Inflation targeting in India: A comparison with the multiple indicator approach

The empirical literature on identification and measurement of the impact of monetary policy shocks on the real side of the economy is fairly comprehensive for developed economies, but very limited for emerging and transition economies. In this study, we propose an identification scheme for a developing economy (taking India as a case study), which is able to capture the monetary transmission mechanism for that economy without giving rise to empirical anomalies. Using a VAR approach with recursive contemporaneous restrictions, we identify monetary policy shocks by modelling the reaction function of the central bank and structure of that economy. The effect of monetary policy shocks on the exchange rate and other macroeconomic variables is consistent with the predictions of a broad set of theoretical models. This set-up is used to build a hypothetical case of inflation targeting where the monetary policy instrument is set after assessing the current values of inflation only. This is in contrast with the ‘multiple indicator approach’ currently followed by the Reserve Bank of India (RBI). The results in this study suggest that the demand effects of interest rate are stronger than the exchange rate effects. There is also evidence of the mitigation of potential conflict between exchange rate and interest rate, one of main monetary policy dilemmas of the RBI in inflation targeting.     

Monetary policy interaction within or without an exchange-rate arrangement

In a simple stochastic two-country model in which each country uses monetary policy to offset shocks that impinge on its national income, the policy rule chosen by each country is affected by the rule chosen by the other. A monetary union emerges as a Nash equilibrium (and is Pareto optimal) if the variance of shocks affecting the real exchange rate is small. An exchange-rate arrangement, and in particular a system of exchange-rate bands such as the European Monetary System (EMS), may create a need for more policy cooperation and may give scope for strategic asymmetries.     

Monetary policy shocks and exchange rates in Asian countries

In this paper, we empirically investigate the effects of monetary policy shocks on exchange rates in Asian countries. To do so, we use VAR models which impose sign restrictions on impulse responses to identify monetary policy shocks. We find that contractionary monetary policy shocks lead to significant exchange rate appreciation in Malaysia, the People’s Republic of China, and the Republic of Korea. However, in India, Indonesia, the Philippines and Thailand, we find either a significant depreciation or no significant effect. These results suggest that an interest rate increase (or decrease) may not necessarily shield Asian countries from exchange rate depreciation (or appreciation) pressure following a U.S. interest rate increase (or decrease).     

The Behavior of the Real Exchange Rate Under Fixed and Floating Exchange Rate Regimes

This article investigates the behavior of real exchange rates under fixed and flexible exchange rates. Using data from both the Bretton Woods and the modern floating periods, we decompose real exchange rate movements into components attributable to supply shocks, real demand shocks, monetary shocks, capital flows shocks, and real oil price shocks. Empirical results show that real demand shocks are an important source of real exchange rate movements under both fixed and flexible rates, while monetary shocks are negligible. Supply and oil price shocks seem to be more important under Bretton Woods, while capital flows shocks seem to explain a relatively higher proportion of real exchange rate movements under the modern floating period.     

Monetary operations by Hong Kong's Currency Board

Currency Boards are typically seen as demonstrating the advantages of rule-bound monetary policies with automatic responses to exchange market imbalances. We study the monetary operations conducted by Hong Kong's Currency Board, using daily data between September 1998 and December 2001. Since this regime is one-sided in that there is a commitment to sell, but not to buy, US dollars at a given rate, we estimate logit equations for dollar purchases. We show that these have shifted over time and that while the variables are statistically highly significant, the predictive power is low.     

Proposal for a common currency among rich democracies

This paper proposes the creation of a common currency for the industrialized democracies, notably the United States, the European Union, and Japan. A common currency implies a common monetary policy; institutional arrangements for which are discussed. The rationale rests on the assumption that asymmetrical financial shocks will become more important than asymmetrical real shocks for these large, diversified economies, and that one of the growing sources of financial shocks will be changing expectations about exchange rate movements among national currencies. These financial shocks will in turn disturb real economies, such that flexible exchange rates among major currencies will increasingly become sources of shock more than shock absorbers. Such a common currency would also make it much easier for emerging markets to frame their monetary and exchange rate policies.     

Sectoral Effects of Monetary Policy: Evidence from Malaysia

The present paper analyzes the effects of monetary policy shocks on aggregate and eight sectoral outputs for Malaysia using vector autoregressive models. In line with many existing studies on Malaysia, the results are supportive of the real effects of monetary policy shocks. More importantly, we find evidence suggesting sector-specific responses to innovations in monetary policy. In response to positive interest rate shocks, we note that the manufacturing, construction, finance, insurance, real estate and business services sectors seem to decline more than aggregate production. By contrast, we observe the relative insensitivities of agriculture, forestry and fishing, mining and quarrying, electricity, gas and water to interest rate changes. The results, therefore, seem to confirm potential disparities in the effect of monetary policy on real sectoral activities.     

International monetary arrangements in the Asia-Pacific before and after

This paper assesses the characteristics and policy implications of the international monetary arrangements in the Asia-Pacific pre- and post-July 1997. It first examines the literature on speculative attacks on fixed and managed exchange rate regimes. Since these speculative attacks are more likely to be successful when financial markets are well integrated, it then assesses the degree of financial market integration in the region. Furthermore, as the empirical evidence also suggests a possible role for real exchange rate overvaluation, we examine the evidence regarding misalignment. Using a purchasing power parity (PPP) criterion and a criterion based on a Balassa-Samuelson model, we find mixed evidence of exchange rate overvaluation. Given that our ability to determine the equilibrium real exchange rate is so limited, we caution against a return to a fixed or highly managed exchange rate regime. Finally, we assess how monetary policy and exchange rate policy have interacted over the pre- and post-crisis periods, using a monetary model of exchange rates. JEL classification: F31; F33; F34     

THE ROLE OF THE EXCHANGE RATE IN A NEW KEYNESIAN DSGE MODEL FOR THE SOUTH AFRICAN ECONOMY

We build a small open economy New Keynesian dynamic stochastic general equilibrium model for South Africa similar to Steinbach et al. We abandon their assumption of complete risk sharing with the foreign economy, and introduce country risk shocks to allow deviations from uncovered interest rate parity. These changes allow us to include the exchange rate as an observable variable in the estimation of the model. Using forecast error variance decompositions and historical decompositions, we show that country risk shocks have sizable effects on the South African business cycle. We also explore the optimal monetary policy implications of our model within the context of Taylor rules.     

International monetary transmission in East Asia: Floaters,non-floaters,and capital controls

This paper analyzes the impacts of the United States (US) monetary shocks on East Asian countries using structural vector-autoregression (VAR) model. We find that the impacts of the US monetary shocks on East Asian domestic interest rates and exchange rates contradict conventional wisdom. The conventional exchange rate channel is unlikely to play much role in the transmission of the US monetary policy shocks to floaters in East Asian countries, excluding Japan. In these countries, the domestic interest rates respond strongly to the US interest rate changes, by giving up monetary autonomy, probably because of fear of floating. However, the domestic interest rate does not respond much in countries with fixed exchange rate regimes and capital account restrictions, such as China and Malaysia. This may suggest that the countries with fixed exchange rate regimes enjoy a higher degree of monetary autonomy, most likely with the help of capital account restrictions.     

Measuring Monetary Policy in a Small Open Economy with Managed Exchange Rates: The Case of Taiwan

We use sign restrictions to identify monetary policy for a small open economy with heavily managed exchange rates. We apply the proposed sign restrictions to the Taiwanese case, where existing studies tend to find no clear effect of monetary policy shocks on the output and price level. Our principal findings are that a contractionary monetary policy shock causes a permanent and significant decline in real gross domestic product, broad money, and price level. Our identification scheme is able to avoid the puzzling impulse responses from which other identification schemes more or less suffer. The fact that monetary policy has not been correctly identified may have led existing studies to conclude that monetary policy is ineffective.     

China's monetary policy surprises and corporate real investment

We evaluate the effect of China's monetary policy shocks on corporate real investment. We propose a new approach to identify China's monetary policy shocks using high-frequency surprises based on treasury futures around monetary policy announcements as external instruments. We then estimate the dynamic effect of monetary policy shocks on corporate real investment using a rich firm-level data of all listed non-financial firms in China. We find that an unexpected monetary policy easing boosts firms' investment expenditures with heterogeneous dynamic responses across firms: small-sized firms have quicker responses than large-sized firms, especially for non-state-owned enterprises (non-SOEs). We show that sales revenue response could be the channel through which monetary policy shock transmits to non-SOEs' investment expenditures in China.     

Testing the Taylor Model Predictability for Exchange Rates in Latin America

Exchange rates forecasting performance is tested by a model which incorporates endogenous monetary policy through a Taylor rule reaction function. Other usual monetary and equilibrium empirical exchange rate models are also evaluated for comparison purposes. Predictability is tested by comparing the models to a benchmark random walk specification. We contribute to the recent literature in many ways. First, we include models of forward-looking endogenous monetary policy to the exchange rate forecasting exercise, the Taylor model. Second, our data, set across countries, is uniform in terms of economies adopting both inflation targeting and a flexible exchange rate. Third, our study sheds light on exchange rate determinants for emerging economies: Brazil, Chile, Colombia, Peru and Mexico. Our results show strong predictability evidence for the Taylor model and indicate that assuming models of endogenous monetary policy and the present value of expected fundamentals is a rewarding strategy to model exchange rate determination.     

Price Stability and the Case for Flexible Exchange Rates

We revisit Friedman’s case for flexible exchange rates in a small open economy with several distortions and rigidities and a variety of domestic and external shocks. We find that, for external shocks, the flexible exchange rate regime outperforms the fixed regime independent of the source of domestic nominal rigidities provided that the monetary authorities pursue a policy of strict inflation targeting. For domestic supply shocks, a joint policy of a flexible exchange rate and strict inflation targeting fares well when the main source of nominal rigidities is in the domestic goods markets, but not if rigidities arise in the labor markets.     

The Optimal Monetary and Macroprudential Policies for the South African Economy

We investigate the optimal design and effectiveness of monetary and macroprudential policies in promoting macroeconomic (price) and financial stability for the South African economy. We develop a New Keynesian dynamic stochastic general equilibrium model featuring a housing market, a banking sector and the role of macroprudential and monetary policies. Based on the parameter estimates from the estimation, we conduct an optimal rule analysis and an efficient policy frontier analysis, and compare the dynamics of the model under different policy regimes. We find that a policy regime that combines a standard monetary policy rule and a macroprudential policy rule delivers a more stable economic system with price and financial stability. A policy regime that combines an augmented monetary policy (policy rate reacts to financial conditions) with macroprudential policy is better at attenuating the effects of financial shocks, but at a much higher cost of price instability. Our findings suggest that monetary policy should focus solely on its primary objective of price stability and let macroprudential policy facilitate financial stability on its own.     

The Role of the Exchange Rate as a Shock Absorber in a Small Open Economy

This paper analyses interactions between the real exchange rate and business cycles in a small open economy like Norway. Using a structural vector autoregression model, the role of different shocks are analysed, to investigate to what extent the real exchange rate is absorbing shocks, or a source of shocks itself. The results are ambiguous. Output and the real exchange rate are mainly explained by separate shocks, so that relinquishing exchange rate independence should come at little cost. However, the importance of nominal shocks in the business cycle emphasises that stabilisation is possible. Hence, remaining monetary independence may be attractive.     

The Exchange Rate and the Monetary Transmission Mechanism in Germany

For the conduct of monetary policy under floating exchange rates it is important to understand the role of the exchange rate in the monetary transmission mechanism (MTM). The timing and the magnitude of the effects of a change in the exchange rate on output and inflation may be quite different from traditional interest rate channels, thereby affecting optimal policy. In this paper we examine the exchange rate channel in the MTM in Germany by estimating an identified VAR model. Two features of the results are highlighted. The effect of a policy shock on the exchange rate accelerates the pass-through of policy into prices and leads to a different response of the various components of GDP. We then show that these qualitative effects can be duplicated in a general equilibrium model for a semi-small open economy with sticky prices and wages that is calibrated to capture the main features of the German economy.     

THE HONG KONG CURRENCY BOARD'S DEFENSE AGAINST FINANCIAL MARKET PRESSURE: A BEHAVIORAL PERSPECTIVE

Exchange rate regimes do not operate in an institutional vacuum, even when the scope for exercising policy discretion is distinctly limited. The Hong Kong linked exchange rate system is no exception. An interesting feature of the institutional environment in this case, not highlighted previously, is the apparent divergence in the assumptions of policymakers and market players regarding the merits of this mechanism in particular and currency boards in general. The corollary is that the Hong Kong monetary authorities need to intensify their efforts to disseminate relevant information, focusing especially on targets in the financial sector.     

Policy Choices and Resilience to International Monetary Shocks

Abstract

The well-known trilemma theory states that the nominal exchange rate regime plays a crucial role in a country's ability to pursue monetary policy that is for its domestic objectives independent from other countries' influences. In particular, a flexible exchange rate is required for an independent monetary policy. Capital controls may help a country with a fixed exchange rate to gain some policy space but the effect of capital controls is leaky and often short-lived. We revisit these conventional wisdoms and find no strong evidence supporting them in practice. In particular, a flexible exchange rate does not reliably deliver monetary policy independence, but capital controls do. This is consistent with the view that most (developing) countries dislike either depreciation or appreciation of their currencies, and therefore would choose to follow US monetary policy moves even if they are on a flexible exchange rate regime. In other words, to build resilience to international monetary policy shocks, capital controls are a necessarily component.     

Openness and the Effects of Fiscal and Monetary Policy Shocks on Real Output in Nigeria (1960–2003)*

Abstract: This study investigates the effects of monetary and fiscal policies on the real output growth in a small open economy. It is a country‐specific, time series study that verifies the implication of increasing economic openness on the efficacy of monetary and fiscal policy. A modified GARCH model was used to estimate the anticipated and unanticipated shocks. Two measures of fiscal and monetary shocks were combined with openness and real oil price shocks in a VECM model to assess the effects of anticipated and unanticipated policy shocks on the output equations. The empirical results showed that anticipated and unanticipated fiscal and monetary shocks had no significant positive effects on real output. This suggests that the open macroeconomic version of the policy ineffectiveness proposition was valid for both monetary and fiscal policy shocks in Nigeria. This is in consonance with earlier works in this area. Furthermore, the degree of openness and oil price shocks had a negative implication on the efficacy of macroeconomic policy in Nigeria; also in agreement with the Dutch Disease Syndrome. Finally, the policy implication of this study therefore is that trade liberalization policy should be implemented cautiously. The Nigerian economy is weak to withstand the unwholesome consequences of full economic integration.