated more as an o‰cial inﬂation projection rather
than as a formal hard target (Morande ´and Schmidt-Hebbel, 1997, 2000; Morande ´,
in this volume). Over time, the Central Bank put greater emphasis on the price sta-
bility objective. The Central Bank’s success in both lowering inﬂation and meeting its
inﬂation objectives eventually led the public to interpret those objectives as hard tar-
gets for which the Central Bank could be held accountable. Finally, in May 2000, theCentral Bank of Chile began to issue an inﬂation report, with all the features seen in
similar documents in industrialized countries. For example, not only does the Mone-
tary Policy Report outline developments on the inﬂation front and how the Bank
intends to achieve its inﬂation target, but it also includes inﬂation and output fore-
casts, along with conﬁdence intervals for these forecasts displayed in the famous fan
charts pioneered by the Bank of England.
Mexico has also followed a gradual approach to implementing inﬂation targeting.
Senior o‰cials of the Bank of Mexico recently characterized Mexico’s monetary pol-
icy framework as being in ‘‘a transition period toward a clear-cut inﬂation targeting
scheme’’ (Carstens and Werner, 1999). The Bank of Mexico has increasingly empha-
sized the inﬂation goal as the central objective of its monetary policy. For a numberof years, Mexico has made public an explicit inﬂation objective, which was initially
announced when the Minister of Finance submitted to Congress the government’s
economic program for the following year. In 1999, after annual inﬂation fell below418 Chapter 16

the 13 percent target to 12.3 percent, the central bank announced the 10 percent in-
ﬂation target for the year 2000 before the Ministry of Finance submitted the year’s
economic program to Congress. Starting in April 2000, the Bank of Mexico has
issued an Inﬂation Report , which documents what has been happening on the inﬂa-
tion front and how the Bank of Mexico intends to achieve its inﬂation objectives,
but which does not provide inﬂation and output forecasts. The third Inﬂation Report ,
published in October 2000, announced multi-year, annual targets that converge to a
long-run target of 3 percent by December 2003.
Weak credibility stemming from high initial inﬂation increases the likelihood that
the public and markets will not believe that the central bank is serious about hitting
its targets if veriﬁcation has to wait for more than one year in the future. This prob-
lem may make it very di‰cult for a central bank adopting inﬂation targeting under
circumstances to choose inﬂation targets with horizons longer than a year. As dis-
cussed in the previous subsection, this presents the central bank with a dilemma, be-
cause the lags in transferring the e¤ects of monetary policy to inﬂation are likely to
be longer than one year. A solution to this dilemma is to specify a path for the inﬂa-
tion target with multi-year targets, which is what the central banks of Brazil, theCzech Republic, Mexico, and Poland have done since 1998. However, specifying a
multi-year path for the annual inﬂation targets carries its own risk: even though a
central bank is making good progress toward its long-run inﬂation goal, the greater
uncertainty of controlling inﬂation at high rates might still cause inﬂation to deviate
substantially from the multi-year path. This problem helps explain why the Central
Bank of Chile chose not to specify multi-year inﬂation targets when it embarked on
its inﬂation-targeting regime in 1991.
When countries are in the transition from high to low inﬂation, there appears to be
a strong rationale for adopting a wide range for inﬂation targets to reﬂect the sub-stantial uncertainty of controlling inﬂation when it is initially high. However, as dis-
cussed above, a wide range for the inﬂation target can lead to credibility problems,
because the government may be willing to advocate that all is well on the inﬂation
front when the inﬂation rate is substantially above the midpoint of the target range,
but is still below the ceiling of the range. A point target makes this behavior on the
part of the government less likely. Making sure that the government does not weaken
its commitment to lowering inﬂation is especially important for inﬂation-targeting
regimes when inﬂation is high because credibility is so much more precarious in these
situations. This strengthens the argument for choosing a point target over a target
range in an inﬂation-targeting regime during the transition from high to low inﬂa-
tion. Interestingly, the Central Bank of Chile switched from target ranges to pointtargets in 1994 in the process of hardening its inﬂation-targeting regime.
Imperfect credibility during the transition from moderately high to low inﬂation
implies that inﬂation expectations are more geared to higher past inﬂation than toA Decade of Inflation Targeting in the World 419

the lower o‰cial inﬂation targets. Inﬂation inertia is thus potentially larger, and
rapid disinﬂation potentially more costly, in the transition to low inﬂation. Evidence
for Chile, based on counterfactual simulations carried out by Corbo, Landerretche,
and Schmidt-Hebbel (2002) and Morande ´(2002), suggests that a quicker pace of dis-
inﬂation toward the long-term 2–4 percent target would have involved a larger out-
put sacriﬁce.
As argued in Mishkin (2000a), focusing on not undershooting the inﬂation target
is likely to improve the performance of inﬂation-targeting regimes. When inﬂation
approaches levels that are consistent with price stability, a symmetric approach to in-
ﬂation targeting, which seeks to avoid undershoots just as strongly as overshoots,
reduces the likelihood of output declines and deﬂation. It also indicates that the cen-
tral bank cares appropriately about output ﬂuctuations and thus helps maintain sup-
port for its independence. However, an asymmetric approach to inﬂation targeting
may have some advantages when credibility is weak as a result of relatively high in-
ﬂation rates, which is often the situation for emerging market countries adopting
inﬂation targeting. Overshooting the target when inﬂation is still high may create
fears that monetary policy is going back to its old, high-inﬂation ways; they couldthus have devastating e¤ects on central bank credibility. Given high inﬂation, there-
fore, the central bank may want to be particularly aggressive if it thinks that inﬂation
could possibly overshoot the target. This bias to preventing overshoots of the target
necessarily implies that the central bank’s preferences would be somewhat asymmet-
ric, with overshoots receiving a greater weight in the loss function than undershoots.
For example, the behavior of the Bank of Israel in recent years seems to be consistent
with asymmetric preferences of this type.
Asymmetric preferences can be taken too far, however. If the central bank is not
su‰ciently concerned about undershooting the targets, uncertainty about inﬂationmay increase and thus interfere with private sector planning. Undershooting the tar-
get can also lead to sharp declines in aggregate output, which is not only harmful
to the economy, but can also lead to decreased public support for the central bank
and the inﬂation-targeting regime. Even if asymmetric preferences make sense at
high inﬂation rates, they are no longer appropriate once the transition from high to
low inﬂation is complete.
16.2.3 Who Should Set the Medium-Term Inflation Target?
Debelle and Fischer (1994) and Fischer (1994) make the useful distinction betweengoal independence, in which the central bank sets the goals of monetary policy, and
instrument independence, in which the central bank controls monetary policy instru-ments. Instrument independence for central banks is supported by the need to insu-
late the central bank from short-run political pressures that may lead it to pursue
time-inconsistent, expansionary policy that produces bad long-run outcomes. How-420 Chapter 16

ever, the argument that a central bank’s long-run preferences should coincide with
society’s preferences suggests that a central bank should be goal dependent. Having
the government decide on the long-run inﬂation target for the central bank thus
receives a lot of support.
Whether the government rather than the central bank should set the medium-term
inﬂation target is a trickier question. If inﬂation is currently low, the medium-term target is likely to be the same as the long-run target and so there is no conﬂict
between them. This makes it easier to argue that the government should set the
medium-term target, as it does in many inﬂation-targeting regimes. If inﬂation is
currently far from the long-run target, however, the designation of who sets the
medium-term target is more complicated. The length of the lags from monetary
policy to inﬂation is a technical issue that the central bank is far more qualiﬁed to
determine than are politicians. How long it should take for inﬂation to return to the
long-run target necessarily requires judgement about these lags; such decisions
should be insulated from short-term political pressure if time-inconsistent policies
are to be avoided. This points to having the central bank set the medium-term inﬂa-
tion target, because how quickly it approaches the long-run target reﬂects the lags ofmonetary policy e¤ects on inﬂation.
On the other hand, preferences on the weight given to minimizing output ﬂuctua-
tions relative to inﬂation ﬂuctuations a¤ect the speed at which inﬂation should be
adjusted toward the long-run goal (Svensson, 1997). Thus if the government’s long-
run preferences are to be reﬂected in monetary policy, the government should have a
role in setting the medium-term target, because this determines how fast inﬂation
converges to the long-run target.
Clearly, there is a tradeo¤ with regard to who should set medium-term inﬂation
targets when inﬂation is far from the long-run goal. The argument for instrument in-dependence suggests that the central bank should set the medium-term target, while
the argument for goal dependence indicates that the government should set the
medium-term target. For industrial countries, this may not represent much of a di-
lemma because medium-term targets and long-run targets are likely to be quite close.
For countries in the transition from high to low inﬂation, however, it is far less
obvious that the government should determine the medium-term inﬂation target.
16.2.4 The Role of the Exchange Rate and Other Asset Prices
Movements of the exchange rate are clearly a major concern of central banks in bothinﬂation-targeting and non-inﬂation-targeting countries. Changes in the exchange
rate can have a major impact on inﬂation, particularly in small, open economies.For example, depreciations lead to a rise in inﬂation as a result of the pass-through
from higher import prices and greater demand for exports, while an appreciation of
the domestic currency can make domestic business uncompetitive. A depreciation isA Decade of Inflation Targeting in the World 421

often seen as a sign of failure on the part the central bank, as has recently been the
case for the European Central Bank, even if this view is an unfair one. In addition,
the public and politicians pay close attention to the exchange rate, and this puts pres-
sure on the central bank to alter monetary policy.
Emerging market countries, quite correctly, have an even greater concern about
exchange rate movements. Not only can a real appreciation make domestic indus-tries less competitive, but it can lead to large current account deﬁcits which can
make the country more vulnerable to currency crisis if capital inﬂows turn to out-
ﬂows. Depreciations in emerging market countries are particularly dangerous be-
cause they can trigger a ﬁnancial crisis along the lines suggested in Mishkin (1996b,
1999b). These countries have much of their debt denominated in foreign currency;
when the currency depreciates, the debt burden of domestic ﬁrms increases. Since
assets are typically denominated in domestic currency and so do not increase in
value, net worth declines. This deterioration in balance sheets then increases adverse
selection and moral hazard problems, which leads to ﬁnancial instability and a sharp
decline in investment and economic activity. This mechanism explains why the cur-
rency crises in Mexico in 1994–95 and East Asia in 1997 pushed these countries intofull-ﬂedged ﬁnancial crises, with devastating e¤ects on their economies.
The fact that exchange rate ﬂuctuations are a major concern in so many countries
raises the danger that monetary policy may put too much focus on limiting exchange
rate movements, even under an inﬂation-targeting regime. The ﬁrst problem with a
focus on limiting exchange rate movements is that it can transform the exchange
rate into a nominal anchor that takes precedence over the inﬂation target. For exam-
ple, as part of its inﬂation-targeting regime, Israel established an intermediate target
of a quite narrow exchange rate band around a crawling peg, whose rate of crawl
was derived from the inﬂation target for the coming year. Although the Bank of Is-rael downplayed the exchange rate target relative to the inﬂation target over time,
the use of a secondary target slowed the Bank’s e¤orts to win support for disinﬂation
and the lowering of the inﬂation targets (see Bernanke and others, 1999).
The second problem that results from a focus on limiting exchange rate ﬂuctua-
tions is that the impact of changes in exchange rates on inﬂation and output can dif-
fer substantially depending on the nature of the shock that causes the exchange rate
movement. Di¤erent types of shocks call for di¤erent monetary policy responses. If
the domestic currency depreciates because of a pure portfolio shock, inﬂation is likely
to rise; the appropriate response to keep inﬂation under control is for the monetary
authorities to tighten monetary policy and raise interest rates. If the depreciation
occurs in an emerging market country which has a substantial amount of foreign-denominated debt, tightening monetary policy to prevent a sharp depreciation may
be even more necessary to avoid ﬁnancial instability. On the other hand, if the ex-
change rate depreciation occurs because of real shocks, the impact is less likely to422 Chapter 16

be inﬂationary and a di¤erent monetary policy response is warranted. Even here,
however, the response depends on the nature of the shock. A negative terms-of-trade
shock, which lowers the demand for exports, reduces aggregate demand and is thus
likely to be deﬂationary. In this situation, the correct interest rate response is to lower
interest rates to counteract the drop in aggregate demand, and not to raise interest
rates. If the negative terms-of-trade shock is instead due to a rise in import prices,the result is a negative income e¤ect, which could be o¤set by lowering interest rates.
But there is also a direct inﬂationary e¤ect, particularly if there is high indexation
and pass-through, which might suggest that interest rates should rise to prevent
second-round e¤ects.
One graphic example of a focus on limiting exchange rate ﬂuctuations that induced
the wrong policy response occurred in New Zealand in 1997 and 1998. As mentioned
above, 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 be-
cause of the direct impact of exchange rate movements on inﬂation. By early 1997,
the Reserve Bank institutionalized this focus by adopting as its primary indicator of
monetary policy a Monetary Conditions Index (MCI) similar to that developed bythe 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¤setting impacts on inﬂation, on the assumption that portfo-
lio shocks dominate exchange rate movements. The adoption of the MCI in 1997 led
to a questionable monetary policy response to the East Asian crisis. When the crisis
began in July 1997 after the devaluation of the Thai baht, depreciation set in and the
MCI began a sharp decline, indicating that the Reserve Bank needed to raise interest
rates, which it did by over 200 basis points. The result was very tight monetary pol-
icy, and the overnight cash rate exceeded 9 percent by June of 1998. Because the de-preciation was due to a substantial negative terms-of-trade shock that decreased
aggregate demand, the tightening of monetary policy, not surprisingly, led to a reces-
sion and an undershooting of the inﬂation target range, with actual deﬂation occur-
ring in 1999. 14The Reserve Bank of New Zealand eventually reversed its course: it
lowered interest rates sharply beginning in July 1998 after the economy had entered a
recession. It also recognized the problems with using an MCI as an indicator of mon-
etary policy and abandoned the measure in 1999. Now the Reserve Bank operates
monetary policy more conventionally, using the overnight cash rate as its policy in-
strument and placing far less emphasis on the exchange rate in its monetary policy
decisions.
Another example is the case of Chile in 1998. At that time Chile’s inﬂation-
targeting regime included a focus on limiting exchange rate ﬂuctuations by having
an exchange rate band with a crawling peg that was loosely tied to lagged domestic
inﬂation. In response to the combined ﬁnancial and terms-of-trade shock stemmingA Decade of Inflation Targeting in the World 423

from the Asian crisis, the Central Bank of Chile adopted a stringent monetary policy
and a defense of the peso, with a narrowing of the exchange rate band and interven-
tion in the foreign exchange market. When the economy entered into a mild recession
in late 1998, the tight monetary policy was reversed, interest rates were lowered, and
the peso was allowed to decline. The exchange rate band was abolished in September
1999 and the peso now ﬂoats freely.
The experiences of New Zealand and Chile during this period contrast sharply
with that of Australia, another small open economy with an inﬂation-targeting re-
gime. Prior to adopting its inﬂation-targeting regime in 1994, the Reserve Bank of
Australia adopted a policy of allowing the exchange rate to ﬂuctuate without inter-
ference, particularly if the source of the exchange rate change was a real shock, such
as a terms-of-trade shock. When faced with the devaluation in Thailand in July 1997,
the Reserve Bank recognized that it would face a substantial negative terms-of-trade
shock because of the large component of its foreign trade conducted with the Asian
region and that it should not ﬁght the inevitable depreciation of the Australian
dollar. 15It thus immediately lowered the overnight cash rate by 50 basis points to 5
percent and kept it near this level until the end of 1998, when it was lowered again byanother 25 basis points.
The adoption of the inﬂation-targeting regime probably helped the Reserve Bank
of Australia to be even more aggressive in its easing in response to the East Asian
crisis, and it helps explain why the response was so rapid. The Reserve Bank was
able to make clear that easing was exactly what inﬂation targeting called for in order
to prevent an undershooting of the target, so that the easing was unlikely to have an
adverse e¤ect on inﬂation expectations. The outcome of the Reserve Bank’s policy
actions was extremely favorable. In contrast to New Zealand and Chile, real output
growth remained strong throughout this period. Furthermore, there were no negativeconsequences for inﬂation despite the substantial depreciation of the Australian
dollar against the U.S. dollar by close to 20 percent: inﬂation remained under control
and actually fell during this period, ﬁnishing slightly under the target range of 2 to 3
percent.
Targeting the exchange rate is thus likely to worsen the performance of monetary
policy. This does not imply, however, that central banks should pay no attention to
the exchange rate. The exchange rate serves as an important transmission mechanism
for monetary policy, and its level can have important e¤ects on inﬂation and aggre-
gate demand, depending on the nature of the shocks. This is particularly true in
small, open economies. The control of inﬂation and aggregate demand therefore
requires monitoring exchange rate developments and factoring them into decisionson setting monetary policy instruments. A depreciation of the exchange rate resulting
from portfolio shocks requires a tightening of monetary policy to keep inﬂation from
rising. On the other hand, a depreciation from a negative terms-of-trade shock stem-424 Chapter 16

ming from falling export prices requires a di¤erent response, namely, an easing of
monetary policy as pursued in Australia in 1997.
Mishkin (2000b) and Mishkin and Savastano (2000) emphasize another reason
why central banks should not pursue a benign neglect of exchange rates. As men-
tioned above, emerging market countries with large foreign-denominated debt may
not be able to a¤ord sharp depreciations of their currencies, which can destroy bal-ance sheets and trigger a ﬁnancial crisis. Central banks in these countries may thus
have to smooth excessive exchange rate ﬂuctuations, although without attempting
to prevent the exchange rate from reaching its market-determined level over longer
horizons. Exchange rate smoothing via foreign exchange market interventions might
sometimes be necessary because such interventions can prevent dynamics in the
microeconomic structure of this market that may lead to exchange rate ﬂuctuations
that are divorced from fundamentals. Continuing exchange market interventions,
particularly unsterilized ones, are likely to be counterproductive, however, because
they are not transparent. Instead, exchange rate smoothing via changes in the interest
rate instrument are more transparent, and they indicate that the nominal anchor—
and not the exchange rate—continues to be the inﬂation target. Central banks canalso explain to the public the rationale for exchange rate intervention in a manner
analogous to that for interest rate smoothing, that is, as a policy aimed not at resist-
ing market-determined movements in an asset price, but at mitigating potentially
destabilizing e¤ects of abrupt and sustained changes in that price.
The conclusion that targeting the exchange rate is likely to worsen the perfor-
mance of monetary policy also applies to targeting other asset prices. Clearly, setting
monetary policy instruments to achieve inﬂation targets requires factoring in asset
price movements. Changes in asset prices such as common stock, housing or long-
term bonds have important e¤ects on aggregate demand and inﬂation, and they thusact as important transmission mechanisms for monetary policy (see Mishkin 1996a).
The response to ﬂuctuations in these asset prices cannot be mechanical, however, be-
cause optimal monetary policy responds in di¤erent ways depending on the nature of
the shocks driving these asset prices. Furthermore, because many asset prices matter,
targeting just one would be suboptimal.
It is also highly problematic for a central bank to target variables that are hard to
control—and asset prices such as housing and stock prices clearly fall into this cate-
gory. Central banks look foolish if they act to control asset prices and then are un-
able to do so. Furthermore, when central banks act as if they can control asset prices
such as common stocks, the public may begin to fear that central banks are too pow-
erful and thus to question support for central bank independence. Some researchers(such as Cecchetti and others, 2000) suggest that the monetary authorities should act
to limit asset price bubbles to preserve ﬁnancial stability. However, this requires that
the monetary authorities identify appropriate asset values. It is, to say the least,A Decade of Inflation Targeting in the World 425

highly presumptuous to think that government o‰cials, even if they are central
bankers, know better than private markets what the asset prices should be, given
that markets have stronger incentives to get things right. Furthermore, as pointed
out in Bernanke and Gertler (1999), an inﬂation-targeting approach that does not
target asset prices, but instead makes use of an information-inclusive strategy in set-
ting policy instruments, has the ability to make asset price bubbles less likely, therebypromoting ﬁnancial stability.
The bottom line is that the optimal conduct of monetary policy requires that
many asset prices, whether the exchange rate, stock prices, housing prices, or long-
term bond prices, be factored into decisions about the setting of monetary policy
instruments. Doing so is completely consistent with inﬂation targeting, which is an
information-inclusive strategy for the conduct of monetary policy. Targeting asset
prices, on the other hand, is likely to lead to serious mistakes in monetary policy,
and it may weaken not only the commitment to the inﬂation target as a nominal an-
chor, but also the support for central bank independence.
16.3 Some Unresolved Issues
Inﬂation-targeting regimes are continually evolving as experience and new researchsuggests better ways to conduct monetary policy. Two unresolved issues that are cen-
tral to inﬂation-targeting regimes are currently high on the research agenda of mon-
etary economists: the speciﬁcation of the optimal long-run inﬂation goal and the
merit of targeting the price level rather than inﬂation.
16.3.1 Long-Run Inflation Goal
A key question for any central bank pursuing an inﬂation-targeting strategy is what
the long-run goal for inﬂation should be. Much research ﬁnds a negative relationship
between inﬂation and economic growth. 16As pointed out in Bruno and Easterly
(1996), however, the evidence for this negative relationship is weak at low inﬂation
rates.
Because the empirical evidence on the direct relationship between inﬂation and
growth is unlikely to help discriminate between di¤erent long-run goals that are
under 10 percent, another approach to deciding on the appropriate long-run inﬂation
target is to ask the deeper question of what price stability means. Alan Greenspan
has provided a widely cited deﬁnition of price stability: a rate of inﬂation that is suf-
ﬁciently low that households and businesses do not have to take it into account in
making everyday decisions. This deﬁnition of price stability is a reasonable one,and, operationally, any inﬂation number between 0 and 3 percent seems to meet this
criterion. Some economists, such as Feldstein (1997) and Poole (1999), argue for a
long-run inﬂation goal of 0 percent, which has a psychological appeal. Indeed, one426 Chapter 16

concern is that an inﬂation goal greater than zero might lead to a decline in central
bank credibility and an increase in the instability of inﬂation expectations, which
could, in turn, trigger an upward creep in inﬂation. However, Bernanke and others
(1999) suggest that maintaining an inﬂation target above zero—but not too far
above (less than 3 percent)—for an extended period does not lead to instability in
the public’s inﬂation expectations or to a decline in central bank credibility.
One prominent argument against setting the long-run inﬂation target at zero is
that setting inﬂation at too low a level produces ine‰ciency and will result in a
higher natural rate of unemployment (Akerlof, Dickens, and Perry, 1996). The
authors argue that downward rigidity of nominal wages, which they say is consistent
with the evidence, indicates that reductions of real wages can occur only through
inﬂation. The implication is that a very low rate of inﬂation might prevent real
wages from adjusting downward in response to declining labor demand in certain
industries or regions, thereby leading to increased unemployment and hindering the
re-allocation of labor from declining sectors to expanding sectors.
The evidence for the Akerlof-Dickens-Perry mechanism through which low inﬂa-
tion raises the natural rate of unemployment is not at all clear-cut. Carruth andOswald (1989), Ingrams (1991), McLaughlin (1994), and Yates (1995) all ﬁnd little
evidence for downward nominal rigidities in wages in the United States and the
United Kingdom. As pointed out by Groshen and Schweitzer (1996, 1999), inﬂation
can not only ‘‘grease’’ the labor markets and allow downward shifts in real wages in
response to a decline in demand along the lines of Akerlof, Dickens, and Perry
(1996), but it can also put in ‘‘sand’’ by increasing the noise in relative real wages.
This noise reduces the information content of nominal wages and hence the e‰ciency
of the process by which workers are allocated across occupations and industries.
A more persuasive argument for a long-run inﬂation goal above zero is that the
economy is less likely to experience episodes of deﬂation. Deﬂation is a key factor
promoting episodes of ﬁnancial instability in industrialized countries (Mishkin,
1991, 1997). Because debt contracts in industrialized countries frequently have long
maturities, a deﬂation leads to an increase in the real indebtedness of ﬁrms and
households, which in turn leads to a decline in their net worth and a deterioration
of their balance sheets. Irving Fisher (1933) named this phenomenon debt deﬂation
(although it might more accurately be referred to as debt inﬂation in real terms
through deﬂation) and saw it as a major factor promoting the economic downturn
of the Great Depression. 17With decreased net worth, adverse selection and moral
hazard problems increase for lenders, who therefore cut back on lending. The decline
in net worth also leads to a decline in the amount of collateral a lender can grab if theborrower’s investments turn sour, and the reduction in collateral therefore increases
the consequences of adverse selection, because loan losses resulting from default are
likely to be more severe. In addition, the decline in net worth increases moral hazardA Decade of Inflation Targeting in the World 427

incentives for borrowers to take on excessive risk because they now have less to lose
if their investments fail. This reasoning indicates that deﬂation can promote ﬁnancial
instability in industrialized countries through the debt-deﬂation mechanism. A recent
example of this phenomenon is the case of Japan in the last decade (Mishkin, 1998;
Bernanke, 1999).
Another reason for choosing an inﬂation goal that reduces the likelihood of deﬂa-
tion is that deﬂation may make it more di‰cult to conduct monetary policy. Fre-
quent periods of deﬂation resulting from too low a level of the inﬂation target will
cause short-term interest rates to hit a ﬂoor of zero during deﬂations, as occurred
during the Great Depression and recently in Japan. Some economists argue that
monetary policy becomes ine¤ective when the interest rate hits a ﬂoor of zero. 18
This argument is a fallacy for the reasons outlined in Meltzer (1995) and Mishkin
(1996a). Monetary policy works through many other asset prices besides those of
short-term debt securities. Even when short-term interest rates hit the ﬂoor of zero,
monetary policy can still be e¤ective, and indeed was so during the Great Depression
(see Romer, 1992).
Nonetheless, monetary policy becomes more di‰cult during deﬂationary episodes
when interest rates hit a ﬂoor of zero because the usual guides to the conduct of mon-
etary policy are no longer relevant. In recent years, much of the research on how cen-
tral banks should optimally conduct monetary policy focus on so-called Taylor rules,
in which the central bank sets the short-term interest rates at a level that depends on
both output and inﬂation gaps. The Taylor (1999) volume is an excellent example of
this type of research. Once the interest rate hits a ﬂoor of zero, however, this entire
class of research on optimal monetary policy rules is no longer useful because manip-
ulating short-term interest rates ceases to be an e¤ective tool of monetary policy. In
such a deﬂationary environment, central banks do have the ability to lift the econ-omy out of recession by pursuing expansionary policy and creating more liquidity,
but it becomes much less clear how far they need to go. This rightfully makes central
bankers quite uncomfortable. Therefore, an important disadvantage of too low a level
of the long-run inﬂation target is that it makes deﬂationary environments more likely
to occur, leaving central bankers at sea without the usual knowledge to guide them
and thus making it harder for them to get monetary policy exactly right.
Another reason why central banks might be better o¤ with a long-run inﬂation goal
above zero is that it is crucial that they not be perceived as being overly obsessed
with controlling inﬂation at the expense of output stability. A central bank is likely
to lose the support of the public if it is perceived as being inﬂation nutters, in Mervyn
King’s (1996) terminology, and putting no weight on output ﬂuctuations in makingits decisions about monetary policy. Too low an inﬂation target, say, 0 or even 1 per-
cent, may signal to the public that the central bank does not care su‰ciently about
the public’s concerns.428 Chapter 16

On the other hand, Fischer (1986), Feldstein (1997), and the papers in Feldstein
(1999) ﬁnd that lowering the inﬂation rate from currently low levels to zero in indus-
trialized countries reduces distortions caused by the interaction of inﬂation with the
tax system. This can produce substantial welfare gains, on the order of 1 percent of
GDP. 19However, these distortions can also be eliminated by changes in the tax
code, so they do not provide a clear justiﬁcation for choosing a zero long-run inﬂa-tion goal.
Emerging market countries that grow at high levels may be better o¤ having inﬂa-
tion rates that are slightly higher than those in industrialized countries. High-growth
countries typically experience real exchange rate appreciation that is proportional to
the di¤erence in the productivity growth of the traded and nontraded sectors relative
to the rest of the world (the Harrod-Belassa-Samuelson e¤ect). If it is appropriate for
these countries to aim for a long-run traded goods inﬂation similar to that of indus-
trialized countries, then trend real appreciation requires a domestic nontraded goods
inﬂation that is somewhat higher. Hence, the long-run inﬂation goal in high-growth
economies might need to be slightly higher than would be desirable for average-
growth countries. This explains why Chile, a high-growth country, has chosen along-term inﬂation target range of 2–4 percent per year.
Given these conﬂicting arguments, the deﬁnition of an appropriate long-run goal
for inﬂation is still an open question. As a practical matter, all inﬂation-targeting
countries have chosen long-run inﬂation goals slightly above zero, with the midpoints
of the long-run target ranges lying between 1 and 3 percent. Future research may
help central banks decide whether a long-run goal outside this range is appropriate
and provide more precision as to what this goal should be.
16.3.2 Price-Level versus Inflation Targets
All countries that currently implement an inﬂation-targeting regime have chosen to
target inﬂation rather than the price level. However, which of these two targets
would result in better economic performance is an open question.
A price-level target has two key advantages relative to an inﬂation target. First, a
price-level target can reduce the uncertainty about what the price level will be over
long horizons. With an inﬂation target, misses of the inﬂation target are not reversed
by the central bank. Consequently, inﬂation will be a stationary stochastic process,
that is, integrated of the order zero, I(0), while the price level will be nonstationary,
an I(1) process. The uncertainty regarding the future price level thus grows with
the forecast horizon. This uncertainty can make long-run planning di‰cult and may
therefore lead to a decrease in economic e‰ciency. Although McCallum (1999)argues that the amount of long-run uncertainty about the future price level arising
from successful adherence to an inﬂation target may not be all that large, it still com-
plicates the planning process and may lead to more mistakes in investment decisions.A Decade of Inflation Targeting in the World 429

The second possible advantage of a price-level target is that it produces less
output variance than an inﬂation target in models with a high degree of forward-
looking behavior on the part of ﬁrms. 20However, empirical evidence (such as that
presented in Fuhrer, 1997) does not clearly support the formation of forward-looking
expectations, and models with forward-looking behavior have counterintuitive prop-
erties that seem to be inconsistent with inﬂation dynamics (Estrella and Fuhrer,1998).
The traditional view, forcefully articulated by Fischer (1994), argues that a price-
level target produces more output variability than an inﬂation target because unanti-
cipated shocks to the price level are not treated as bygones and must be o¤set. 21A
price-level target requires that overshoots or undershoots of the target must be
reversed, which could impart signiﬁcantly more volatility to monetary policy and,
with sticky prices, to the real economy in the short run. Although the models with
forward-looking price setting cited above do not ﬁnd that this feature of a price-level
target increases output variability, they do not focus on one particular problem with
a price-level target: the fact that a price-level target may lead to more frequent epi-
sodes of deﬂation. As demonstrated in the previous subsection, episodes of deﬂationpresent policymakers with two problems, namely, a possible increase in ﬁnancial in-
stability with potentially high output losses for the economy and an increased likeli-
hood that nominal interest rates hit a ﬂoor of zero, which complicates the conduct of
monetary policy.
Another problem for a price-level target that has received little attention in the lit-
erature is the presence of measurement error in inﬂation. Most research on measure-
ment error takes the view that it is inﬂation that is measured with error rather than
the price level. This was the approach taken by the Boskin Commission. 22This
implies that the measurement error in the price level is I(1), such that a price-leveltarget results in growing uncertainty about the true price level as the forecast horizon
lengthens. Many of the arguments that a price-level target results in lower long-run
uncertainty about the true price level may thus be overstated.
Such conﬂicting arguments indicate that whether price-level rather than inﬂation
targets would produce better outcomes is an open question. Given this uncertainty
about the beneﬁts of price-level targeting, it is not surprising that no central bank
has decided to target the price level in recent years. However, the arguments made
here for preferring an inﬂation target over a price-level target do not rule out hybrid
policies that combine features of an inﬂation target and a price-level target and so
might provide the best of both worlds. For example, an inﬂation target could be
announced with a commitment to some error correction in which target misses wouldbe o¤set to some extent in the future. Recent research shows that an inﬂation target
with a small amount of error correction can substantially reduce the uncertainty
about the price level in the long run, while generating very few episodes of deﬂation430 Chapter 16

(Black, Macklem, and Rose, 1997; King, 1999; Batini and Yates, 1999). Further-
more, putting a small weight on the price-level error correction term improves the
trade-o¤ between output and inﬂation ﬂuctuations (see Williams, 1999; Smets, 2000;
Gaspar and Smets, 2000; McLean and Pioro, 2000). Evaluating hybrid policies of
this type is likely to be a major focus of future research.
One issue that would have to be addressed if such a hybrid policy were adopted
is how to explain the mechanism to the public. As emphasized in Bernanke and
Mishkin (1997), Mishkin (1999a), and Bernanke and others (1999), a critical factor
in the success of inﬂation targeting is that it provides a vehicle for more e¤ective com-
munication with the public. The public will clearly not understand the technical
jargon of error correction models. However, an error correction feature of an
inﬂation-targeting regime could be communicated fairly easily by not only announc-
ing an intermediate-term inﬂation target, but also indicating that there is a target for
the average inﬂation rate over a longer period, say ﬁve years.
Another possible hybrid policy would be to pursue an inﬂation target under nor-
mal conditions, but to provide an escape clause that activates a price-level target only
when the unusual condition of deﬂation sets in, particularly if interest rates near aﬂoor of zero. The inﬂation target under normal conditions would not require that
overshoots of the inﬂation target be reversed and so would not increase the likeli-
hood of deﬂation. On the other hand, if deﬂation sets in, then activating a price-level
target to induce expectations of reﬂation of the economy would not only make it less
likely that nominal interest rates would hit a ﬂoor of zero, but would also lead to
higher inﬂation expectations. This would lower real interest rates, thereby stimulat-
ing the economy, and would help induce a rise in the price level, which would repair
balance sheets. Given the success of a price-level target in ameliorating the e¤ects of
the Great Depression in Sweden in the 1930s (Berg and Jonung, 1998), price-leveltargets have recently been proposed to help jumpstart the Japanese economy (Ber-
nanke, 1999; Blinder, 1999; Goodfriend, 1999; Svensson, 2000).
16.4 Conclusions
The emergence of inﬂation targeting over the last ten years is an exciting develop-
ment in the central banks’ approach to the conduct of monetary policy. The review
in this chapter has indicated that inﬂation targeting has been quite successful in
controlling inﬂation and improving the performance of the economy. However, our
discussion of operational design issues for inﬂation targeting and unresolved issues
indicates that there is still much to learn about how best to operate inﬂation-targeting regimes. We expect that future experience and research will help reﬁne
the inﬂation targeting approach and further improve the process of monetary
policymaking.A Decade of Inflation Targeting in the World 431

Appendix A: Summary of Inflation-Targeting Regimes
Table 16.A1
Implementation and Design of Inﬂation Targeting in Nineteen Countries
CountryDate
introducedTarget
price index Target widthTarget
horizon
Australia Sept. 1994 Core CPI 2–3% Over one business
cycle
Brazil Jun. 1999 Headline CPI 1999: 8% ( G2%)
2000: 6% ( G2%)
2001: 4% ( G2%)1 year
Canada Feb. 1991 Core CPI (excl.
food, energy,and indirecttaxes)1991: 3–5%
1992: 2–4%Jun. 94: 1.5–3.5%1995–2001: 1–3%1991: 22 months;
since 1992: multi-year
Chile Jan. 1991 Headline CPI 1991: 15–20%
1992: 13–16%
1993: 10–12%1994: 9–11%1995: 8%1996: 6.5%1997: 5.5%1998: 4.5%
1999: 4.3%
2000: 3.5%2001 onwards: 2–4%1991–2000: 1 year;
2001 onwards:
indeﬁnite
Colombia Sept. 1999 Headline CPI 1999: 15%
2000: 10%2001: 8%2002: 6%1 year
Czech
RepublicJan. 1998 Core CPI (excl.
regulated pricesand indirect
taxes)1998: 5.5–6.5%
1999: 4–5%2000: 3.5–5.5%
2001: 2–4%1 year
Finland Feb. 1993 to
Jun. 1998Core CPI (excl.
indirect taxes,
subsidies,housing prices,and mortgageinterest)Annual average of 2%
by 1995Until 1995: multi-year;
since 1996: indeﬁnite432 Chapter 16

Table 16.A1
Implementation and Design of Inﬂation Targeting in Nineteen Countries
Escape
clausesAccountability
of target missesEntity that
sets targetPublications and
accountability
None None Jointly by government
and central bankInﬂation report; inﬂation
projections (2-year point
estimate)
None Issuance of open
letter to Minister ofFinance explainingtarget breach andmeasures taken tobring inﬂation within
the target (and the
time required)Government in
consultation withcentral bankInﬂation report; inﬂation
projections (2-year fanchart); extract of boardmeetings; models used forinﬂation outlook
Revision of target
path underexceptionalcircumstances(e.g., major oilprice shock,
natural disaster)Public explanation Jointly by government
and central bankMonetary policy report;
inﬂation projections (1-year point estimate)
None None Central bank in
consultation with
governmentInﬂation report (2000);
minutes of monetary
policy meetings; inﬂationprojections (2-year fanchart)
None None Jointly by government
and central bankInﬂation report
Natural disasters,
global raw mate-rial price shocks,
exchange rate shocks
unrelated todomestic eco-nomic fundamentalsand monetary policy,and agricultural
production shocksNone Central bank Inﬂation report (1998);
minutes of monetarypolicy meetings; inﬂation
projections (1-year range)
None None Central bank NoneA Decade of Inflation Targeting in the World 433

Table 16.A1
(continued)
CountryDate
introducedTarget
price index Target widthTarget
horizon
Israel Jan. 1992 Headline CPI 1992: 14–15%
1993: 10%
1994: 8%
1995: 8–11%1996: 8–10%1997: 7–10%1998: 7–10%1999: 4%
2000: 3–4%
2001: 2.5–3.51 year
Korea Jan. 1998 1998: 9% ( G1%)
1999: 3% ( G1%)
2000: 2.5%(G1%)
2001 onwards:2.5%1998–2000: 1 year;
2001 onwards:indeﬁniteNone (before 2000:
changes caused bymajor forces)
Mexico Jan. 1999 Headline CPI 1999: 13%
2000: <10%
2001: 6.5%2002: 4.5%2003: similar to tradepartners’ inﬂation (3%)1998–2002: 1 year;
2002 onwards:indeﬁnite
New
ZealandMar. 1990 Headline CPI
(since 1999,
headline CPI
excludes interestcharges; prior to1999, targetswere deﬁned interms ofheadline CPI less
interest charges
and other ﬁrst-round-e¤ectprices)1990: 3–5%
1991: 2.5–4.5%
1992: 1.5–3.5%
1993–1996: 0–2%Since 1997: 0–3%1990–92: 1 year;
1993–96: multi-year;
since 1997: indeﬁnite
Peru Jan. 1994 Headline CPI 1994: 15–20%
1995: 9–11%1996: 9.5–11.5%1997: 8–10%
1998: 7.5–9%
1999: 5–6%2000: 3.5–4%2001: 2.5–3.5%2002: 1.5–2.5%2003: 1.5–2.5%1 year434 Chapter 16

Table 16.A1
(continued)
Escape
clausesAccountability
of target missesEntity that
sets targetPublications and
accountability
None Public explanation of
deviation of inﬂation
forecast from target
in excess of 1%Government in
consultation with
central bankInﬂation report (1998)
None Government in
consultation withcentral bankInﬂation report (and
submission toParliament); monthlyannouncement ofmonetary policydirection; minutes of
monetary policy
meetings
None None Central bank Inﬂation report (2000)
Unusual events,
provided they do
not cause general
inﬂationarypressuresPublic explanation of
target breach and
measures taken to
bring inﬂation withinthe target (and thetime required);Minister of Financemay ask forresignation of RBNZ
GovernorJointly by government
and central bankInﬂation report (1990);
inﬂation projections
None None Central bank in
consultation withgovernmentNoneA Decade of Inflation Targeting in the World 435

Table 16.A1
(continued)
CountryDate
introducedTarget
price index Target widthTarget
horizon
Poland Oct. 1998 Headline CPI 1998: <9.5%
1999: 6.6–7.8%
2000: 5.4–6.8%
2003: <4%1998–2000: 1 year;
2000–03: multi-year;
2003 onwards:
indeﬁnite
South
AfricaFeb. 2000 Core CPI (excl.
interest costs)2003: 3–6% Multi-year
Spain Nov. 1994 to
Jun. 1998Headline CPI Jun. 1996: 3.5–4%
1997: 2.5%1998: 2%Until 1996: multi-year;
1997–98: 1 year
Sweden Jan. 1993 Headline CPI Since 1995: 2% ( G1%) Until 1995: multi-year;
since 1996: indeﬁnite
Switzerland Jan. 2000 Headline CPI <2% 3 years
Thailand Apr. 2000 Core CPI (excl.
raw food and
energy prices)2000: 0–3.5% Indeﬁnite
United
KingdomOct. 1992 RPIX (excl.
mortgageinterest)1992–95: 1–4%
Since 1996: 2.5%Until 1995: multi-year;
since 1996: indeﬁnite
Source: J. P. Morgan, ‘‘Guide to Central Bank Watching;’’ country sources; central banks’ Web pages;
Schaechter, Stone, and Zelmer (2000).436 Chapter 16

Table 16.A1
(continued)
Escape
clausesAccountability
of target missesEntity that
sets targetPublications and
accountability
None None Central bank Inﬂation report; inﬂation
guidelines; report on
monetary policy
implementation
Major unforeseen
events outsidecentral bank’scontrolNone Central bank Inﬂation report
None None Central bank Inﬂation report (1995);
governor reportsregularly to Parliament
None None Central bank Inﬂation report (1997);
minutes of monetary
policy meetings; inﬂation
projections (2-year fanchart); submission ofmonetary policy report toParliament
Unusual events,
provided they donot cause generalinﬂationary
pressuresNone Central bank Inﬂation report; inﬂation
projections (3 years)
None Public explanation of
target breach and
measures taken tobring inﬂation withinthe target (and thetime required)Government in
consultation with
central bankInﬂation report (2000);
inﬂation projections (2-
year fan chart); minutesof monetary policymeetings
None Issuance of open
letter to the Ministerof Finance
explaining target
breach and measurestaken to bring theinﬂation within thetarget (and the timerequired)Government Inﬂation report; inﬂation
projections (2-year fanchart); models used for
inﬂation outlookA Decade of Inflation Targeting in the World 437

Appendix B: Specification of the Data Set
This appendix deﬁnes the variables and outlines the data sources used for the analysis
in section 16.1.
IT:a dummy variable for implementing inﬂation targeting. Speciﬁes a value of 1
(0 otherwise) for a year in which at least six months are covered by a previously
announced inﬂation target. Source: country sources; Schaechter, Stone, and Zelmer
(2000).
Inf:CPI inﬂation, normalized as the percentage variation of the annual average
CPI divided by one plus the percentage variation of the average annual CPI. Source:
IMF, International Financial Statistics , various issues (code 64e).
MT: a dummy variable for pursuing monetary growth targets. Speciﬁes a value of
1 (0 otherwise) for a year in which any month is covered by a previously announced
monetary target. Source: country sources; J. P. Morgan, ‘‘Guide to Central BankWatching.’’
BW: the width of the exchange rate band, normalized as the band width divided
by one plus the band width. Source: IMF, ‘‘Exchange Arrangements and Exchange
Restrictions,’’ various issues.
Fiscal: the ratio of the government surplus to GDP. Source: country sources; IMF,
International Financial Statistics , various issues (codes 80 and 99b).
Fin:ﬁnancial depth, measured as the ratio of M2 to GDP. Source: country sources;
IMF, International Financial Statistics , various issues (codes 80 and 99b).
Open: trade openness, measured as the ratio of the sum of exports and imports to
GDP. Source: country sources; IMF, International Financial Statistics , various issues
(codes 90c, 98c, and 99b).
CBFI: a dummy for formal independence of the central bank. Speciﬁes a value of
1 (0 otherwise) for a year in which any month is covered by central bank formal in-
dependence. Formal independence is attained when a central bank is established as a
legally independent or autonomous state institution. Source: country sources; J. P.
Morgan, ‘‘Guide to Central Bank Watching.’’
CBGI: a dummy for goal independence of the central bank. Speciﬁes a value of 1
(0 otherwise) for a year in which any month is covered by central bank goal indepen-
dence. Goal independence is attained when the central bank alone determines the
levels for its monetary policy targets (that is, the exchange rate, monetary growth,and inﬂation targets). When target levels are determined separately by the govern-
ment or congress, jointly by the bank and either government or congress, or by a
government representative who casts votes on central bank board decisions, the
central bank is considered goal dependent. Source: country sources; J. P. Morgan,
‘‘Guide to Central Bank Watching.’’438 Chapter 16

CBII: a dummy for instrument independence of the central bank. Speciﬁes a value
of 1 (0 otherwise) for a year in which any month is covered by central bank instru-
ment independence. Instrument independence is attained when the central bank freely
sets its instrument in its pursuit of monetary policy goals. When central bank policy
decisions are either subject to government approval or can be reversed by the gov-
ernment, instrument independence is not in place. Source: country sources; J. P.Morgan, ‘‘Guide to Central Bank Watching;’’ Schaechter, Stone, and Zelmer (2000).
Acknowledgments
We thank Mark Stone for excellent comments, as well as Ben Bernanke and Bennett
McCallum for insightful discussion. We are also grateful to Vero ´nica Mies for out-
standing research assistance.
Notes
1. Classifying country cases into inﬂation-targeting and other monetary regimes involves subjective
choices for two reasons. First, there is lack of full agreement on the main conditions and features of inﬂa-tion targeting and how they apply during transition to low inﬂation—an issue that we discuss below. Sec-ond, some countries have simultaneously used inﬂation targets and other nominal anchors (the exchangerate or a monetary aggregate or both), particularly in their early years of inﬂation targeting. IMF (2000),Mahadeva and Sterne (2000), and Sterne (2000) discuss and present comprehensive country classiﬁcations
of monetary regimes. The di¤erent classiﬁcation criteria is reﬂected in the di¤erent country samples of re-
cent cross-country studies of inﬂation-targeting experiences. See, for example, Bernanke and others (1999);Schaechter, Stone, and Zelmer (2000); Corbo, Landerretche, and Schmidt-Hebbel (in this volume); Corboand Schmidt-Hebbel (2000).
2. Starting dates are deﬁned by the ﬁrst month of the ﬁrst period for which inﬂation targets have been
announced previously. For example, the starting date for Chile is January 1991 (the ﬁrst month of calendaryear 1991, for which the ﬁrst inﬂation target was announced in September 1990). The initial inﬂation levelis deﬁned as the year-on-year consumer price index (CPI) inﬂation rate of the last quarter before the ﬁrst
month of inﬂation targeting (for example, the fourth quarter of 1990 in the case of Chile).
3. The sample includes eighteen inﬂation targeters, as opposed to the nineteen listed in ﬁgure 16.1, because
Switzerland did not adopt inﬂation targeting until 2000.
4. Germany adopted the euro in early 1999 and Switzerland adopted explicit inﬂation targeting in 2000.
5. The use of this control group of high-income industrial economies with alternative monetary frame-
works in place reﬂects our objective of linking the adoption of inﬂation targeting with structural features,
as observed in the world sample of eighteen industrial and higher-middle-income countries. Deﬁning acontrol group of high-performing economies with similar features to those that have adopted inﬂationtargeting makes it statistically more di‰cult to identify signiﬁcant determinants of the choice of in-ﬂation targeting than if we had chosen a control group including developing countries that do not targetinﬂation.
6. For example, although the central banks of Peru and Colombia announce inﬂation targets, their mone-
tary policy frameworks do not contain many crucial features of an inﬂation-targeting regime (Mishkin andSavastano, 2000). Korea is classiﬁed as an inﬂation targeter because it announces an inﬂation target, yet it
appears to have pursued a de facto exchange rate peg in the ﬁrst two years of its inﬂation-targeting regime,
which is inconsistent with inﬂation targeting. Dropping these three countries from the sample does notappreciably a¤ect the empirical results.A Decade of Inflation Targeting in the World 439

7. Similar deﬁnitions are used for other discrete variables used here (see the appendix for variable deﬁni-
tions and data sources).
8. There are only a few large positive or negative correlations among variables other than inﬂation target-
ing. In particular, the three measures of central bank independence are highly and positively correlatedwith each other.
9. See, for example, Bernanke, and others (1999); Cecchetti and Ehrmann (2000); Schaechter, Stone,
and Zelmer (2000); Corbo and Schmidt-Hebbel (2000); Corbo, Landerretche, and Schmidt-Hebbel(2002).
10. Inferences about inﬂation targeters’ success are still highly tentative, in view of the ambiguities sur-
rounding the sample deﬁnitions for inﬂation-targeting countries, the possible systemic equivalence of somefeatures of inﬂation targeting with those of alternative monetary regimes, the relevant potential and coun-terfactual selection bias, and mutual causation of inﬂation-targeting adoption and country performance.
11. See, for example, Haldane and Salmon (1995); Stevens and Debelle (1995).12. Mishkin (2000c) argues that a point target for inﬂation may be more desirable than a target range be-
cause the edges of the target range can take on a life of their own. Politicians, ﬁnancial markets, and thepublic often focus on whether inﬂation is just outside or inside the edge of a range, rather than on the mag-
nitude of the deviation from the midpoint. As discussed above, the opposite problem occurred in the
United Kingdom in 1995, when inﬂation exceeded the target midpoint by over one percentage point, butwithout breaching the upper band. Too much focus on the edges of the range can lead the central bank toconcentrate on keeping the inﬂation rate just within the bands rather than on trying to hit the midpoint ofthe range. It is di‰cult to imagine a sensible objective function for policymakers that would justify suchasymmetric reactions to inﬂation rates just inside and outside the bands.
13. It has even been a feature of the adoption strategy of industrialized countries that adopted inﬂation
targeting when inﬂation was at rates of less than 10 percent (Bernanke and others, 1999).
14. The terms-of-trade shock, however, was not the only negative shock the New Zealand economy faced
during that period. The farm sector experienced a severe drought that also hurt the economy. Thus a mis-
take in monetary policy was not the only source of the recession; bad luck played a role too. See Drew and
Orr (1999); Brash (2000).
15. See MacFarlane (1999); Stevens (1999).
16. For example, see Kormendi and Meguire (1985); Grier and Tullock (1989); Cozier and Selody (1992);
Fischer (1993); Andersen and Gruen (1995); Barro (1995); Andres and Hernando (1999).
17. Technically this debt-deﬂation mechanism requires that the deﬂation be unanticipated, that is, it must
come as a surprise after the debt contracts have been written. Because in industrialized countries many of
these contracts are quite long, a deﬂation that becomes anticipated after a period of time may still be un-anticipated from the point of view of many debt contracts, such that the debt-deﬂation story still holds.If debt contracts are of very short duration, as is typically the case in emerging market countries, thendeﬂations are less likely to be unanticipated, and so the debt deﬂation mechanism is inoperative (seeMishkin 1997).
18. Summers (1991) is one prominent example, and o‰cials of the Bank of Japan recently used this
argument to indicate that expansionary monetary policy is likely to be ine¤ective in promoting Japanese
recovery.
19. Welfare costs arising from inﬂation because interest is not paid on high-powered money (the so-called
shoe leather costs) are estimated to be an order of magnitude smaller than costs stemming from tax distor-
tions, and they are thus unlikely to be important for deciding the optimal long-run inﬂation goal. SeeLucas (1981, 2000); Fischer (1986); Cooley and Hansen (1989).
20. For example, Svensson (1999); Woodford (1999); Svensson and Woodford (1999); Clarida, Galı ´, and
Gertler (1999); Dittmar and Gavin (2000); Dittmar, Gavin, and Kydland (1999); Vestin (2000).
21. This view is supported by simulations of macroeconometric models with backward-looking expecta-
tions, which typically ﬁnd that a price-level target leads to greater variability of output and inﬂation thanan inﬂation target. See, for example, Haldane and Salmon (1995).
22. See, for example, Boskin and others (1996); Moulton (1996); Shapiro and Wilcox (1996).440 Chapter 16

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London: Bank of England.444 Chapter 16

17The Dangers of Exchange-Rate Pegging in Emerging Market
Countries
Frederic S. Mishkin
17.1 Introduction
In recent years, there has been a growing consensus, even in emerging-market coun-
tries, that controlling inﬂation should be the primary or overriding long-term goal ofmonetary policy. Past experience with high inﬂation in emerging-market countries
has not been a happy one, and there is a growing literature that suggests that high
inﬂation can be an important factor that retards economic growth. 1Although central
bankers, as well as the public, in emerging-market countries now put more emphasis
on controlling inﬂation, there is still the crucial question of how best to do this. To
achieve low inﬂation, one choice that emerging-market countries have often made is
to peg their currency to that of a large, low-inﬂation country, typically the United
States. 2Is this choice a good one?
This chapter examines the question of whether pegging its exchange rate is a good
strategy for an emerging-market country. The analysis here suggests that the answer
is usually no, except in extreme circumstances where a particularly strong form of
exchange-rate pegging might be worth pursuing. Indeed, an important point in the
analysis of this chapter is that pegging the exchange rate is a less viable strategy for
emerging-market countries than it is for industrialized countries.
After examining rationales for exchange-rate pegging, the chapter discusses
criticisms of exchange-rate pegging and why it is so dangerous for emerging-market
countries. Because the chapter argues that exchange-rate pegging is highly problem-
atic for emerging-market countries, it goes on to explore what other strategies for in-
ﬂation control might be reasonable alternatives in these countries.
17.2 Rationales for Exchange-Rate Pegging
Fixing the value of an emerging-market’s currency to that of a sounder currency,which is exactly what an exchange-rate peg involves, provides a nominal anchor for
the economy that has several important beneﬁts. First, the nominal anchor of an

exchange-rate peg ﬁxes the inﬂation rate for internationally traded goods, and thus
directly contributes to keeping inﬂation under control. Second, if the exchange-rate
peg is credible, it anchors inﬂation expectations in the emerging-market country to
the inﬂation rate in the country to whose currency it is pegged. The lower inﬂation
expectations that then result bring the emerging-market country’s inﬂation rate in
line with that of the low-inﬂation, anchor country relatively quickly.
Another way to think of how the nominal anchor of an exchange-rate peg works
to lower inﬂation expectations and actual inﬂation is to recognize that, if there are no
restrictions on capital movements, a serious commitment to an exchange-rate peg
means that the emerging-market country has in e¤ect adopted the monetary policy
of the anchor country. As long as the commitment to the peg is credible, the interest
rate in the emerging-market country will be equal to that in the anchor country. Ex-
pansion of the money supply to obtain lower interest rates in the emerging-market
country relative to that of the low-inﬂation country will result only in a capital out-
ﬂow and loss of international reserves that will cause a subsequent contraction in the
money supply, leaving both the money supply and interest rates at their original
levels. Thus, another way of seeing why the nominal anchor of an exchange-ratepeg lowers inﬂation expectations and thus keeps inﬂation under control in an
emerging-market country is that the exchange-rate peg helps the emerging-market
country inherit the credibility of the low-inﬂation, anchor country’s monetary policy.
A further beneﬁt of having an exchange-rate peg as a nominal anchor in an
emerging-market country is that it helps provide a discipline on policymaking that
avoids the so-called time-inconsistency problem described by Kydland and Prescott
1977, Calvo 1978 and Barro and Gordon 1983. The time-inconsistency problem
arises because there are incentives for a policymaker to pursue discretionary policy
to achieve short-run objectives, such as higher growth and employment, even thoughthe result is a poor long-run outcome—high inﬂation. The time-inconsistency prob-
lem can be avoided if policy is bound by a rule that prevents policymakers from pur-
suing discretionary policy to achieve short-run objectives. Indeed, this is what an
exchange-rate peg can do if the commitment to it is strong enough. In this case, the
exchange-rate peg eliminates discretionary monetary policy and implies an automatic
policy rule that forces a tightening of monetary policy when there is a tendency for
the domestic currency to depreciate or a loosening of policy when there is a tendency
for the domestic currency to appreciate.
As McCallum 1995 has pointed out, simply by recognizing the problem that
forward-looking expectations in the wage- and price-setting process creates for a
strategy of pursuing expansionary monetary policy, central banks can decide not topursue expansionary policy which leads to inﬂation. However, even if the central
bank recognizes the problem, there will still be political pressure on the central bank
to pursue overly expansionary monetary policy that can lead to this outcome, so that446 Chapter 17

the time-inconsistency problem remains. The simplicity and clarity of an exchange-
rate peg can help to reduce pressures on the central bank from the political process
because the exchange-rate peg is easily understood by the public, providing ‘‘mainte-
nance of a sound currency’’ as an easy-to-understand rallying cry for the central
bank. Thus, an exchange-rate peg can help the monetary authorities to resist any po-
litical pressures to engage in time-inconsistent policies.
With all the above advantages, it is not surprising that many emerging-market
countries have adopted an exchange-rate peg as a strategy for controlling inﬂation. 3
However, as discussed in sections 17.3 and 17.4, the dangers inherent in pursuing an
exchange-rate peg make it an unwise course for most emerging-market countries.
17.3 General Criticisms of Exchange-Rate Pegging
There are several criticisms levelled against exchange-rate pegging in both developed
and emerging-market countries. 4These include the loss of an independent monetary
policy, the transmission of shocks from the anchor country, the likelihood of specu-
lative attacks and the potential for weakening the accountability of policymakers topursue anti-inﬂationary policies. These criticisms are analysed in this section. How-
ever, there is an additional criticism of exchange-rate pegs in emerging-market coun-
tries that does not apply to developed countries: the potential for an exchange-rate
peg to increase ﬁnancial fragility and the likelihood of a ﬁnancial crisis (as discussed
in the following section 17.4).
17.3.1 Loss of Independent Monetary Policy
One prominent criticism of adopting an exchange-rate peg to control inﬂation is thatit results in the loss of an independent monetary policy for the pegging country. Withopen capital markets, interest rates in the country pegging its exchange rate are
closely linked to those of the anchor country it is tied to, and its money creation is
constrained by money growth in the anchor country. A country that has pegged its
currency therefore loses the ability to use monetary policy to respond to domestic
shocks that are independent of those hitting the anchor country. For example, if
there is a decline in domestic demand speciﬁc to the pegging country, perhaps be-
cause of a decline in the domestic government’s spending or a decline in the demand
for exports speciﬁc to that country, monetary policy cannot respond by lowering in-
terest rates because these are tied to those of the anchor country. The result is that
output and even inﬂation may fall below desirable levels, with the monetary author-
ities powerless to stop these movements.
This criticism of exchange-rate pegging may be less relevant for emerging-market
countries than for developed countries. Because many emerging-market countries
have not developed the political or monetary institutions which result in the abilityThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 447

to use discretionary monetary policy successfully, they may have little to gain from
an independent monetary policy but a lot to lose. Therefore, they would be better
o¤ by, in e¤ect, adopting the monetary policy of a country such as the United States
through exchange-rate pegging than in pursuing their own independent policy.
17.3.2 Transmission of Shocks from the Anchor Country
Another criticism of exchange-rate pegging is that shocks in the anchor country will
be more easily transmitted to the pegging country, with possible negative conse-
quences. For example, in 1994 concerns about inﬂationary pressure in the United
States led the Federal Reserve to implement a series of increases in the federal funds
rate. Although this policy was appropriate and highly successful for the United
States, the consequences for Mexico, which had adopted a peg to the dollar as part
of its stabilization strategy, were severe. The doubling in short-term US rates from
around 3% to 6% was transmitted immediately to Mexico, which found its short-
term rates doubling to around 20%. This rise in rates was damaging to the balance
sheets of households, non-ﬁnancial business and banks, and was a factor in provok-
ing the foreign exchange and ﬁnancial crisis in Mexico which began in December1994 (see Mishkin 1996).
17.3.3 Speculative Attacks
A further criticism of exchange-rate pegging is that, as emphasized in Obstfeld andRogo¤ 1995, it leaves countries open to speculative attacks on their currencies. As
seen in Europe in 1992, Mexico in 1994 and more recently in south-east Asia, it is
certainly feasible for governments to maintain exchange-rate pegs by raising interest
rates sharply, but they do not always have the will to do so. Defending the exchange
rate by raising interest rates can be very costly because it involves having to toleratethe resulting rise in unemployment and damage to the balance sheets of ﬁnancial
institutions. Once speculators begin to question whether the government’s commit-
ment to the exchange-rate peg is strong, because of the increased costs of maintaining
it, they are in e¤ect presented with a one-way bet, where the value of the currency
can only go down. Defence of the currency then requires massive intervention and
even higher domestic interest rates.
With all but the strongest commitment to the exchange-rate peg, a government
will be forced to devalue its currency. The attempted defence of the currency will
not come cheaply because of the losses sustained as a result of the previous
exchange-rate intervention. For example, in the September 1992 European crisis,
the British, French, Italian, Spanish and Swedish central banks had intervened to thetune of an estimated $100 billion. Press reports estimated that these central banks
lost between $4 billion and $6 billion as a result of their exchange-rate intervention
in the crisis, a sum in e¤ect paid by taxpayers in these countries. Although the losses448 Chapter 17

su¤ered by central banks in emerging-market countries after an unsuccessful defence
of the currency are harder to estimate, they are likely to be very substantial.
17.3.4 Weakened Accountability
In the United States, the long-term bond market provides signals that make overlyexpansionary monetary policy less likely. If the Federal Reserve pursues such a pol-icy, or if politicians put a lot of pressure on it to do so, the bond market is likely to
undergo an inﬂation scare of the type described in Goodfriend 1993, in which long-
term bond prices sink dramatically and long-term rates spike upwards. Concerns
about inﬂation scares in the long-term bond market help to keep the Federal Reserve
from pursuing expansionary policy to meet short-term employment objectives, which
reduces the time-inconsistency problem. Thus, the signals from the long-bond market
make the Federal Reserve more accountable for keeping inﬂation under control.
Similarly, politicians are more reluctant to criticize the Federal Reserve’s anti-
inﬂation actions because of their fears of what the long-bond market’s reaction will
be. The long-bond market thus not only produces signals which help to diminish the
time-inconsistency problem by making the central bank more accountable, but alsoby reducing political pressure for overly expansionary monetary policy to increase
employment in the short-term.
In many countries, particularly emerging-market countries, the long-term bond
market is essentially non-existent. In these countries, however, the foreign ex-
change market can play a similar role to the long-bond market in constraining policy
from being too expansionary. In the absence of an exchange-rate peg, daily ﬂuctua-
tions in the exchange rate provide information on the stance of monetary policy, thus
making monetary policymakers more accountable. A depreciation of the exchange
rate can provide an early warning signal to the public and policymakers that mone-tary policy is overly expansionary. Furthermore, just as the fear of a visible inﬂation
scare in the bond market that causes bond prices to decline sharply constrains politi-
cians from encouraging overly expansionary monetary policy, fear of immediate ex-
change rate depreciations can constrain politicians in countries without long-term
bond markets from supporting overly expansionary policies.
An important disadvantage of an exchange-rate peg is that it removes the signal
that the foreign exchange market provides on a daily basis about the stance of mon-
etary policy. Under a pegged exchange-rate regime, central banks often pursue overly
expansionary policies that are not discovered until too late, until after a successful
speculative attack has begun. The problem of lack of central bank accountability
under a pegged exchange-rate regime is particularly acute in emerging-marketcountries, where the balance sheets of the central banks are not as transparent as in
developed countries, making it harder to ascertain the central bank’s policy actions.
Although an exchange-rate peg appears to provide rules for central bank behaviourThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 449

that eliminates the time-inconsistency problem, it can increase the problem by mak-
ing central bank actions less transparent and less accountable.
17.4 Why Exchange-Rate Pegging Is So Dangerous for Emerging-Market Countries
The potential dangers from an exchange-rate peg described above apply to bothdeveloped and emerging-market countries and are indeed serious ones. On these
grounds alone, using an exchange-rate peg to control inﬂation is problematic. How-
ever, there is an additional danger that arises for emerging-market countries from an
exchange-rate peg—one that does not apply to developed countries: the potential to
promote ﬁnancial fragility and even a fully ﬂedged ﬁnancial crisis. Indeed, this addi-
tional danger is so severe that it argues against an exchange-rate peg except in very
rare circumstances.
The credit markets of emerging-market countries have a very di¤erent institutional
structure than those of developed countries. Industrialized countries typically have
long-duration debt, almost all of which is denominated in the domestic currency,
and also have a fair degree of credibility that they will not allow inﬂation to spinout of control. The institutional features of credit markets in emerging-market coun-
tries are diametrically opposite. Because of past experience with high and variable
inﬂation rates, these countries have little inﬂation-ﬁghting credibility and debt con-
tracts are therefore of very short duration and are often denominated in foreign
currencies. The structure of debt markets in emerging-market countries means that
exchange-rate pegs can make it more likely that they will experience ﬁnancial crises,
with disastrous e¤ects for their economies.
To see why exchange-rate pegs in emerging-market countries make a ﬁnancial
crisis more likely, we must ﬁrst understand what a ﬁnancial crisis is and why it is sodamaging to the economy. In recent years, an asymmetric information theory of ﬁ-
nancial crises has been developed which provides a deﬁnition of a ﬁnancial crisis. 5A
ﬁnancial crisis is a non-linear disruption to ﬁnancial markets in which asymmetric in-
formation problems (adverse selection and moral hazard) become much worse, so
that ﬁnancial markets are unable e‰ciently to channel funds to the economic agents
with the most productive investment opportunities. A ﬁnancial crisis thus prevents
the e‰cient functioning of ﬁnancial markets, which therefore leads to a sharp con-
traction in economic activity.
With a pegged exchange-rate regime, depreciation of the currency is a highly non-
linear event because it involves a devaluation. In most developed countries a devalu-
ation has little direct e¤ect on the balance sheets of households, ﬁrms and banksbecause their debts are denominated in domestic currency. 6This is not true in
emerging-market countries, because of their very di¤erent institutional structure.
In these countries, but not in developed countries, a foreign-exchange crisis can trig-450 Chapter 17

ger a full-scale ﬁnancial crisis in which ﬁnancial markets are no longer able to move
funds to those with productive investment opportunities, thereby causing a severe
economic contraction.
There are three reasons why exchange-rate pegs make emerging-market countries
more prone to ﬁnancial crises. First, a devaluation under an exchange-rate peg can
cause a non-linear deterioration in the balance sheets of non-ﬁnancial and ﬁnancialﬁrms that can cause a collapse in the ability of ﬁnancial markets to move funds
to ﬁrms with productive investment opportunities. Second, when an exchange-rate
peg breaks down, this can lead to a sharp surge in inﬂation that causes a further
weakening of balance sheets, with the negative e¤ects described above. Third, an
exchange-rate peg may encourage capital inﬂows, which lead to a lending boom,
bad loans, and a deterioration in banks’ balance sheets which interferes with the
ability of ﬁnancial institutions to intermediate funds to those with productive invest-
ment opportunities. Each of these factors is examined in more detail below.
With debt contracts denominated in foreign currency, as in emerging-market coun-
tries, the debt burden of domestic ﬁrms increases when there is a depreciation or de-
valuation of the domestic currency. On the other hand, because assets are typicallydenominated in domestic currency, there is no simultaneous increase in the value of
ﬁrms’ assets. The result is that a depreciation or devaluation leads to a deteriora-
tion in ﬁrms’ balance sheets and a decline in net worth, which, in turn, means that
e¤ective collateral has shrunk, thereby providing less protection to lenders. Further-
more, the decline in net worth increases moral hazard incentives for ﬁrms to take on
greater risk because they have less to lose if the loans go sour. Because lenders are
now subject to much higher risks of losses, there is a decline in lending and hence a
decline in investment and economic activity.
Although depreciation in an emerging-market country under a ﬂoating exchange-
rate regime does promote ﬁnancial fragility for the reasons discussed above, it is less
likely to cause a fully ﬂedged ﬁnancial crisis in which ﬁnancial markets seize up and
stop performing their role of moving funds to those with productive investment
opportunities. Under a pegged exchange-rate regime, when a successful speculative
attack occurs the decline in the value of the domestic currency is usually much larger,
more rapid and more unanticipated than when a depreciation occurs under a ﬂoating
exchange-rate regime. For example, during the Mexican crisis of 1994–95, the value
of the peso halved within a few months, and in the recent south-east Asian crisis, the
worst-hit country, Indonesia, has seen its currency decline to a quarter of its pre-crisis
value, also within a very short period. The damage to balance sheets after these
devaluations has thus been extremely severe. In Mexico, there was a several-fold in-crease in the net debtor position of business enterprises between December 1994 and
March 1995, while in Indonesia the four-fold increase in the value of foreign debt
arising from the currency collapse has made it very di‰cult for Indonesian ﬁrmsThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 451

with appreciable foreign debt to remain solvent. The results of these collapses in bal-
ance sheets were sharp economic contractions. In Mexico, real GDP growth in the
second and third quarters of 1995 fell to rates of around /C010%, while current fore-
casts predict similar rates of decline for Indonesia over the coming year.
In addition, the depreciation of the domestic currency can lead to deterioration in
banking-sector balance sheets. In emerging-market countries, banks typically havemany short-term liabilities denominated in foreign currency which increase sharply
in value when a depreciation occurs. However, ﬁrms and households are unable to
pay o¤ their debts, resulting in loan losses on the assets side of the banks’ balance
sheets. In the aftermath of the foreign-exchange crises, the share of non-performing
loans to total loans in Mexico rose to above 15%, while the proportion has risen to
between 15% and 35% in Thailand, Malaysia, South Korea and Indonesia. 7Once
there is a deterioration in bank balance sheets, with the substantial loss of bank
capital, banks have two choices: to cut back on lending in order to shrink their asset
bases and thereby restore their capital ratios, or to try to raise new capital. However,
when banks experience a deterioration in their balance sheets, it is very hard for them
to raise new capital at a reasonable cost. The typical response of banks with weak-ened balance sheets is hence a contraction in their lending, which slows economic
activity. In the extreme case in which the deterioration of bank balance sheets leads
to a banking crisis which forces many banks to close, thereby directly limiting the
ability of the banking sector to make loans, the e¤ect on the economy is even more
severe. The non-linear nature of the decline in the value of the domestic currency
when an exchange-rate peg collapses means that the possibility of an especially sharp
deterioration in bank balance sheets is greater under an exchange-rate peg than a
ﬂoating exchange-rate regime. Thus the potential for a collapse of the banking sys-
tem is greater when an emerging-market country adopts an exchange-rate peg.
An additional danger from using an exchange-rate peg to control inﬂation in
emerging-market countries is that a successful speculative attack can lead to a rapid
surge in inﬂation that can be especially damaging to the ability of ﬁnancial markets
to move funds to those with productive investment opportunities. Because many
emerging-market countries have previously experienced both high and variable in-
ﬂation, their central banks are unlikely to have deep-rooted credibility as inﬂation
ﬁghters. A sharp decline in the value of the currency after a speculative attack that
leads to immediate upward pressure on prices can therefore lead to a dramatic rise
in both actual and expected inﬂation. Mexican inﬂation surged to 50% in 1995 after
the foreign-exchange crisis of 1994; current forecasts for Indonesia predict that the
same will happen there.
The sharp rise in expected inﬂation after a successful speculative attack against the
currency of an emerging-market country leads to particularly sharp rises in interest
rates, exacerbating the ﬁnancial crisis, as has occurred in Mexico and Indonesia.452 Chapter 17

The interaction of the short duration of debt contracts and the interest-rate rise leads
to huge increases in interest payments by ﬁrms, thereby weakening their cash-ﬂow
positions and their balance sheets. As a result, both lending and economic activity
are likely to undergo a sharp decline.
Another potential danger from an exchange-rate peg is that by providing a more
stable value of the currency, it might reduce risk for foreign investors and thus en-courage capital inﬂows. 8Although these inﬂows might be channelled into productive
investments and thus stimulate growth, they might promote excessive lending, mani-
fested by a lending boom, because domestic ﬁnancial intermediaries such as banks
play a key role in intermediating these capital inﬂows. 9Indeed, Folkerts-Landau
et al. (1995) found that emerging-market countries in the Asia-Paciﬁc region which
had large net private capital inﬂows also experienced large increases in their banking
sectors. Furthermore, if the bank supervisory process is weak, as it often is in
emerging-market countries, so that the government safety net for banking institu-
tions creates incentives for them to take on risk, there is a greater likelihood that a
capital inﬂow will produce a lending boom. With inadequate bank supervision, the
likely outcome of a lending boom is substantial loan losses and a deterioration ofbank balance sheets. 10
The deterioration in bank balance sheets can damage the economy in two ways.
First, the deterioration in the balance sheets of banking ﬁrms leads them to restrict
their lending in order to improve their capital ratios or can even lead to a full-scale
banking crisis which forces many banks into insolvency, thereby directly removing
the ability of the banking sector to make loans. Second, the deterioration in bank
balance sheets can promote a foreign-exchange crisis because it becomes very di‰cult
for the central bank to defend its currency against a speculative attack. Any rise in
interest rates to keep the domestic currency from depreciating has the additional ef-fect of weakening the banking system further because the rise in interest rates hurts
banks’ balance sheets. This negative e¤ect of a rise in interest rates on banks’ balance
sheets occurs because of their maturity mismatch and their exposure to increased
credit risk when the economy deteriorates. Thus, when a speculative attack on the
currency occurs in an emerging-market country, the banking system may collapse
if the central bank raises interest rates su‰ciently to defend the currency. Once
investors recognize that a country’s weak banking system makes it less likely that
the central bank will take the steps required successfully to defend the domestic cur-
rency, they have even greater incentives to attack the currency because expected prof-
its from selling it have now risen. The outcome is a successful attack on the currency,
and the resulting foreign-exchange crisis causes a collapse of the economy for the rea-sons already discussed.
The scenarios seen recently in emerging-market countries such as Mexico, Thai-
land, South Korea, Malaysia and Indonesia illustrate how dangerous exchange-rateThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 453

pegs can be. These countries experienced massive capital inﬂows which were interme-
diated by the banking sector, and the resulting lending booms led to large loan losses
and a deterioration in bank balance sheets, which helped to promote the subsequent
foreign-exchange crises. The collapse of domestic currencies then led to a huge num-
ber of insolvencies and sharp rises in inﬂation and interest rates which caused further
deteriorations in balance sheets. The outcome has been severe depressions in all thesecountries, which have engendered substantial social unrest. Their experience suggests
that using an exchange-rate peg to control inﬂation is highly problematic.
17.5 When Might the Benefits of an Exchange-Rate Peg Outweigh the Costs for an
Emerging-Market Country?
So far the discussion on exchange-rate pegging in emerging-market countries has
been su‰ciently negative that one might conclude that it should never be adopted
as a strategy to control inﬂation. However, this view is too strong. Exchange-rate
pegging can be an especially e¤ective means of reducing inﬂation quickly if there is
a very strong commitment to the exchange-rate peg. In the extreme situation wherethere appears to be no alternative way to break inﬂationary psychology, it is an op-
tion that might be considered, although even then it is a dangerous course.
A particularly strong form of commitment mechanism to a pegged exchange rate
is a currency board. A currency board requires that the note-issuing authority,
whether the central bank or the government, announce a ﬁxed exchange rate against
a particular foreign currency and then stand ready to exchange domestic currency for
foreign currency at that rate whenever the public requests it. In order credibly to
meet these requests, a currency board typically has foreign reserves backing more
than 100% of the domestic currency and allows the monetary authorities absolutelyno discretion. In contrast, the typical ﬁxed or pegged exchange-rate regime does allow
the monetary authorities some discretion in their conduct of monetary policy because
they can still adjust interest rates or conduct open-market operations which a¤ect do-
mestic credit. The currency board thus involves a stronger commitment by the cen-
tral bank to the ﬁxed exchange rate and may therefore be e¤ective in bringing down
inﬂation quickly and in decreasing the likelihood of a successful speculative attack
against the currency.
An important recent example in which a currency board was implemented to
reduce inﬂation is Argentina. Because of continuing bouts of hyperinﬂation and pre-
vious past failures of stabilization programmes, the Argentine government felt that
the only way it could break the back of inﬂation was to adopt a currency board,which it did in 1991 by passing the Convertibility Law. This law required the central
bank to exchange US dollars for new pesos at a ﬁxed exchange rate of 1 to 1. Argen-454 Chapter 17

tina’s currency board appeared strikingly successful in its early years. Inﬂation,
which had been running at an annual rate of over 1,000% in 1989 and 1990, fell to
well under 5% by the end of 1994 and economic growth was rapid, averaging almost
8% per year from 1991 to 1994.
Although the stronger commitment to a ﬁxed exchange rate may mean that a cur-
rency board is better equipped than an exchange-rate peg to stave o¤ a speculativeattack against the domestic currency, it is not without its problems. In the aftermath
of the Mexican peso crisis, concern about the health of the Argentine economy led
the public to withdraw their money from the banks (deposits fell by 18%) and to ex-
change their pesos for dollars, causing a contraction of the Argentine money supply.
The result was a sharp contraction in Argentine economic activity with real GDP
dropping by over 5% in 1995 and the unemployment rate jumping to above 15%.
The economy began to recover only in 1996, with ﬁnancial assistance from interna-
tional agencies such as the IMF, the World Bank and the Inter-American Develop-
ment Bank, which lent Argentina over $5 billion to help shore up its banking system.
Because the central bank of Argentina had no control over monetary policy under
the currency board system, it was relatively helpless to counteract the contractionarye¤ects of the public’s behaviour. Furthermore, because the currency board does not
allow the central bank to create money and lend to the banks, it limits the capability
of the central bank to act as a lender of last resort, and other means must be used to
cope with potential banking crises.
Although a currency board is highly problematic, it may be the only way to break
a country’s inﬂationary psychology and alter the political process so that it no longer
leads to continuing bouts of high inﬂation. However, there are two issues that policy-
makers must confront in order to make a currency board successful. First there is a
need to pay particular attention to preventing excessive risk-taking by the bankingsector. As already noted, weakness of the banking sector because of excessive risk-
taking is an important factor that can help trigger a speculative attack on the cur-
rency. If the currency board does not survive the speculative attack, the resulting
ﬁnancial crisis is likely to be especially severe because a characteristic of debt markets
in countries with a currency board is that they have an especially large amount of
debt denominated in the foreign currency to which the domestic currency is pegged.
Thus a devaluation hits the balance sheets of businesses and banks particularly hard,
with even more damaging e¤ects on the economy. Even if the currency board sur-
vives the speculative attack, the resulting exchange of the domestic currency for
foreign currency leads to a sharp contraction of the money supply, as occurred in Ar-
gentina, which also is highly damaging to the economy.
Furthermore, because a currency board limits a central bank’s ability to engage
in lender-of-last-resort operations, coping with banking crises is very di‰cult. 11The Dangers of Exchange-Rate Pegging in Emerging Market Countries 455

Because problems in the banking sector can be so costly to an economy with a cur-
rency board, it is especially important that policy-makers keep banks from taking on
too much risk which can lead to deterioration in bank balance sheets. Indeed, this
has been recognized by policy-makers in Argentina and is an important reason why
they have been among the most committed in Latin America to developing a system
of bank regulation and supervision that will preserve the health and soundness of thebanking sector. 12
The second issue that policy-makers contemplating institution of a currency board
must confront is the need for an exit strategy. The longer a currency board stays in
existence, the greater the likelihood that there will occur a su‰ciently large shock
that leads to its collapse. Furthermore, once inﬂation is under control, a country
with a currency board is subject to three disadvantages: being strongly a¤ected by
shocks to the country to whose currency it is pegged; not having its own independent
monetary policy; and not having the ability to engage in lender-of-last-resort opera-
tions. Thus, even if the currency board is successful, at some point it may outlive its
usefulness. The key question for policy-makers is how it can exit from the currency
board arrangement.
Clearly, exiting a currency board when the currency is under attack is not an op-
tion, because in this situation the collapse of the currency board would lead to a ﬁ-
nancial crisis and an explosion in inﬂation. On the other hand, when there is no
pressure on the currency, there is no threat to the currency board, and so the usual
attitude is ‘‘if it ain’t broke, don’t ﬁx it.’’ Exiting a currency board is thus not a trivial
task. It is exactly when things are going well that smooth transition out of the cur-
rency board is feasible. On the other hand, this is when the political will to exit
from the currency board may be weakest, even if the country would be better served
by a di¤erent monetary regime.
The discussion in this section provides a qualiﬁed answer to the question of when
an exchange-rate peg might be a worthwhile option for an emerging-market country.
Under extreme circumstances in which past poor inﬂation performance suggests that
there is no other way to alter inﬂationary psychology, pegging the exchange rate has
advantages, although it also presents substantial dangers. However, because the costs
of being driven o¤ the exchange-rate peg by a successful speculative attack are so
high, if this option is chosen a very strong commitment mechanism to the exchange-
rate peg, such as a currency board, is absolutely necessary. Compromises such as an
exchange-rate peg with the option for discretionary monetary policy are likely to be
doomed to failure and to be severely damaging to the economy. If a currency board
is chosen, it is also crucial that policymakers focus on developing a system of bankregulation and supervision that preserves the soundness of the ﬁnancial system and
also prepare for an exit strategy once the currency board has outlived its usefulness.456 Chapter 17

17.6 Alternative Strategies for Inflation Control
So far this chapter has argued that an exchange-rate peg is a dangerous strategy for
inﬂation control in emerging-market countries. If exchange-rate pegging is not an
option, what other strategies can be used by emerging-market countries to control
inﬂation?
A basic strategy for inﬂation control in emerging-market countries requires two
primary components. First, the central bank needs to be given su‰cient indepen-
dence to pursue long-run objectives such as price stability. Politicians in both indus-
trialized and emerging-market countries are likely to be short-sighted because they
are driven by the need to win their next election. With their focus on the coming elec-
tion, they are unlikely to focus on long-term objectives, such as promoting a stable
price level. Instead, they will tend to seek short-term objectives, such as low unem-
ployment and low interest rates, even if these objectives may have undesirable long-term consequences. If the central bank is controlled by the government, it is likely to
accede to these political demands, resulting in high inﬂation and low credibility for
the central bank. Only with the granting of independence can the central bank be
su‰ciently insulated from short-term political pressures that it can focus on the
long-run goal of inﬂation control. Recent evidence seems to support the hypothesis
that macroeconomic performance is improved when central banks are more indepen-
dent. When central banks are ranked from least legally independent to most legally
independent, the inﬂation performance is found to be the best for countries with the
most independent central banks. 13
The second component of a successful strategy for inﬂation control in emerging-
market countries is an explicit nominal anchor. As discussed earlier, an explicit nom-
inal anchor helps to establish credibility for monetary policy and to ﬁx inﬂation
expectations, while it also helps to avoid the time-inconsistency problem. It is true
that industrialized countries have often been able to conduct successful monetary
policy without an explicit nominal anchor, but it is far more crucial to have one in
emerging-market countries which have typically had high and variable inﬂation rates
in the past and therefore su¤er from a lack of monetary policy credibility. 14
There are two basic alternatives to an exchange-rate peg for an explicit nominal
anchor: monetary targets and inﬂation targets. Although monetary targets have
been used successfully in some countries, particularly Germany, they may not be ase¤ective in the emerging-market country context. Because of velocity shocks, the re-
lationship between monetary aggregates and inﬂation has not been very tight, even in
Germany. 15Hitting the monetary target will not always produce the desired inﬂation
outcome and may not be a su‰ciently good signal about the appropriate stance of
monetary policy. Because of instabilities in the money-inﬂation relationship, noThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 457

monetary targeter has strictly adhered to its targets: even the Germans miss their
monetary target range about half of the time. This is not a serious problem in the
German context because of the high credibility of the German central bank, which
is able to explain the deviations from the target without losing the public’s belief in
its commitment to price stability. Because the credibility of central banks in emerging
market countries is so much lower than that of the Bundesbank, this strategy is un-likely to be as successful in these countries.
The other alternative nominal anchor for emerging-market countries is an inﬂation
target. Inﬂation targeting not only involves the public announcement of medium-
term numerical targets for inﬂation, with an institutional commitment by the mone-
tary authorities to achieve these targets, but also includes increased communication
with the public and the markets about the plans and objectives of monetary policy-
makers and increased accountability of the central bank for obtaining its inﬂation
objectives. 16As outlined in Bernanke and Mishkin 1997, Mishkin and Posen 1997,
Mishkin 1998 and Bernanke, Laubach, Mishkin and Posen 1998 the primary advan-
tage of inﬂation targeting is its transparency to the public. Like an exchange-rate
peg, it is readily understood by the public, but, even more directly than other meth-ods, it makes clear the commitment to price stability. Inﬂation targeting keeps the
goal of price stability in the public’s eye, thus making the central bank more account-
able for keeping inﬂation low, which helps to counter the time-inconsistency problem.
In contrast to the exchange-rate target, inﬂation targets enable monetary policy to
focus on domestic considerations and to respond to shocks to the economy. Finally,
inﬂation targets have the advantage that velocity shocks are largely irrelevant be-
cause the monetary-policy strategy no longer requires a stable money–inﬂation
relationship. Indeed, an inﬂation target allows the monetary authorities to use all
available information, and not just one variable, to determine the best settings formonetary policy.
One criticism of inﬂation targets is that, in contrast to exchange rates and mone-
tary aggregates, inﬂation is not easily controlled by the monetary authorities. This
can be a particularly severe problem for an emerging-market country that is trying
to bring down inﬂation from a high level and so is more likely to experience large
inﬂation-forecast errors. This suggests that hard targets for inﬂation might be worth
phasing in only after there has been some successful disinﬂation. This is exactly the
strategy that has been followed by Chile (see Morande and Schmidt-Hebbel 1997),
which adopted inﬂation targeting in September 1990. Initially, inﬂation targets were
announced and interpreted as o‰cial inﬂation projections, rather than as hard tar-
gets. However, over time as inﬂation fell, inﬂation targets came to be viewed by thecentral bank and the markets as hard targets. Waiting to harden inﬂation targets
until after some success has already been achieved on the inﬂation front is also
consistent with what inﬂation-targeting industrialized countries have done; they did458 Chapter 17

not institute inﬂation targeting until after substantial disinﬂation had already been
achieved. 17
Another criticism of inﬂation targets is that a sole focus on inﬂation may lead to
large adverse e¤ects on output. Although this could be a problem if the inﬂation tar-
geting implied that monetary authorities must try to reduce inﬂation very rapidly
without concern for output ﬂuctuations, this is not the way inﬂation targeting hasbeen conducted in practice in the industrialized countries. All inﬂation-targeting cen-
tral banks have left themselves considerable scope to respond to output growth and
ﬂuctuations. When inﬂation starts at a level that is higher than the long-run inﬂation
goal, inﬂation targets have been lowered gradually. This feature of inﬂation targeting
is also characteristic of the Chilean case, in which inﬂation targets were lowered
gradually from an annual rate of around 25% when they were instituted in 1991 to
around 5% today.
Furthermore, inﬂation targeting can actually help to minimize output ﬂuctuations.
This is because inﬂation targeting provides not only a ceiling for the inﬂation rate,
but also a ﬂoor. Inﬂation targeting can therefore act to attenuate the e¤ects of nega-
tive, as well as positive, shocks to aggregate demand. Indeed, this beneﬁt of inﬂationtargeting has been emphasized by the Canadian monetary authorities.
17.7 Conclusions
Although pegging the exchange rate provides a nominal anchor for emerging-market
countries that can help them to control inﬂation, the analysis in this chapter does not
provide support for this strategy for the conduct of monetary policy. First, there are
the usual criticisms of exchange-rate pegging; that it entails the loss of an indepen-
dent monetary policy, exposes the country to the transmission of shocks from the an-chor country, increases the likelihood of speculative attacks and potentially weakens
the accountability of policymakers to pursue anti-inﬂationary policies. However,
most damaging to the case for exchange-rate pegging in emerging-market countries
is that it can increase ﬁnancial fragility and heighten the potential for ﬁnancial crises.
Because of the devastating e¤ects on the economy that ﬁnancial crises can bring, an
exchange-rate peg is a very dangerous strategy for controlling inﬂation in emerging-
market countries. Instead, this chapter suggests that a strategy with a greater likeli-
hood of success involves the granting of independence to the central bank and the
adoption of inﬂation targeting.
Acknowledgments
I thank Adam Posen, Robert Hodrick, an anonymous referee and participants inthe macro lunch at Columbia University for their helpful comments. Any viewsThe Dangers of Exchange-Rate Pegging in Emerging Market Countries 459

expressed in this chapter are those of the author only and not those of Columbia
University or the National Bureau of Economic Research.
Notes
1. See, for example, Anderson and Gruen 1995, Briault 1995, Bruno 1991, Feldstein 1997, Fischer 1993,
1994 and Sarel 1996.
2. In some cases, this strategy involves pegging the exchange rate at a ﬁxed value to that of the other coun-
try so that its inﬂation rate will eventually gravitate to that of the other country, while in other cases itinvolves a crawling peg or target in which its currency is allowed to depreciate at a steady rate so that itsinﬂation rate can be slightly higher than that of the other country.
3. Another potential advantage of an exchange-rate peg is that by providing a more stable value of the
currency, it might lower risk for foreign investors and thus encourage capital inﬂows which could stimulategrowth. However, as discussed in section 17.4, capital inﬂows may be highly problematic for an emerging-
market country because they may help encourage a lending boom which eventually weakens the banking
sector and helps to stimulate a ﬁnancial crisis.
4. An excellent additional discussion of these criticisms is contained in Obstfeld and Rogo¤ 1995.
5. See Bernanke 1983, Calomiris and Gorton 1991 and Mishkin 1991, 1994 and 1996.
6. Indeed, a devaluation in developed countries can actually stimulate economic activity because it makes
the country’s goods more competitive internationally, thereby increasing its net exports and hence aggre-
gate demand. This was the experience of the United Kingdom when it was forced to devalue its currencyafter the September 1992 foreign-exchange crisis. Its economic performance after the devaluation was sub-stantially better than that of France, which successfully defended its currency in 1992.
7. See Mishkin 1996 and Goldstein 1998.8. Capital inﬂows are not only encouraged by exchange-rate pegs but also by convertibility—the right of
domestic citizens to convert currencies into one another without restrictions. Capital controls can enable acountry to maintain an exchange-rate peg while restricting capital inﬂows and outﬂows. It is far beyondthis chapter to debate the desirability of capital controls, though it should be noted that there are seriousdoubts as to whether these can be e¤ective in today’s ﬁnancial environment, with many ﬁnancial instru-ments that make it easier to circumvent these controls. Furthermore, capital controls may block entry to
funds which will be used for productive investment opportunities. Elsewhere, Mishkin 1997b, I have
argued that there is a strong case to improve bank regulation and supervision so that capital inﬂows areless likely to lead to a lending boom and excessive risk-taking by banking institutions. This may be themore appropriate way to make sure that capital inﬂows do not lead to excessive risk-taking, rather thanrestricting convertibility through capital controls.
9. See Calvo, Leiderman and Reinhart 1994.10. Gavin and Hausman 1996 and Kaminsky and Reinhart 1996 ﬁnd that lending booms are a predictor of
banking crises, yet it is less clear that capital inﬂows will produce a lending boom which causes a deteriora-tion in bank balance sheets. Kaminsky and Reinhart 1996, for example, ﬁnd that ﬁnancial liberalization,rather than balance-of-payments developments, appears to be a more important predictor of banking crises.
11. However, as pointed out in Mishkin 1996, the ability to successfully engage in lender-of-last-resort
operations to cope with ﬁnancial crises is limited in emerging-market countries, even if they do not have a
currency board. This is because pumping liquidity into the system is likely to lead to a rise in inﬂationexpectations and a depreciation of the currency, causing a further deterioration in balance sheets, andthus making informational problems worse in ﬁnancial markets.
12. For a description of the Argentine bank regulatory system, see Banco Central de la Republica Argen-
tina 1997 and Calomiris 1997.
13. See Alesina and Summers 1988, Cukierman 1992 and Fischer 1994 among others. However, there is
some question as to whether causality runs from central bank independence to low inﬂation or whether athird factor is involved, such as the general public’s preferences for low inﬂation, that creates both centralbank independence and low inﬂation (see Posen 1995).460 Chapter 17

14. Even in industrialized countries, there is a strong case for an explicit nominal anchor such as inﬂation
target (see Mishkin 1997a).
15. See Estrella and Mishkin 1997, for example.
16. Other detailed analyses of experiences with inﬂation targeting can be found in Goodhart and Vinals
1994, Leiderman and Svensson 1995, Haldane 1995 and McCallum 1996. A variant of inﬂation targeting
is targeting of nominal GDP growth. As discussed in Mishkin 1997a, although nominal GDP-growth tar-geting is close to inﬂation targeting, it su¤ers from distinct disadvantages.
17. Israel is another high-inﬂation country that, like Chile, has adopted a strategy of inﬂation targeting
only after a successful disinﬂation. See Bufman, Leiderman and Sokoler 1995 and Bernanke, Laubach,Mishkin and Posen 1998. The example of Chile is used in the text because it is hard to classify Israel asan emerging-market country.
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nomic Policy Research.
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nomic Review , 85 (May), 207–11.
——— (1996), ‘‘Inﬂation Targeting in Canada, New Zealand, Sweden, the United Kingdom, and in Gen-
eral,’’ NBER Working Paper, No. 5597 (May).
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R. G. Hubbard, ed., Financial Markets and Financial Crises , 69–108. Chicago: University of Chicago
Press.
——— (1994), ‘‘Preventing Financial Crises: An International Perspective,’’ Manchester School , 62, 1–40.
——— (1996), ‘‘Understanding Financial Crises: A Developing Country Perspective,’’ in Michael Bruno
and Boris Pleskovic, eds, Annual World Bank Conference on Development Economics 1996 , 29–62. Wash-
ington: World Bank.
——— (1997a), ‘‘Strategies for Controlling Inﬂation,’’ in Phillip Lowe, ed., Monetary Policy and Inﬂation
Targeting , 7–38. Sydney: Reserve Bank of Australia.
——— (1997b), ‘‘International Capital Movements, Financial Volatility and Financial Instability,’’ in
Proceedings of the Annual Conference 1997 . German Association of Economic and Social Sciences.
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Morande, Felipe, and Klaus Schmidt-Hebbel (1997), ‘‘Inﬂation Targets and Indexation in Chile,’’ manu-
script, Central Bank of Chile, August.
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pendence,’’ NBER Macroeconomics Annual 1995 , 253–74.
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Fund Sta¤ Papers , 43 (March), 199–215.The Dangers of Exchange-Rate Pegging in Emerging Market Countries 463

18The Mirage of Exchange-Rate Regimes for Emerging Market
Countries
Guillermo A. Calvo and Frederic S. Mishkin
In recent years, a number of emerging market countries have experienced devastating
ﬁnancial crises and macroeconomic turbulence, including Argentina (2001–2002),
Turkey (2000–2001), Ecuador (1999), Russia (1998), east Asia (1997), Mexico
(1994–1995) and even Chile (1982). In the ensuing postmortems, an active debate
has followed over how the choice of exchange rate regime might have contributed
to macroeconomic instability—and conversely, how a shift in exchange rate regime
might have improved macroeconomic performance. Should an emerging marketeconomy prefer a ﬂoating exchange rate, a ﬁxed exchange rate or some blend of the
two, like an exchange rate that was usually ﬁxed but might sometimes shift?
Many countries used to choose an intermediate path: that is, an exchange rate that
was often stabilized by the central bank, but might sometimes shift, often known as a
‘‘soft peg.’’ However, in the aftermath of the macroeconomic crisis across east Asia
in 1997–1998, a view emerged that this exchange rate regime was in part responsible
for the depth of the macroeconomic crisis. The governments of Thailand, Malaysia,
South Korea and other nations in that region had kept exchange rates ﬁxed. There
was no explicit institutional guarantee that the exchange rate would remain ﬁxed,but the rates had been stable for long enough that local ﬁnancial institutions
borrowed in dollars abroad and then loaned freely in U.S. dollars to domestic bor-
rowers. But when a surge of foreign investment stopped, the existing exchange rate
became unsustainable. For example, when the Thai baht collapsed against the U.S.
dollar, Thai borrowers were unable to repay their dollar-denominated loans—and in
turn many Thai ﬁnancial institutions were insolvent. This meltdown of the ﬁnancial
sector led to an enormous economic contraction.
Thus, one often-told lesson of the east Asian experience is that nations must make
a bipolar choice: either choose a framework for credibly guaranteeing a ﬁxed ex-
change rate, known as a ‘‘hard peg,’’ or else accept a freely ﬂoating exchange rate. 1
Yet neither of these extreme exchange rate regimes has an unblemished record,either.

There are two basic ways a government can o¤er a credible guarantee of a ﬁxed
exchange rate: a currency board and full dollarization. In a currency board, the
note-issuing authority, whether the central bank or the government, ﬁxes a conver-
sion rate for this currency vis-a `-vis a foreign currency (say, U.S. dollars) and pro-
vides full convertibility because it stands ready to exchange domestically issued
notes for the foreign currency on demand and has enough international reserves todo so. Full dollarization involves eliminating the domestic currency altogether and
replacing it with a foreign currency like the U.S. dollar, which is why it is referred
to as ‘‘dollarization,’’ although it could instead involve the use of another currency,
like the euro. This commitment is even stronger than a currency board because it
makes it much more di‰cult—though not impossible—for the government to regain
control of monetary policy and/or set a new parity for the (nonexistent) domestic
currency.
Argentina, for example, chose the currency board approach for ensuring a ﬁxed
exchange rate. Indeed, Argentina even recognized that full backing of the monetary
base may not be enough, because that would leave the banking system without a
lender of last resort or a situation where the government might need additionalcredit, so the Argentines also paid for contingent credit lines. From a legal perspec-
tive, the central bank of Argentina was highly independent. But in 2001, large budget
deﬁcits (including contingent government obligations, like supporting state-owned
banks) forced the Argentine government to look for a new source of funds. After
Domingo Cavallo became Minister of the Economy in April 2001, the supposedly
independent central bank president, Pedro Pou, was forced to resign. Soon after,
Argentina’s prudential and regulatory regime for its ﬁnancial sector, which had
been one of the best in the emerging market world, was weakened. Banks were
encouraged and coerced into purchasing Argentine government bonds to fund theﬁscal debt. An attempt was made to reactivate the economy via expansive monetary
policy. With the value of these bonds declining as the likelihood of default on this
debt increased, banks’ net worth plummeted. The likely insolvency of the banks
then led to a classic run on the banks and a full-scale banking crisis by the end of
2001. Because most debt instruments in Argentina were denominated in U.S. dollars,
the depreciation of the Argentinean currency made it impossible for borrowers to
earn enough Argentinean currency to repay their dollar-denominated loans. The Ar-
gentine ﬁnancial sector melted down, and the economy, as well. Argentina’s experi-
ment with its currency board ended up in disaster.
The remaining option of freely ﬂoating exchange rates is also problematic. With-
out further elaboration, ‘‘ﬂoating exchange rate’’ means really nothing other thanthat the regime will allow for some exchange rate ﬂexibility. It rules out a ﬁxed ex-
change rate regime, but nothing else. A country that allows a ﬂoating exchange rate
may pursue a number of very di¤erent monetary policy strategies: for example, tar-466 Chapter 18

geting the money supply, targeting the inﬂation rate or a discretionary approach in
which the nominal anchor is implicit but not explicit (the ‘‘just do it’’ approach,
described in Mishkin, 1999b, 2000, and Bernanke, Laubach, Mishkin and Posen,
1999). But regardless of the choice of monetary regime, in many emerging market
economies, exports, imports and international capital ﬂows are a relatively large
share of the economy, so large swings in the exchange rate can cause very substantialswings in the real economy. Even a central bank that would prefer to let the ex-
change rate ﬂoat must be aware that if the country’s banks have made loans in U.S.
dollars, then a depreciation of the currency versus the dollar can greatly injure the
ﬁnancial system. Under these circumstances, the monetary authority is likely to dis-
play ‘‘fear of ﬂoating’’ (Calvo and Reinhart, 2002), deﬁned as a reluctance to allow
totally free ﬂuctuations in the nominal or real exchange rate, which Mussa (1986)
showed are very closely linked.
Thus, the literature on exchange rate regimes seems to have backed itself into a
corner where none of the available options is without problems. In this chapter, we
argue that much of the debate on choosing an exchange rate regime misses the boat.
We will begin by discussing the standard theory of choice between exchange rateregimes, and then explore the weaknesses in this theory, especially when it is applied
to emerging market economies. We discuss a range of institutional traits that might
predispose a country to favor either ﬁxed or ﬂoating rates and then turn to the
converse question of whether the choice of exchange rate regime may favor the devel-
opment of certain desirable institutional traits. Overall, we believe that the key to
macroeconomic success in emerging market countries is not primarily their choice
of exchange rate regime, but rather the health of the countries’ fundamental macro-
economic institutions, including the institutions associated with ﬁscal stability, ﬁnan-
cial stability and monetary stability. In general, we believe that less attention shouldbe focused on the general question of whether a ﬂoating or a ﬁxed exchange rate is
preferable and more on these deeper institutional arrangements.
18.1 The Standard Theory of Choosing an Exchange Rate Regime
Much of the analysis of choosing an exchange rate regime has taken place using the
theory of optimal exchange rate regimes—and its close relative, the theory of opti-
mal currency areas—which owes much to Mundell (1961) and Poole (1970). Models
of choosing an exchange rate regime typically evaluate such regimes by how e¤ective
they are in reducing the variance of domestic output in an economy with sticky prices.
If an economy faces primarily nominal shocks—that is, shocks that arise from
money supply or demand—then a regime of ﬁxed exchange rates looks attractive. If
a monetary shock causes inﬂation, it will also tend to depreciate a ﬂoating exchange
rate and thus transmit a nominal shock into a real one. In this setting, the ﬁxedThe Mirage of Exchange-Rate Regimes for Emerging Market Countries 467

exchange rate provides a mechanism to accommodate a change in the money de-
mand or supply with less output volatility.
On the other hand, if the shocks are real—like a shock to productivity, or to the
terms of trade (that is, if the relationship between export prices and import prices
shifts due to movements in demand or supply)—then exchange rate ﬂexibility of
some sort becomes appealing. In this case, the economy needs to respond to a changein relative equilibrium prices, like the relative price of tradables with respect to non-
tradables. A shift in the nominal exchange rate o¤ers a speedy way of implementing
such a change and, thus, ameliorating the impact of these shocks on output and em-
ployment (De Grauwe, 1997). On the other hand, if a downturn is driven by real fac-
tors in an economy with a ﬁxed exchange rate, the demand for domestic money falls
and the central bank is forced to absorb excess money supply in exchange for foreign
currency. The result is that (under perfect capital mobility) the decrease in the de-
mand for domestic money leads to an automatic outﬂow of hard currency and a
rise in interest rates. In this case, the hard peg contributes to increasing the depth of
the downturn.
This standard model of choosing an exchange rate regime o¤ers some useful
insights. However, it ultimately fails to address a challenge issued by Mundell him-
self in his original 1961 paper, and many of the underpinnings of the model do not
apply especially well to emerging market economies.
18.1.1 The Mundell Challenge
In Robert Mundell’s (1961) original paper on optimum currency areas, he pointedout that this theory implies that the optimality of ﬁxed exchange rates within a given
country cannot be taken for granted. Why should Texas and New York in the United
States, or Tucuman and Buenos Aires in Argentina, share the same currency? Theseregions are hit by di¤erent real shocks and would, according to the standard theory,
beneﬁt by the extra degree of freedom provided by having their own currencies and
allow them to ﬂoat against each other. We will call this deep observation the ‘‘Mun-
dell challenge.’’
The usual response to the Mundell challenge is that a country has internal mecha-
nisms that can substitute for regional exchange rate variability, including labor
mobility between regions and compensatory ﬁscal transfers from the central govern-
ment. However, these arguments are only partially persuasive. Fiscal transfers, in
contrast to currency devaluation, do not change relative prices. Moreover, labor
mobility is a poor substitute for exchange rate ﬂexibility. Imagine the social costs of
having to ship people from Texas to New York, when a simple movement in theexchange rate would have restored equilibrium.
Indeed, the Mundell challenge cuts even more deeply. After all, why should ex-
change rate ﬂexibility be limited to large regions like New York or Texas? Why not468 Chapter 18

have di¤ering exchange rates between cities or neighborhoods? Indeed, why not move
to a world of complete contingent contracts, with no money at all, and thus in e¤ect
have a di¤erent ﬂexible exchange rate for every transaction? Of course, no one has
pushed the theory to this implausible extreme. However, notpushing the theory in
this way implies acknowledging the existence of other factors that are key and, actu-
ally, that dominate the factors emphasized by the theory of exchange rate regimes.
An important set of such factors relate to the observation that modern economies
have not yet been able to function without some kind of money. The fundamental
functions of money are to reduce transactions costs and to address liquidity concerns,
functions that are especially valuable in a world with seriously incomplete state-
contingent markets. A common currency is a useful coordinating mechanism within
a national economy, even if it can sometimes go awry. Similarly, a ﬁxed exchange
rate may be a useful mechanism for an economy, even if that country faces di¤eren-
tial real shocks, because the gains from reducing transactions costs and providing li-
quidity are great enough. Thus, in choosing an exchange rate regime, it is not enough
to analyze the nature of the shocks. The potential beneﬁts from ﬁxed exchange rates
must be taken into accounts, too.
18.1.2 The Realities of Emerging Market Economies
The standard framework for choosing an exchange rate regime is based on a number
of implicit assumptions that do not apply well to many emerging economies. The
standard theory presumes an ability to set up institutions that will assure a ﬁxed ex-
change rate, but after the experience of Argentina, this assumption of an institutional
guarantee seems improbable. The standard theory assumes that a time-consistent
choice is made on the exchange rate regime, when in many countries the exchange
rate regime may frequently shift. In the standard model of exchange rate choices,the focus is on adjustments in goods and labor markets and the ﬁnancial sector is
thoroughly ignored. However, no recent macroeconomic crisis in an emerging mar-
ket has been free from ﬁnancial turmoil of one form or another. Finally, as men-
tioned a moment ago, the standard exchange rate model pays no attention to
transaction costs and liquidity considerations, which are essential to explain why
money should exist in the ﬁrst place. This issue is especially severe for emerging
market economies, where the lack of contingent contracts is more severe than in
advanced economies.
To illustrate the shortcomings of the standard model of choosing an exchange rate
regime for emerging markets, and also to highlight some of the main issues in mak-
ing such a choice, it is useful to identify several institutional features that arecommon in emerging market economies: weak ﬁscal, ﬁnancial and monetary institu-
tions; currency substitution and liability dollarization; and vulnerability to sudden
stops of outside capital ﬂows.The Mirage of Exchange-Rate Regimes for Emerging Market Countries 469

Weak ﬁscal, ﬁnancial and monetary institutions make emerging market countries
highly vulnerable to high inﬂation and currency crises. A key lesson from the ‘‘un-
pleasant monetarist arithmetic’’ discussed in Sargent and Wallace (1981) and the re-
cent literature on ﬁscal theories of the price level (Woodford, 1994, 1995) is that
irresponsible ﬁscal policy puts pressure on the monetary authorities to monetize the
debt, thereby producing rapid money growth, high inﬂation and downward pressureon the exchange rate. Similarly, poor regulation and supervision of the ﬁnancial sys-
tem can result in large losses in bank balance sheets that make it impossible for the
monetary authorities to raise interest rates in a way that holds down inﬂation or to
prop up the exchange rate because doing so would likely lead to a collapse of the ﬁ-
nancial system (Mishkin, 2003). Also, a frail banking system can produce ﬁscal insta-
bility, and hence high inﬂation and devaluations, because the need for a bailout can
imply a huge unfunded government liability (Burnside, Eichenbaum and Rebelo,
2001). Weak monetary institutions in which there is little commitment to the goal of
price stability or the independence of the central bank mean that the monetary
authorities will not have the support or the tools to keep inﬂation under control or
to prevent large depreciations of the currency. Thus, in an economy where the gov-ernment may run up enormous ﬁscal deﬁcits, banks are poorly regulated and the cen-
tral bank may recklessly expand the money supply, the real value of money cannot
be taken for granted.
Firms and individuals in emerging market countries react to the threat that their
money may dramatically change in value—either through inﬂation or the exchange
rate—by turning to currency substitution , where they use a foreign currency for many
transactions (Calvo and Ve ´gh, 1996). Currency substitution is likely to be due not
only to past inﬂationary experience resulting from weak monetary, ﬁscal and ﬁnan-
cial institutions, but also to the fact that a currency like the U.S. dollar is a key unitof account for international transactions. This phenomenon induces the monetary
authority to allow banks to o¤er foreign exchange deposits—that is, a ﬁrm in Argen-
tina can deposit U.S. dollars directly in an Argentine bank without converting to
local currency. 2
Foreign exchange deposits induce banks—partly for regulatory reasons that pre-
vent banks from taking exchange rate risk—to o¤er loans denominated in foreign
currency, usually U.S. dollars, leading to what is called liability dollarization . Liabil-
ity dollarization leads to an entirely di¤erent impact of a sharp currency devaluation
in an emerging market (Mishkin, 1996; Calvo, 2001). In emerging market countries,
a sharp real currency depreciation creates a situation where those who have bor-
rowed in U.S. dollars are unable to repay. The money they are earning is in local cur-rency, but their debts are in U.S. dollars. Thus, the net worth of corporations and
individuals falls, especially those whose earnings are primarily in local currency.
The result is many bankruptcies and loan defaults, a sharp decline in lending and470 Chapter 18

an economic contraction. Liability dollarization may become a major problem for
countries where the level of dollar borrowing has been especially high and where the
economy is relatively closed so that most parties earn only in local currency, as has
recently been the case in several emerging market countries (Calvo, Izquierdo and
Talvi, 2002). However, not all emerging market countries su¤er from liability dolla-
rization in a serious way; for example, Chile and South Africa, which have stronger
monetary, ﬁscal and ﬁnancial institutions, are commonly cited exceptions (Eichen-
green, Hausmann and Panizza, 2002).
Vulnerability to large negative changes in capital inﬂows, which often have a
largely unanticipated component (Calvo and Reinhart, 2000), also contributes to sus-
ceptibility to currency and ﬁnancial crises. Table 18.1 shows the incidence of thesesudden stops over the last decade. Table 18.1 shows that this phenomenon is mostly
conﬁned to emerging market countries and is more likely to be associated with large
currency devaluations in these countries, probably because of their weak ﬁscal and
ﬁnancial institutions. (The precise deﬁnition of a ‘‘sudden stop’’ and ‘‘large’’ devalu-
ations are found in the note to the table.) In addition, preliminary evidence suggests
that there is a high degree of bunching of sudden stops across emerging market coun-
tries. This bunching is especially evident after the Russian 1998 crisis and also after
the recent Wall Street scandals that included Enron and other ﬁrms. This pattern
leads us to conjecture that, to a large extent, sudden stops have been a result of fac-tors somewhat external to emerging market countries as a group. 3
The links from weak institutions and sudden stops to currency substitution and li-
ability dollarization—and then the links from liability dollarization to collapsed bal-
ance sheets and economic downturn—naturally di¤er from country to country. 4But
currency depreciations and sudden stops bring about large changes in relative prices
and have a deep impact on income distribution and wealth (Calvo, Izquierdo andTable 18.1
The Incidence of Sudden Stops, 1992–2001
Emerging markets Developed economies
Event typeNumber of
episodesPercentage
of totalNumber of
episodesPercentage
of total
Devaluations associated with sudden stop 12 63 4 17
Of which: First sudden stop, then devaluation 8 42 2 9
First devaluation, then sudden stop 4 21 2 9
Devaluations not associated with sudden stop 7 37 19 83
Notes: A sudden stop is deﬁned as a reversal in capital inﬂows that i) exceeds the mean minus two stan-
dard deviations of the annual change in capital inﬂows observed since 1990, and ii) is associated with adecline in output. The exercise also considers rises in the real exchange rate that i) exceed the mean plustwo standard deviations of the annual change in the real exchange rate observed since 1990, and ii) aregreater than 20 percent. The sample consists of 15 emerging economies and 17 developed countries. See
Calvo, Izquierdo, and Mejı ´a (2003) for further details and some sensitivity analysis.The Mirage of Exchange-Rate Regimes for Emerging Market Countries 471

Talvi, 2002). In addition, the sudden stop is typically associated with a sharp fall in
growth rates, if not outright collapse in output and employment. A ﬂoating exchange
rate is clearly the wrong prescription for this situation, since it allows the sharp de-
preciation that cripples balance sheets and the ﬁnancial sector. But under the dual
stresses of weak institutions and sudden stops, it is not clear that a ﬁxed exchange
rate is sustainable, either. Rather than focusing on the choice of exchange rate re-gime, the appropriate answer to this situation would seem to be an improvement in
ﬁscal, ﬁnancial and monetary institutions. Such an improvement would limit the
amount of currency substitution and liability dollarization and also make the econ-
omy more resilient in reacting to sudden stops when they occur. In more graphic
terms: ‘‘It’s the institutions, stupid.’’
18.2 Choosing between Exchange Rate Regimes
No exchange rate regime can prevent macroeconomic turbulence. But the choice of
exchange rate regime can be better- or worse-suited to the economic institutions and
characteristics of an economy. In the discussion that follows, we will focus primarilyon the overall choice between ﬁxed and ﬂoating exchange rates. However, it is worth
remembering that exchange rate regimes come in a wide variety of arrangements:
currency boards, dollarization, soft pegs, crawling bands, free ﬂoating and many
others. Moreover, a ﬂoating exchange rate regime can be accompanied by a number
of di¤erent domestically oriented monetary policies (inﬂation targeting, monetary
targeting or a ‘‘just do it’’ discretionary approach).
18.2.1 The Ability to Have Domestic Monetary Policy
The strongest argument in favor of a ﬂoating exchange rate regime is that it retains
the ﬂexibility to use monetary policy to focus on domestic considerations. In con-
trast, a hard exchange rate peg leaves very narrow scope for domestic monetary pol-
icy, because the interest rate is determined by monetary policy in the anchor country
to which the emerging market country has pegged. However, in emerging market
economies, this argument is more relevant in some institutional contexts than in
others.
One di‰culty that emerging market economies face is that their capital markets
are geared to interest rates set in major ﬁnancial centers. Frankel, Schmukler and
Serven (2002) show, for example, that in Latin America, all interest rates reﬂect
changes in U.S. interest rates and, furthermore, that countries that do not peg to the
dollar see their interest rates change by a larger factor than those that do. In addi-tion, emerging market economies may be hit as a group with ﬁnancial contagion, as
noted earlier, which will a¤ect their interest rates. The central bank in an emerging
market country thus faces real practical di‰culties.472 Chapter 18

Moreover, although a ﬂoating exchange rate raises the theoretical possibility for
domestic monetary authorities to pursue countercyclical monetary policy, the central
bank may not possess this capability in practice. If the monetary authorities have
little credibility in terms of their commitment to price stability, then monetary policy
may be ine¤ective. For a central bank without inﬂation-ﬁghting credibility, an
expansionary monetary policy will only lead to an immediate jump in interest ratesand/or the price level.
Building credible monetary institutions is a di‰cult task. It requires a public and
institutional commitment to price stability. Some of this commitment can be
expressed through laws and rules that assure the central bank will be allowed to set
the monetary policy instruments without interference from the government, that the
members of the monetary policy board must be insulated from the political process
and that the central bank is prohibited from funding government deﬁcits. There is a
large literature on the forms that central bank independence can take (for example,
Cukierman, 1992), but what is written down in the law may be less important than
the political culture and history of the country. The contrast between Argentina and
Canada is instructive here. Legally, the central bank of Canada does not look partic-ularly independent. In the event of a disagreement between the Bank of Canada and
the government, the minister of ﬁnance can issue a directive that the bank must fol-
low. However because the directive must be speciﬁc and in writing and because
the Bank of Canada is a trusted public institution, a government override of the
bank is likely to cost the ruling party heavily in the polls. Thus, in practice, the
Bank of Canada is highly independent. In contrast, the central bank of Argentina
was highly independent from a legal perspective. However, this did not stop the
Argentine government from forcing the resignation of the highly respected president
of the central bank and replacing him with a president who would do the govern-ment’s bidding. It is unimaginable in countries like Canada, the United States or in
Europe that the public would tolerate the removal of the head of the central bank
in such a manner, and, indeed, we do not know of any case of this happening in
recent history. 5
Many emerging market countries, like Argentina, have had a history of poor sup-
port for the price stability goal, and laws supporting central bank independence in
these countries are easily overturned. It is therefore important for such countries to
develop genuine public and political support for central bank independence as well
as legal independence in order to have the ability to conduct domestic monetary
policy successfully.
Ifan emerging market country is able to develop ﬁscal, ﬁnancial and monetary
institutions that provide credibility for society’s pursuit of price stability, then mone-
tary policy can be used to stabilize the economy. However, not all emerging market
countries are up to this task, and so they may decide to choose a hard exchange rateThe Mirage of Exchange-Rate Regimes for Emerging Market Countries 473

peg instead. (However, the absence of strong institutions may make it di‰cult for
them to sustain the hard peg.)
This interdependence between institutions and exchange rate regimes helps to ex-
plain the general empirical ﬁnding that whether a country has a ﬁxed or ﬂexible
exchange rate tells us little about whether it has higher economic growth or smaller
output ﬂuctuations. Indeed, when you look more closely at which emerging marketcountries have successful macroeconomic performance, the exchange rate regime
appears to be far less important than deeper institutional features of the economy
relating to ﬁscal stability, ﬁnancial stability and the credibility of monetary institu-
tions that promote price stability. 6However, there is some evidence that ﬂoating ex-
change rate regimes can help countries cope with terms-of-trade shocks and might
promote economic growth (Broda, 2001; Levy-Yeyati and Sturzenegger, 2003).
18.2.2 Reducing Inflation
Just as the main advantage of a ﬂoating exchange rate may be that it allows the mon-etary authorities some discretion and ﬂexibility to use monetary policy to cope with
shocks to the domestic economy, the main weakness of a ﬂoating exchange rate maybe that it allows too much discretion to monetary policy and so may not provide a
su‰cient nominal anchor (for example, Calvo, 2001; Calvo and Mendoza, 2000).
Of course, many emerging market countries have been able to keep inﬂation under
control with ﬂexible exchange rate regimes, which is why the evidence on whether
ﬁxed versus ﬂoating exchange rate regimes are associated with lower inﬂation rates
on average is not clear-cut (for example, Edwards and Magendzo, 2001; Reinhart
and Rogo¤, 2002). But a central bank can only work to reduce inﬂation if it is sup-
ported by the public and the political process. In some countries, giving the central
bank an explicit focus on inﬂation targeting can help focus the public debate so thatit supports a monetary policy focus on long-run goals such as price stability (Ber-
nanke, Laubach, Mishkin and Posen, 1999). However, these beneﬁts require excel-
lent communication skills on the part of the central bank in what can be a swirling
political environment in emerging market countries.
18.2.3 A Misaligned Exchange Rate?
One danger of a hard exchange rate peg is the risk of being locked into a misalignedexchange rate, which can be deﬁned as a sizable di¤erence between its actual level
and the one to which ‘‘fundamentals’’ would dictate. This possibility supports the
case for ﬂexible exchange rates, but again, the situation is more complex than it
may at ﬁrst seem.
Even in a country with a ﬁxed nominal exchange rate, it is possible to use taxes
and subsidies on imports and exports to alter the e¤ective real exchange rate. For ex-474 Chapter 18

ample, a uniform tax on imports accompanied by a uniform subsidy on exports of
the same size is equivalent to a realcurrency depreciation—even though the nominal
exchange rate stays unchanged. Moreover, a tax-and-subsidy-induced ﬁscal devalua-
tion has one built-in advantage over nominal denomination. The ﬁscal devaluation
has an upper bound, determined by the fact that beyond a certain point, tax evasion
becomes rampant. Nominal devaluation, on the other hand, has no upper bound andcan lead to high inﬂation.
But ﬁscal devaluation may be di‰cult to implement in a timely and e¤ective
manner without well-run ﬁscal institutions. For example, politicians may be quick
to impose a tax on imports out of protectionist sentiment, happy to use a ﬁscal deval-
uation as an excuse, but then slow to remove that import tax later when the reason
for the devaluation has evaporated.
18.2.4 Expanding the Gains from Trade
A hard exchange rate peg will tend to promote openness to trade and economic inte-gration (Frankel and Rose, 2002; Rose, 2000). For example, an exchange rate ﬁxed
to the U.S. dollar will likely promote trade with the United States and other coun-tries tied to the U.S. dollar. Fixed exchange rates or even a common regional cur-
rency as in the European monetary union may help regional economic integration
(this point is also discussed further below in connection with the e¤ect of exchange
rate regimes on institutions). Thus, countries that are seeking to expand trade would
naturally place a higher value on some form of a ﬁxed exchange rate with a trading
partner.
Along with gains from trade, an economy that is more open to trade may also be
less susceptible to sudden stops. An expansion of trade means that a greater share of
businesses are involved in the tradable sector. Because the goods they produce aretraded internationally, they are more likely to be priced in foreign currency, which
means that their balance sheets are less exposed to negative consequences from a de-
valuation of the currency when their debts are denominated in foreign currency.
Then, a devaluation that raises the value of their debt in terms of domestic currency
is also likely to raise the value of their assets as well, thus insulating their balance
sheets from the devaluation. 7Moreover, the more open is the economy, the smaller
will be the required real currency depreciation following a sudden stop (Calvo,
Izquierdo and Talvi, 2002).
18.2.5 Reducing the Risk Premium in Interest Rates
Advocates of hard exchange rate pegs suggest that it can reduce the currency
risk component in domestic interest rates, thus lowering the borrowing costs for
both the government and the private sector and improving the outlook for ﬁnancialThe Mirage of Exchange-Rate Regimes for Emerging Market Countries 475

deepening, investment and growth. Some, such as Schuler (1999), have even gone so
far as to suggest that dollarization will allow domestic interest rates in emerging
market countries to converge to those in the United States.
However, the risk of government default and the related risk of conﬁscation of pri-
vate assets denominated in both domestic and foreign currency are more likely to be
the source of high interest rates in emerging market countries than is currency risk.The experience of Ecuador serves to illustrate this point. The spread between Ecua-
dor’s sovereign bonds and U.S. Treasury bonds remained at high levels in the ﬁrst
half of 2000, even though the government had already dollarized in January of the
same year. Spreads came down considerably only after the government reached an
agreement with its creditors in August 2000 that resulted in a substantial debt reduc-
tion of 40 percent. Sound ﬁscal policies that make government defaults extremely
unlikely are thus essential to getting interest rates to approach those in advanced
countries. Indeed, Chile, with its ﬂexible exchange rate regime, has been able to
achieve lower interest rates on its sovereign debt than Panama, which is dollarized
(Edwards, 2001).
18.2.6 Flexibility in Wages and Prices
It is possible that emerging market economies, with their large informal sectors, have
greater price and wage ﬂexibility than developed economies. An economy with highly
ﬂexible wages and prices has less need of a ﬂexible exchange rate.
To some extent, the degree of ﬂexibility in wages and prices is controlled by gov-
ernment regulation. For example, public sector wages are often a component of the
economy that is quite inﬂexible. However, it may be politically palatable to index
public sector wages to their comparable private sector wages and thus create greater
ﬂexibility. In general, an emerging market economy with a greater degree of ﬂexibil-ity in wages and prices will beneﬁt less from the additional ﬂexibility of a ﬂoating ex-
change rate.
18.2.7 Widespread Loans in a Foreign Currency
Liability dollarization makes a policy of freely ﬂoating exchange rates more di‰cultto sustain. When the monetary authority knows that a currency devaluation can lead
to extreme stress on the ﬁnancial sector, it cannot turn a blind eye to exchange rate
ﬂuctuations (Mishkin and Savastano, 2001). A large devaluation when there is exten-
sive liability dollarization raises the value of the foreign-denominated debt, deals a
heavy blow to balance sheets and therefore can lead to a full-ﬂedged ﬁnancial crisis
(Mishkin, 1996). 8
The extent of liability dollarization is partly a¤ected by government ﬁnancial reg-
ulatory policy. For example, banking regulations can help to ensure that ﬁnancial
institutions match up any foreign-denominated liabilities with foreign-denominated476 Chapter 18

assets and thus reduce currency risk. But even when the banks have equal foreign-
denominated (dollar) assets and liabilities, if banks’ dollar assets are loans to compa-
nies in dollars who themselves are unhedged, then banks are e¤ectively unhedged
against currency devaluations because the dollar loans become nonperforming when
the devaluation occurs; for discussion of how this problem occurred in Mexico, see
Mishkin (1996) and Garber (1999). Thus, limiting currency mismatches may requireadditional government policies to limit liability dollarization or at least reduce the
incentives for it to occur. If a country wishes to choose a ﬂoating exchange regime,
it would be wise to implement ﬁnancial regulatory policies to discourage currency
mismatches and liability dollarization. 9For example, both Chile and Argentina ex-
perienced a sudden stop after the 1998 Russian crisis, but the impact on the Chilean
economy was relatively small because Chile’s stronger ﬁscal, ﬁnancial and monetary
institutions have resulted in much less liability dollarization.
18.2.8 International Reserves
A hard peg exchange rate system, like a currency board, may require a substan-tial war chest of international reserves. It may seem that a ﬂoating exchange ratesystem could avoid the cost of these reserves, but this conclusion would be too
simple.
Many large emerging market economies like Mexico, Chile and Brazil, which have
a ﬂoating exchange rate and have announced a domestic monetary policy aimed at
targeting inﬂation, also have large international reserves. Indeed, they occasionally
hold international reserves in excess of monetary base. Because of these large
reserves, it could be said that such countries ‘‘ﬂoat with a large life jacket.’’ Why do
large reserves appear to be necessary even with ﬂoating exchange rates? One explana-
tion is that international reserves provide collateral for public bonds issued in con-nection with open market operations. Another explanation is that even a nation
with a ﬂoating exchange rate must be concerned about the possibility of a run on its
currency. Finally, policymakers in emerging market economies are very sensitive to
the exchange rate because many such economies often exhibit a high pass-through
coe‰cient; that is, devaluation often leads to inﬂation (Gonza ´lez, 2000; Hausmann,
Panizza and Stein, 2001).
Thus, nations with a domestically oriented monetary policy and ﬂoating ex-
change rates also have good reasons to carry high reserves, and it does not appear
that they typically have much smaller reserves than nations with ﬁxed exchange
rates.
18.2.9 Lender of Last Resort
A hard exchange rate peg is sometimes said to be at a disadvantage relative to a
ﬂoating exchange rate regime because it cannot accommodate a money-printingThe Mirage of Exchange-Rate Regimes for Emerging Market Countries 477

lender of last resort. While this argument would seem to weaken the case for ﬁxed
exchange rates, the scope for a lender of last resort for emerging market countries
with ﬂoating rates is oversold (Calvo, 2001; Mishkin, 1999a, 2001).
In advanced economies, the monetary authority can issue liquidity to bail out the
banking system, but this extra liquidity is expected to be soaked up by open market
operations in the near future, so that bank bailouts can stabilize the banking systemwith little if any inﬂationary consequence. In contrast, in emerging market countries,
central bank lending to the banking system in the wake of a ﬁnancial crisis—
characterized by a sudden stop in capital inﬂows—is likely to unleash fears of an
inﬂationary explosion and produce a sharp exchange rate depreciation. If there is
substantial liability dollarization, the depreciation will then have a major negative
impact on private sector balance sheets, which will then promote even more ﬁnancial
instability.
This discussion reemphasizes an earlier lesson. If monetary institutions are well
developed and the central bank has su‰cient credibility, only then can the central
bank act as a lender of last resort. Alternatively, a government can secure contingent
credit lines (like the central bank of Argentina did during the so-called ConvertibilityProgram), but these credit lines can be very expensive and may not be su‰cient when
a crisis hits.
18.2.10 Shifts from Fixed to Floating Regimes
Even if a country might be better served in the long run by adopting a ﬂoatingexchange rate regime, the timing of the shift from a peg can have serious economic
consequences. The costs of shifting from a ﬁxed exchange rate regime to a ﬂoating
regime under conditions of economic stress, like a sudden stop, are especially strik-
ing. As discussed earlier, a move from a ﬁxed to a ﬂoating exchange rate regime inthe midst of a sudden stop is likely to exacerbate the crisis. The initial devaluation
that raises the value of foreign-denominated debt can cause widespread destruction
of corporation and household balance sheets, which sends the economy into a devas-
tating downward spiral. Recent papers by Caballero and Krishnamurthy (2003) and
Jeanne (2002) also suggest that de-dollarization (the reestablishment of a domestic
currency) may require a major overhaul of the domestic ﬁnancial sector. Develop-
ment of the necessary institutions to support a successful domestically oriented mon-
etary policy takes time.
18.3 Can Exchange Rate Regimes Improve Economic Institutions?
The discussion in the preceding section focuses on what institutional traits or policyconcerns should cause a country to prefer ﬁxed or ﬂoating exchange rates. But the478 Chapter 18

possibility of reverse causation also deserves consideration. Perhaps the choice of ex-
change rate regime should not be analyzed as a response to existing institutional
traits, but instead as a potential cause of preferred institutional outcomes. Research
on theories of institutional development in emerging market countries is in its early
stages, but is developing rapidly (for example, see La Porta, Lopez-de-Silanes, Shlei-
fer and Vishny, 1998; Shleifer and Vishny, 1999; Boone, Breach, Friedman andJohnson, 2000). Several intriguing hypotheses about how exchange rate regimes
may improve institutions have been proposed.
Advocates of hard exchange rate pegs argue that they improve ﬁscal institutions
and trigger sounder budgetary management, because if the central bank is focused
on a ﬁxed exchange rate, then the government no longer has access to the money
printing press to ﬁnance its spending (for example, Hanke and Schuler, 1994). As
the recent example of Argentina suggests, where the ﬁscal tensions between the prov-
inces and the central government were not solved by the currency board, hard pegs
may be less e¤ective at constraining ﬁscal policy than was previously believed. Hard
pegs may even weaken incentives for governments to put their ﬁscal house in order,
because the hard peg may make it easier for governments to borrow foreign funds,thus allowing them to delay necessary reforms to ﬁx ﬁscal imbalances. For example,
Panama (which has been dollarized for close to 100 years) has had poor ﬁscal perfor-
mance, with ﬁscal deﬁcits over 7 percent in the 1970s and averaging 5 percent in the
1980s—it is just in recent years that the ﬁscal position has improved to the point that
the ﬁscal surplus averaged 1.4 percent during the 1990s. On the other hand, it is not
clear that in ﬂoating exchange rate systems, the conduct of monetary policy has any
particular impact in promoting ﬁscal responsibility. However, one might argue that
a ﬂoating exchange rate, particularly if it involves the government in setting an
inﬂation target, has the potential to promote government transparency and ﬁscalresponsibility.
Advocates of hard pegs also suggest that dollarization promotes a healthier ﬁnan-
cial system because it avoids currency mismatches and deepens the ﬁnancial system,
making it less prone to crisis (for example, Hausmann, 1999). However, there is little
evidence to support this view (Eichengreen, 2002). On the other hand, a hard ex-
change rate peg in the form of a currency board might encourage unhedged dollar
(foreign-denominated) liabilities that nonﬁnancial and ﬁnancial ﬁrms might be will-
ing to undertake, thus making the ﬁnancial system more vulnerable in case the
system has to be abandoned, as illustrated by Argentina in 2002. The hard peg
might also encourage the issuance of dollar liabilities because ﬁnancial ﬁrms would
believe that the government would feel responsible for any devaluation and would,thus, be more likely to o¤er a bailout (McKinnon and Pill, 1999; Broda and Levy-
Yeyati, 2000). However, the evidence that ﬂoating rate regimes lead to less liabilityThe Mirage of Exchange-Rate Regimes for Emerging Market Countries 479

dollarization is quite weak (Honing, 2003). After all, on its face, a ﬂoating exchange
rate would seem to encourage holding some assets in several di¤erent currencies as a
form of diversiﬁcation. For example, Peru, with its ﬂoating exchange rate regime, has
a tremendous amount of liability dollarization, while Brazil, when it had a quasi-
ﬁxed exchange regime rate in the period of 1994 to 1999, did not.
Can the choice of exchange rate regime help improve monetary institutions that
enable the monetary authorities to build credibility? If a ﬁxed exchange rate regime
is constructed with a full array of supporting institutions, then it would seem to o¤er
at least a gain in credibility—although after the collapse of Argentina’s ﬁxed rate
system, such credibility will always remain incomplete. Moreover, a ﬂoating ex-
change rate can be a mechanism for monetary credibility as well, Tornell and
Velasco (2000) argue, because the foreign exchange market will anticipate the e¤ects
of policy inconsistency by devaluing the exchange rate, providing a clear signal that
something is rotten. Moreover, the signal itself could help establish some discipline in
government’s quarters and possibly lead to a timely rectiﬁcation of policy inconsis-
tencies (Mishkin, 1998).
Although at the outset, the credibility of the monetary authorities might be weak
and the public support for central bank independence may not be all that strong,
adoption of inﬂation targeting might help the central bank to work to produce ‘‘con-
strained discretion’’ (Bernanke and Mishkin, 1997) in which transparent discussion
of the conduct of monetary policy and accountability of the central bank for achiev-
ing its inﬂation target might make it more di‰cult for the central bank to follow
overly expansionary monetary policy. In addition, over time it may help obtain cred-
ibility for the central bank as it did in Chile, and it may also increase support for the
central bank independence. Indeed, Mishkin and Posen (1997) and Bernanke, Lau-
bach, Mishkin and Posen (1999) suggest that the support for central bank indepen-dence in the United Kingdom was a direct result of the inﬂation targeting regime.
However, although inﬂation targeting might help with central bank credibility and
support for central bank independence to some extent, a fair degree of support for
good monetary institutions already needs to be present if inﬂation targeting is to
have a chance of success.
There is some evidence that hard exchange rate pegs, particularly those in currency
unions, do encourage openness to trade and integration with the countries to which
the currency is pegged (Frankel and Rose, 2002; Rose, 2000). As we mentioned ear-
lier, trade openness can reduce the vulnerability of emerging markets to ﬁnancial
crises, while economic integration with an anchor country reduces the cost of the
loss of domestic monetary policy with a hard peg.
The possible connections between exchange rate regimes and the improvement of
economic institutions is a potentially important topic for future research.480 Chapter 18

18.4 The Choice of Exchange Rate Regimes in Context
When choosing between exchange rate regimes, one size does not ﬁt all (or always).
This argues against international ﬁnancial institutions like the International Mone-
tary Fund, the World Bank and other development banks having a strong bias to-
ward one type of exchange rate regime. Instead, an informed choice of exchange
rate regime requires a deep understanding of a country’s economy, institutions and
political culture.
Indeed, we believe that the choice of exchange rate regime is likely to be of second
order importance to the development of good ﬁscal, ﬁnancial and monetary institu-
tions in producing macroeconomic success in emerging market countries. Rather
than treating the exchange rate regime as a primary choice, we would encourage a
greater focus on institutional reforms like improved bank and ﬁnancial sector regula-
tion, ﬁscal restraint, building consensus for a sustainable and predictable monetarypolicy and increasing openness to trade. A focus on institutional reforms rather
than on the exchange rate regime may encourage emerging market countries to be
healthier and less prone to crises than we have seen in recent years.
Acknowledgments
We are grateful to Luis Fernando Mejı ´a for excellent research assistance and to Jose
De Gregorio, Linda Goldberg, the editors of this journal (especially Timothy Taylor)
and participants in the Macro Lunch at Columbia University for helpful comments.The views expressed in this chapter are exclusively those of the authors and not those
of the Inter-American Development Bank, the University of Maryland, Columbia
University, or the National Bureau of Economic Research.
Notes
1. For a discussion of why soft pegs have fallen out of favor and the rise of the bipolar view, see
Obstfeld and Rogo¤ (1995), Eichengreen and Masson (1998) and Fischer (2001) in Journal of Economic
Perspectives .
2. In this fashion, a sudden switch away from domestic and into foreign money need not result in a bank
run, since in the presence of foreign exchange deposits, such a portfolio shift could be implemented by sim-ply changing the denomination of bank deposits. Otherwise, deposits would be drawn down to purchase
foreign exchange, resulting in a bank run.
3. In this symposium, Kaminsky and Reinhardt discuss how the process of contagion occurs.
4. Among the factors that di¤er across countries, we would mention the problem of tax evasion. As a re-
sult of tax evasion, the tax base of many emerging market economies is very small, the informal sector
large and, thus, any adjustment to shocks causes major distortion in the formal part of the economy, lead-
ing to capital ﬂight. E¤ects could be large if resulting externalities give rise to multiple equilibria (Calvo,2002).The Mirage of Exchange-Rate Regimes for Emerging Market Countries 481

5. The stability of the central bank in advanced countries may be partly explained by the size of the
shocks, rather than by some advantage in the political culture. After all, except for the Great Depression,
advanced countries have not been hit by equally large shocks as in Argentina and other emerging marketeconomies.
6. Indeed, Tommasi (2002) has argued that even deeper institutions, relating to politico-institutional rules
as reﬂected in the constitution, electoral rules and informal practices of the polity, are crucial to the devel-opment and sustainability of strong ﬁscal, ﬁnancial and monetary institutions. Also, Acemoglu, Johnson,Robinson and Thaircharoen (2003) provide evidence that deeper, fundamental institutions are more crucialto lowering economic volatility and raising growth than are speciﬁc macroeconomic policies.
7. If traded goods are not denominated in the same foreign currency as the debt, then this insulation may
be incomplete unless the currency used for denominating debt moves very closely with the currency used
for denominating traded goods.
8. Furthermore, it may induce the government to provide subsidized hedging instruments, which could
substantially increase ﬁscal imbalance (this was the case in Brazil after the 1999 large devaluation of the
real), impairing credibility.
9. However, the possible costs of pursuing such a policy also have to be taken into account. The literature
on liability dollarization is still in its infancy, and, thus, it is hard to tell whether these costs are signiﬁcant(Eichengreen, Hausmann and Panizza, 2002; Jeanne, 2002).
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Polity, Stupid.’’ Mimeo, University of San Andres; forthcoming in Annual World Bank Conference on De-
velopment Economics .
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Fiscal Discipline?’’ Journal of Monetary Economics . 45:2, pp. 399–436.
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Carnegie-Rochester Conference Series on Public Policy . 43:3, pp. 1–46.484 Chapter 18

IVWhat Have We Learned?

Introduction to Part IV
Now it is time to extract the lessons from all the chapters in this book and put the
material into a wider perspective with a ﬁnal chapter outlining my current views on
monetary policy strategy. Besides being distilled from the research discussed in this
book, these views are also shaped by my practical experience in making monetary
policy. This chapter, which I have tried to make as nontechnical as possible, can
serve as a primer for how contemporary monetary policy strategy should be con-
ducted, albeit written from my particular viewpoint. This chapter, however, will notbe my last word on this subject because I and the economics profession will continue
to learn from history and question, re-evaluate, and reﬁne our understanding of
monetary policy strategy.

19Everything You Wanted to Know about Monetary Policy
Strategy, but Were Afraid to Ask
Frederic S. Mishkin
There have been major advances in economic research on monetary policy over the
past thirty years outlined in the previous chapters. What we have learned during this
period has helped countries improve their economic performance substantially in re-
cent years. Inﬂation throughout the world has fallen to levels that would have been
unimaginable thirty years ago when I ﬁrst became an economist; not only has the
volatility of inﬂation declined sharply, but ﬂuctuations in output and employment
have declined as well. In this chapter I outline what this collective body of economicresearch tells us about how monetary policy should be conducted in nine key areas:
1) the importance of price stability and a nominal anchor to successful monetary pol-
icy, 2) ﬁscal and ﬁnancial preconditions for achieving price stability, 3) central bank
independence as an additional precondition, 4) central bank accountability, 5) the
rationale for inﬂation targeting, 6) ﬂexibility of inﬂation targeting, 7) the optimal in-
ﬂation target, 8) central bank transparency and communications, and 9) the role of
asset prices in monetary policy.
19.1 The Importance of Price Stability and a Nominal Anchor to Successful Monetary
Policy
As discussed at the outset of this book, the recognition that price stability and a
nominal anchor are important to the successful conduct of monetary policy has
stemmed from three intellectual developments in economics: 1) the recognition that
expansionary monetary policy cannot raise output and employment, except in the
short run; 2) the realization that inﬂation is costly; and 3) the discovery of the time-
inconsistency problem. These developments in economic science have led to the rec-
ognition that, ﬁrst, price stability should be the overriding long-run goal of monetary
policy and, second, that an explicit nominal anchor should be adopted to achieve the
best economic outcomes.

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