Critically Evaluate Three Monetary Strategies of Central Banks: Exchange Rate Targeting, Monetary Targeting, and Inflation Targeting.

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Alexis Gutiérrez
University of Essex
Department of Economics
Dr. F. Bohn

EC368 International Money and Finance

Term Paper 2001- 02

- Critically evaluate three monetary strategies of central banks: exchange rate targeting, monetary targeting, and inflation targeting.

On this essay I am going to evaluate the three basic frameworks of the strategies for monetary policy used by central banks. Here we are going to look at the advantages and disadvantages of each of these strategies.

Exchange Rate Targeting:
First of all, lets define peg: “ is a system where countries stabilize their exchange rates around par values they retain the right to change. Under this system a country undertakes to intervene in the foreign exchange market to keep its currency within some margin, for example 1 per cent, of some given exchange rate parity, the ‘peg’ ”[1]

There are two types of peg regimes for monetary policy: a currency board and full dollarization. In a currency board, the domestic currency is backed 100% by a foreign currency and the central bank or government, who fixes a conversion rate to this currency and stands ready to exchange domestically issued notes for the foreign currency on demand. Full dollarization involves eliminating altogether the domestic currency and replacing it with a foreign currency ( the U.S. dollar ). It represents a stronger commitment to monetary stability than a currency board because it makes it much more costly for the government to recover control over monetary policy and/or change the parity of the domestic currency. The main purpose of exchange rate targeting is to maintain the real exchange rate at some specific level.

“ The target zone is a non-linear compromise between fixed exchange rates and freely flexible exchange rates. ”[2] In an exchange rate target zone, a country or group of countries sets explicit margins within exchange rates will be allowed to fluctuate. While the exchange rate is within those margins, the policy can be directed toward other goals. When some limit is reached, the central bank focuses resources on maintaining the limits. The target zone does not preclude foreign exchange interventions inside the limits. “ Finite interventions produce counter – intuitive policy behaviour. For example, to implement a target zone, a central bank would impose a large monetary contraction when the exchange rate is appreciating. ”[3]

There is full cooperation between central banks to try to make the target zone credible, the intervention is equitable. For example; if the country whose currency is weak has run out of reserves, the other central bank has to intervene printing money.

The advantages of exchange rate targeting are that it provides a nominal anchor that helps keep inflation under control by tying the prices of domestically produced tradable goods to those in the anchor country, attenuating the component of inflation that feeds into wages and prices of non-tradable goods, and making inflation expectations converge to those prevailing in the anchor country. (e.g. México).

Exchange rate targeting reduces the currency risk component from domestic interest rates thus lowering the cost of funds for the government and the private sector and improving the outlook for financial investment and growth. It helps economic integration ( European Union ). It has the advantage of simplicity and clarity, which make them easily understood by the public.

The main disadvantages are the loss of independent monetary policy; and countries with exchange rate targeting are open to speculative attacks ( e.g. México 1994 ). Successful speculative attack for emerging market countries because it leads to financial crisis; plus weakened accountability because there is no exchange rate signal for developing countries.

Currency Board Versus Full Dollarization: the main disadvantage of a currency board relative to full dollarization is that the currency board does not...
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