Monetary Policy, Interest Rate Rules, and Inflation Targeting: Some Basic Equivalences

Policymakers increasingly view short-term nominal interest rates as the main instrument of monetary policy, often in conjunction with some inflation target. Interest rates on short-term indexed government debt (i.e., a real interest rate) have also been used as policy instruments. To understand the pros and cons of different policy rules and instruments, this paper derives some basic equivalences among different policy rules. It is shown that, under certain conditions, the following three rules are exactly equivalent: (i) a 'k-percent' money growth rule; (ii) a nominal interest rate rule combined with an inflation target; and (iii) a real interest rate rule combined with an inflation target. These policy rules, however, become increasingly complex: the first rule requires no feedback mechanism; the second rule requires responding to the inflation gap; while the third rule involves responding to both the inflation gap and the output gap. It is also shown that policy rules which respond to the output gap may avoid a deflationary adjustment.

Inflation stabilization in chronic inflation countries: The empirical evidence

There is a rich history of stabilizations in chronic inflation countries, which spans more than three decades. This provides a unique opportunity to identify the main patterns of adjustment and examine econometrically some of the main features of disinflation in chronic inflation countries. Our study is based on 17 stabilization plans from 1964 to the present in 7 countries: Argentina, Brazil, the Dominican Republic, Israel, Mexico, Peru, and Uruguay. Twelve of these programs were based on the use of the exchange rate as the nominal anchor, while 5 were based on the use of a monetary aggregate. In addition to reviewing the main "stylized facts" for these 17 stabilization plans we resort to different econometric exercises and thus are able to provide some rigorous econometric basis for several key features of disinflation in chronic inflation countries.inflation stabilization exchange rates mone crises consumption boom

Intertemporal consumption substitution and inflation stabilization:An empirical investigation

Exchange rate based inflation stabilization programs in developing countries often lead to an initial consumption boom followed by an eventual recession. To explain such phenomenon, theoretical models have focused on the role of intertemporal consumption substitution in response to temporary reductions in nominal interest rates. This paper assesses the empirical relevance of such mechanism for six high-inflation developing countries that have gone through repeated stabilization attempts. A simple monetary model is used to obtain estimates of the intertemporal elasticity of substitution, and dynamics simulations are carried out to test the predictive power of the model. The analysis concludes that, in several cases, temporary shocks appeared to have played a key role in generating a consumption boom.inflation consumption boom stabilization interest rates

Do Exchange Rate-Based Stabilizations Carry the Seeds of Their Own Destruction?

Most of the major exchange rate-based stabilizations (ERRS) in chronic inflation countries in the last 30 years have ended in spectacular financial and balance of payments crises. Moreover, there is a stunning resemblance in the dynamics of the main macroeconomic variables in all these programs. In the first stages, inflation falls, the economy expands, and consumer spending (particularly of durable goods) explodes. In light of this, the figure of the Finance Minister takes God¬like proportions. Shortly thereafter, however, the “dark side” of ERRS emerges. The slow convergence of inflation fuels a large real exchange rate appreciation which, together with the fall in private saving, lead to large current account imbalances and overborrowing. At this stage, the Finance Minister faces an unenviable dilemma: deflation or devaluation. Often forced by a run on the currency, he or she is eventually left with no choice but to devalue and then, having broken the no-devaluation pledge, is forced out of office, vilified, and blamed for most of the economic ills of the country.

Output Costs, Currency Crises, and Interest Rate Defense of a Peg

Central banks typically raise short-term interest rates to defend currency pegs. Higher interest rates, however, often lead to a credit crunch and an output contraction. We model this trade-off in an optimizing, first-generation model in which the crisis may be delayed but is ultimately inevitable. We show that higher interest rates may delay the crisis, but raising interest rates beyond a certain point may actually bring forward the crisis due to the large negative output effect. The optimal interest rate defense involves setting high interest rates (relative to the no defense case) both before and at the moment of the crisis. Furthermore, while the crisis could be delayed even further, it is not optimal to do so.

How is Tax Policy Conducted over the Business Cycle?

It is well known by now that government spending has typically been procyclical in developing economies but acyclical or countercyclical in industrial countries. Little, if any, is known, however, about the cyclical behavior of tax rates (as opposed to tax revenues, which are endogenous to the business cycle and hence cannot shed light on the cyclicality of tax policy). We build a novel dataset on tax rates for 62 countries for the period 1960-2013 that comprises corporate income, personal income, and value-added tax rates. We find that, by and large, tax policy is acyclical in industrial countries but mostly procyclical in developing countries. Further, tax policy in countries with better institutions and/or more integrated with world capital markets tends to be less procyclical/more countercyclical.

Delaying the Inevitable: Optimal Interest Rate Policy and BOP Crises

The classical model of balance of payments crises implicitly assumes that the central bank sits passively as international reserves dwindle. In practice, however, central banks typically defend pegs aggressively by raising short-term interest rates. This paper analyzes the feasibility and optimality of raising interest rates to delay a potential BOP crisis. Interest rate policy works through two distinct channels. By raising demand for domestic, interest-bearing liquid assets, higher interest rates tend to delay the crisis. Higher interest rates, however, increase public debt service and imply higher future inflation, which tends to bring forward the crisis. We show that, under certain conditions, it is feasible to delay the crisis, but raising interest rates beyond a certain point may actually hasten the crisis. A similar non-monotonic relationship emerges between welfare and the increase in interest rates. It is thus optimal to engage in some active interest rate defense but only up to a certain point. In fact, there is a whole range of interest rate increases for which it is feasible to delay the crisis but not optimal to do so.

Living with the Fear of Floating: An Optimal Policy Perspective

As documented in recent studies, developing countries (classified by the IMF as floaters or managed floaters) are extremely reluctant to allow for large nominal exchange rate fluctuations. This 'fear of floating' is reflected in the fact that, in spite of being subject to larger shocks, developing countries exhibit lower exchange rate variability and higher reserve variability than developed countries. Moreover, there is a positive correlation between changes in the exchange rate and interest rates and a negative correlation between both changes in reserves and the exchange rate and changes in interest rates and reserves. We build a simple model that rationalizes these key features as the outcome of an optimal policy response to monetary shocks. The model incorporates three key frictions: an output cost of nominal exchange rate fluctuations, an output cost of higher interest rates to defend the currency, and a fixed cost of intervention.

Stabilization and growth in transition economies: The early experience

This paper analyzes the growth and stabilization experience in 26 transition economies in eastern Europe, the former Soviet Union, and Mongolia for the period 1989-1994. Inflation rates have declined significantly in most countries following an inflation stabilization program. Growth resumes after stabilization occurs, typically with a lag of about two years. Reducing inflation thus appears to be a precondition for growth. An econometric analysis of the short-run determinants of inflation and growth illustrates the key roles of fixed exchange rates, improved fiscal balances, and structural reforms in spurring growth and lowering inflation, and confirms that inflation stabilization programs have been beneficial for growth even after controlling for structural reforms.Transition, Eastern Europe, growth, reforms, stabilization, inflation, fixed exchange rates