Uruguay: Two Years of Monetary Policy in Adverse Conditions
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Uruguay: Two Years of Monetary Policy in Adverse Conditions Comments by Víctor Olivo The views expressed in this documents are those of the author and should not be interpreted as those of the Central Bank of Venezuela. Some similarities to the Venezuelan case.

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Uruguay: Two Years of Monetary Policy in Adverse ConditionsComments by Víctor OlivoThe views expressed in this documents are those of the author and should not be interpreted as those of the Central Bank of Venezuela.

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Some similarities to the Venezuelan case

  • This is a very interesting paper, particularly for an economist of a central bank that faces similar problems in the design and implementation of monetary policy to those discussed by Dominioni for the case of Uruguay.

  • The Venezuelan economy has experienced a relatively high (two - digits) and volatile inflation since the beginning of the 80s.

  • Most of the economic programs adopted in Venezuela to stabilize the economy and curb inflation have been based on the control of the exchange rate. The only exception was the program applied during the period 1989 – 1991 under the guidance of the IMF.

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Some similarities to the Venezuelan case

  • From 1996 to january 2002 the central bank adopted an exchange rate band regime to control the inflation rate which accelerated with the 1994 – 1995 finacial crisis.

  • The exchange rate band wich operated in practice as a crawling peg regime achieved a gradual reduction in infaltion (from 100% in 1996 down to 13% in 2001).

  • However, the overvaluation of the currency, an expansive fiscal policy, especially during 2000 and 2001, and political turmoil combined to make the scheme unsustainable.

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Some similarities to the Venezuelan case

  • With the adoption of a floating exchange rate regime the technical staff of the CB proposed to the authorities a transition regime that we called Flexible Monetary Strategy (FMS).

  • This FMS pretended to combine some elements of a strategy based on the control of a monetary aggregate (the monetary base) with those of an inflation targeting regime by introducing an additional set of indicators in the monetary policy decision process.

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Some similarities to the Venezuelan case

  • The monetary aggregate target part of the FMS was based on a band for the monetary base, with its central value determined by the quantity theory and the band limits defined to absorb demand / supply shocks to the monetary base and accommodate an inflation target set as range.

  • Unfortunately, the FMS failed:

    • The monetary authorities never committed to the strategy and continued their concern with the exchange rate, intervening systematically in the FX market.

    • Fiscal indiscipline and political instability intensifed in 2002.

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Why the fascination with inflation targeting?

  • I do not understand the fascination that Latin American central banks show for inflation targeting.

  • Inflation targeting is a very vague strategy and vagueness is a bad start for central banks that lack a solid reputation as inflation fighters.

  • In the context of the models used by Ball (1997, 1998) it is easy to show that inflation targeting (either strict or flexible) implicitly implies a Taylor type interest rate rule (Olivo 2003).

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Why the fascination with inflation targeting?

  • Thus, interpreted as equivalent to following a Taylor rule, inflation targeting would have the problem pointed by Dominioni that it requires a well developed financial market to be effective, but without the transparency that the committment to an interest rate rule would bring about.

  • Defined as a general framework for monetary policy (not a rule) as it is done in Bernanke et al (1999), Svensson (2000), and Mishkin and Savastano (2001), we enter into a vagueness that gives little guidance to policymakers about what to do to achieve the inflation target. This approach is in its core pure discretion (Bofinger 2001).

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Why the fascination with inflation targeting?

  • In a paper that I am working on (Interest rate rules Vs money growth rules: some theoretical issues and an empirical application for Venezuela), I compare the performance of an interest rule, similar to the Taylor rule, with that of the money growth rule proposed by Friedman (1962), and a flexible version of this rule that responds to the inflation gap and the output gap. Performance in this paper is measured in terms of the volatility (unconditional variance) of the output gap and the inflation rate when different shocks affect the economy under each type of rule.

  • At the theoretical and empirical level, I find that the economy (characterized by the output gap and the rate of inflation) should behave in a fairly similar way when different shocks are introduced under the diverse rules considered.

  • In general, the interest rate rule is better in terms of output stabilization, while the money growth rules, particularly the flexible version, is better in terms of inflation stabilization.

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Why the fascination with inflation targeting?

  • These results are in line with those in the empirical studies conducted by Neumann and von Hagen (2002), and Ball and Sheridan (2002), which find that different monetary strategies achieved similar disinflationary results during the 90s.

  • What is the key then for the substantial improvement in the effectiveness of monetary policy and central banks in the 90s in terms of macroeconomic stabilization?

  • My answer is the the widespread change in focus toward price stability in the long-run. In contrast to previous decades, central banks in the 90s seriously committed to the attainment of price stability as their overriding goal.

  • But despite the crucial role of committment to price stability in the recent success of monetary policy, I still share Friedman´s concern with the granting of too much discretion to monetary authorities (Friedman, 1960, p. 86).

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Why the fascination with inflation targeting?

  • A more recent restatement of this argument is presented by Woodford (2003), who considers that to lock in this success, it is necessary to accompany it with a policy commitment.

    “A systematic approach to policy provides an explicit framework for decisionmaking within the bank, but that is also used to explain the bank´s decisions to the public” (Woodford, 2003, p. 14)

  • In contrast to Woodford, however, I believe that in less advanced countries there is a strong case in favor of a monetary policy based on a simple rule for a monetary aggregate.

  • The main reason is that with shallow financial markets and shaky fiscal institutions, the link between the short-run interest rate managed by the central bank and the long-run rate relevant for aggregate demand decisions may be quite weak and unstable.

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Why the fascination with inflation targeting?

  • A weaker recommendation would be that even if monetary policy is conducted based on an interest rate rule, monetary aggregates should still play a major role in policy decisions. This view is strongly supported by Poole (1994), Meltzer (2001), and is embedded in the European Central Bank “two pillars” strategy.

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An assessment of the CBU strategy

  • Given the prior considerations, I think that the CBU is on the right track and it should not rush to join the IT club.

  • The CBU should stick to its strategy, and continue improving operational aspects and transparency.

  • In this sense, announcing publicly an inflation target should contribute to enhance the effectiveness of monetary policy, and it is not contradictory with keeping the commitment to the intermediate monetary base target.

  • My view is that the trick to a successful monetary policy (apart from some luck) is to be persistent and keep a systematic approach based on a clear commitment to price stability.

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Inflation targeting and exchange rate management: a word of caution

  • In Olivo (Taylor Rules and Inflation Targeting Do Not Work with Systematic Foreign Exchange Intervention, 2003), I used a model similar to that developed by Ball (1998) to analyze how the attempt to influence directly the behavior of the nominal exchange rate affects the conduct of monetary policy under a Taylor rule and inflation targeting.

  • The main conclusion of the paper is that a conflict exists between the implementation of a Taylor rule or inflation targeting, and systematic intervention in the FX market.

  • The response of the interest rate to given deviations of in output and inflation from their mean levels is reduced under systematic FX intervention.

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Bibliography and References caution

Ball, Laurence, 1997. Efficient rules for monetary policy. NBER Working Paper 5952

1998. Policy Rules for Open Economies. NBER Working Paper 6760.

Ball, Laurence, Niamh Sheridan, 2003. Does inflation targeting matter? NBER Working Paper 9577.

Bofinger, Peter. 2001. Monetary Policy: Goals, Institutions, Strategies, and Instruments. Oxford University Press.

Friedman, Milton, 1962. A Program for Monetary Stability.

Nelson, Edward, 2002. Direct effects of base money on aggregate demand: theory and evidence. Journal of Monetary Economics 49, 687-708.

McCallum, Bennett, 1999. Recent Developments in the Analysis of Monetary Policy. Federal Reserve of St. Louis Review, November / December, Vo. 81, No. 6.

McCallum Bennett, Edward Nelson, 1999. An optimizing IS-LM specification for monetary policy and business cycle analysis. NBER Working Paper 5875.

Meltzer, Allan, 2001. The transmission process. Published in The Monetary Transmission Process. Edited by the Deutsche Bundesbank.

Mishkin, Frederic, Miguel Savastano, 2001. Monetary Policy Strategies for Latin America. Journal of Development Economics Vol. 66, 415 – 444.

Olivo, Victor, 2003. Interest rate rules and inflation targeting do not work with systematic foreign exchange market intervention. Banco Central de Venezuela, Serie Documentos de Trabajo, 41, March 2003.

2004. Interest rate rules Vs Money Growth Rules: Some Theoretical Issues and an Empirical Application for Venezuela. Unpublished working paper.

Poole, William (1994). Monetary Aggregates Targeting in a Low – Inflation Economy. Published in Goals, Guidelines, and Constraints Facing Monetary Policymakers; edited by Jeffrey Fuhrer. Federal Reserve Bank of Boston.

von Hagen, Jurgen, Manfred Neumann (2002). Does Inflation Targeting Matter? Federal Reserve Bank of St. Louis Review, July / August, Vol. 84, No 4.

Walsh, Carl, 2003. Monetary Theory and Policy. Cambridge.

Woodford, Michael, 2003. Interest and Prices: Foundations of a Theory. Princeton University Press.