What are the different monetary policy regimes? How are they different from one another? How do they work? How have they transitioned over a period of time?
It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
~ Henry Ford
In the earlier post ‘Monetary Policy Frameworks – An Overview’ we threw light on monetary policy frameworks. We also discussed the conventional and unconventional monetary policy frameworks deployed by central banks. To provide a better perspective, we discuss the monetary policy regimes since the establishment of the modern mandates for a central bank from the late nineteenth century.
Gold Standard, Including Inter-War Gold Exchange Standard: The gold standard (1880-1914) required that the central bank exchange a unit of domestic currency for a fixed quantity of gold, as and when the demand is placed. The interwar gold exchange standard (1924 to 1936) had the flexibility where countries held both gold and foreign exchange as international reserves. The money supply changed with the amount of gold held by the central bank, and therefore, the linkage between gold production and economic growth proved crucial in maintaining price stability. This growth in gold reserves, in turn, depended on the balance of payments position, thereby making the defence of the external value of currency the only goal of monetary policy. The convertibility feature between the domestic currency and gold led to price instability, especially in the US, as deflation occurred on gold production rate in the world falling short of economic growth and vice-versa. In other words, in case a country had excess goods to export, it would lead to gold inflows through a balance of payment surplus and an increase in prices relative to world level. These adverse effects on inflation arose from central banks having no understanding, before the Second World War, of the workings of real interest rate as a policy instrument and its interaction with the economy and consequently no understanding of the price system (Hetzel, 2017). The Reserve Banks of the United States did not reduce the discount rate, as was required in the classical gold standard, whenever the gold holdings exceeded the requirement of maintaining gold cover. However, on three occasions between 1919 and 1933, discount rates were raised as per the requirements of the economic situation. It can thus be argued that the control over price level through the creation of money was surrendered by the central banks as the manner of operation of gold standard determining the price level was not completely understood, e.g., during World War-I, Fed Reserve kept the discount rate below the rate of Treasury securities to help investors borrow funds and invest in government debt for financing the war.
Further, in the times of economic downturn, people tried to exchange their currency for gold, as central banks keeping a lesser than cent per cent ratio of gold to currency in circulation created fears of gold scarcity. To prevent runs on gold reserves, central banks raised interest rates to enable arbitrage seekers to ship gold from overseas. This hurt growth and increased unemployment, worsening the already bad economic situation. Following such policies by the central banks to maintain the gold standard is linked inextricably to the worsening of economic situations in many countries in the 1930s. These policies not only had a role in the Great Depression but also eventually led to the demise of the gold standard. The inter-war gold exchange standard was also witness to Great Britain seeking to restore Sterling, at any cost, to pre-war parity to out-flank the US dollar and regain the lead in the financial world. However, the high costs of an overvalued currency became unsustainable (Issing, 2010).
Fixed Exchange Rate and its Variants (Exchange Rate Anchor): In a fixed exchange rate system, a fixed amount of foreign currency is exchanged with one unit of the domestic currency. A flexible version of this regime included letting the exchange rate move within a narrow band or at a preannounced constant rate towards ensuring a more stable domestic inflation rate (e.g., Bretton Woods era of 1944-1973 and the European Exchange Rate Mechanism (ERM) from 1979 onwards), while a stricter version demanded “dollarizing” their economy, i.e., giving up the domestic currency and adopting a foreign currency thereby also having complete monetary dependence on that economy. Even members of the euro area would be considered as following the stricter version of this regime. The conundrum is that a fixed exchange rate economy, over the long term, has the same inflation rate of the economy to which it links its exchange rate. The fixed exchange rate has the benefit of anchoring inflation for high or volatile inflation economies, however, the loss of monetary independence for tackling domestic economic situations can be challenging, especially during tough economic conditions. Credibility can get eroded very fast if investors believe that the domestic economic situations will force the economy to prioritise monetary independence over maintaining the exchange rate. A loss in credibility will then require an even larger amount of forex reserves to protect the exchange rate.
The dollar’s fixed value against gold under the Bretton Woods system struggled through most of the 1960s, with concerns of overvaluation of the US dollar exacerbated by fiscal spending under society programs and funding of Vietnam War. The “temporary” suspension of convertibility of USD into gold in August 1971, eventually led to the collapse of the Bretton Woods system by March 1973 where all major currencies started floating. The Bretton Woods era in the 1960s and 1970s was characterised by the Keynesian view that saw “low” unemployment as a counter to social divisions. Further, Keynesians were of the view that any inflation proliferated though the increase in wage-prices had in-built inertia, irrespective of whether inflation was cost-push or aggregate-demand driven. However, the breakdown of Phillips-curve trade-off with high inflation and unemployment (stagflation) being witnessed by the end of 1970s, altered the view in favour of the monetarists (Hetzel, 2017). This gave rise to the monetary regime of money supply targeting, busting the belief of no association of monetary policy with inflation.
Monetary Targeting (Monetary Aggregates Anchor): Monetary targeting aims to create an environment of low and stable inflation by central banks through controlling money supply growth, usually at a fixed rate. This regime gained traction in the 1970s, where high inflation becoming a concern for central banks, aided by the oil shock and rise in other commodity prices like gold, silver, aluminium and pig iron. High inflation, including double-digit inflation, in several countries in the 1970s and the early 1980s, required increasing interest rates to reduce inflation but also required a nominal anchor for anchoring inflation expectations. Monetary targeting was essentially based on the quantity theory, a long-run model, which created a link between inflation rate and money supply growth rate as under:
π = μ – g
where π is the inflation rate, μ is the money supply growth rate and g is the real output growth rate.
A popular rule of monetary targeting was the k-percent rule, championed by Friedman. The rule envisaged increasing the money supply by a constant percentage per period of time. As this rule did not provide flexibility to a central bank to change the growth of money supply due to unexpected changes in the economy, the consequent rigidity in money supply growth could adversely affect income and employment. Although McCallum’s feedback rule attempted to incorporate changes in macroeconomic variables to derive the target rate of growth of money supply, it required timely measurement of such variables, which had embedded costs.
The fertile ground of high inflation was provided in the 1960s, as price stability was made secondary to full employment when authorities in several developed countries tried to exploit the Phillips curve trade-off (Bordo & Siklos, 2017). However, by the 1980s, it was found that the relationship between inflation, economic growth and money growth was unstable, making countries abandon the framework. Challenges also came from Friedman (1956) and other economists, arguing that inflation was linked to high money growth. Further, rational expectations proponents, led by Lucas and Sargent (1979), argued towards the need for a credible anchor in terms of domestic price level towards weakening link between high unemployment and low inflation. Thus, the prevailing economic situation and the influences to monetary policy theory set the tone for monetary targeting (Hetzel, 2017). Further, the success of Germany in adopting a monetary target from 1975 onwards till 1999 when it entered the European Economic and Monetary Union (EMU), encouraged countries in adopting monetary targeting. During the phase of monetary targeting, Germany escaped the great inflation of the 1970s and the Deutsche Mark also was one of the more stable currencies.
The essence of monetary targeting was directly targeting money or money growth to ultimately target inflation and output gap. However, even Friedman acknowledged that a constant money growth rule would not be the best monetary policy, However, he argued that such an anchor would result in not repeating historical monetary policy mistakes embedded in large movements of money supply dependent on imperfect information (Nelson, 2008). There was the short-term success of constant money rule and other forms of monetary targeting where the reign of inflation was broken in the 1980s. However, the breakdown of the relationship between monetary aggregates and growth in output, primarily due to financial innovations, led to abandoning of monetary targeting by several countries by the late 1980s and during the 1990s.
Inflation Targeting (Inflation Rate Anchor): After the short regime of monetary targeting, the anchor from 1990s shifted to inflation, as inflation control became the central focus of monetary authorities. Important literature from the 1970s to 1990s played an important role in shaping the thinking of central bankers and influencing how monetary policy was conducted. The famous time-inconsistency hypothesis by Kydland and Prescott (1977) proposed that time inconsistency could lead to higher inflation during the current period if households and firms believe that governments may go for higher inflation in future to have a trade-off with unemployment. The underlying theme that comes across is that central bank independence is necessary to ensure inflation is maintained at a socially desired level by constraining the Phillips curve trade-off. The theory also supported the importance of credible commitment and central bank communication as essential pillars for the conduct of a successful monetary policy. Further, the foundation of the role of inflation expectations was laid by Lucas and Sargent (1979) through the rational expectations theory, which argues that expectations formed during interactions amongst policymakers and private agents are to be considered for framing an optimal monetary policy. Similarly, Barro and Gordon (1983) argue the importance of the credibility of central banks for consistently guiding expectations of private agents.
The existing literature during that time advocated that predictable actions of central banks do not have the desired effect even with the underlying assumption of flexible price and wages. The rational expectations theory, on the contrary, argued that monetary policy could be effective even with sticky prices and wages. There was a distinct move away from discretionary monetary policy towards systematic and predictable monetary policy. Taylor (1979) specified a loss function seeking to minimise its expected value, thus penalising deviations from the output gap, i.e., the difference between log of actual output and potential output without nominal rigidities and inflation target calculated as difference between inflation and inflation target.
Thus, the rule recommends a higher interest rate when inflation or output is above their respective targets and vice-versa otherwise. Consequent to increased counterparty risk during the GFC, Taylor (2008) recommended modification in the rule to also adjust for movement in the spread between Libor at 3-month maturity and an index of the overnight federal funds rate, which would enable a reduction in interest rates even when output or inflation was not declining. The Taylor Rule and the “flexible inflation targeting” as proposed by Svensson (1997) grew in prominence such that on the eve of GFC, 13 advanced economies, Eurozone and 23 EMEs had adopted an inflation target or objective linked to price stability, either formally or informally. The inflation mean rate by inflation-targeting countries was second-lowest beaten only by the gold standard regime (Bordo & Siklos, 2017).
References:
Barro, R., & Gordon, D. (1983). Rules, Discretion and Reputation in a Model of Monetary Policy. Journal of Monetary Economics, 12(1), 101-121. doi:https://doi.org/10.1016/0304-3932(83)90051-X
Bordo, M., & Siklos, P. (2017). Central Banks: Evolution and Innovation in Historical Perspective. NBER Working Paper(23847).
Friedman, M. (1956). Studies in the Quantity Theory of Money. University of Chicago Press, Chicago.
Hetzel, R. (2017). The Evolution of U.S. Monetary Policy. FRBR Working Paper(18-01). doi:https://doi.org/10.21144/wp18-01
Issing, O. (2010). The Development of Monetary Policy in the 20th Century – Some Reflections. NBB Working Paper(186).
Kydland, F., & Prescott, E. (1977). Rules Rather than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy, 85(3), 473-491. doi:https://doi.org/10.1086/260580
Lucas, R., & Sargent, T. (1979). After Keynesian Macroeconomics. Quarterly Review, 3(2), 1-16.
Nelson, E. (2008). Friedman and Taylor on Monetary Policy Rules: A Comparison. FRBSL Review, 90(2), 95-116. doi:https://dx.doi.org/10.20955/r.90.95-116
Svensson, L. (1997). Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets. European Economic Review, 41(6), 1111-1146. doi:https://doi.org/10.1016/S0014-2921(96)00055-4
Taylor, J. (1979). Estimation and Control of a Macroeconomic Model with Rational Expectations. Econometrica, 47(5), 1267-1286. doi:https://dx.doi.org/10.2307/1911962
Taylor, J. (1993). Discretion Versus Policy Rules in Practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. doi:https://doi.org/10.1016/0167-2231(93)90009-L
Taylor, J. (1998). Chapter 7 An Historical Analysis of Monetary Policy Rules. Monetary Policy Rules, 319-348.
Taylor, J. (2008). Monetary Policy and the State of the Economy. Testimony before the Committee on Financial Services, U.S. House of Representatives. Retrieved from Stanford University website: https://web.stanford.edu/~johntayl/John%20B%20Taylor%20-%20Testimony%20-%20Monetary%20Policy%20and%20the%20State%20of%20the%20Economy.pdf
