Frameworks for Monetary Stability
Front Matter

Front Matter

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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    Frameworks for Monetary Stability

    Policy Issues and Country Experiences

    Editors Tomás J.T. Baliño

    Carlo Cottarelli

    Papers presented at the sixth seminar on central banking Washington, D.C. March 1–10, 1994

    IMF Institute and Monetary and Exchange Affairs Department International Monetary Fund Washington • 1994

    © 1994 International Monetary Fund

    Cover design by IMF Graphics Section

    Joint Bank-Fund Library Cataloging-in-Publication Data

    Frameworks for monetary stability: policy issues and country experiences: papers presented at the sixth seminar on central banking, Washington, D.C. March 1–10, 1994/editors, Tomás J.T. Baliño, Carlo Cottarelli. — Washington, D.C.: International Monetary Fund, c1994.

    • p. cm.

    • Includes bibliographical references (p.).

    • ISBN 9781557754196

    • 1. Banks and banking, Central — congresses. I. Baliño, Tomás, J.T.

    • II. Cottarelli, Carlo.

    • G1811.E95 1994

    Price: US$35.00

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    There is now a wide consensus that monetary stability should be the primary concern of a central bank. In the last few years, this consensus has been manifested in a wide-ranging revision of the statutes and laws regulating the operations of central banks in many industrial and developing countries. These laws now incorporate the principle that price stability is the primary objective of the central bank and that all other objectives should be pursued only insofar as they are not in conflict with the achievement of this primary goal. In many economies in transition, central bank laws have also followed the same standard. Therefore, many central banks have been considering ways in which they can better carry out their strengthened mandate to pursue monetary stability.

    This volume provides a contribution to the debate on how monetary policy, and more generally central bank policies, should be managed when the monetary authorities endeavor to achieve and maintain monetary stability. It collects the papers presented at the Sixth Seminar on Central Banking organized by the International Monetary Fund and held in Washington, D.C. on March 1–10, 1994. The IMF central banking seminars have become a traditional forum where central bankers from all over the world meet and share their experiences in handling a wide spectrum of issues, ranging from monetary policy to bank supervision, from payment systems to structural financial sector reforms. The 1994 seminar benefited from the participation of senior central bank officials from over thirty countries and from the contributions presented by a number of Fund and World Bank staff members, as well as by several outside speakers, most of whom are themselves central bankers. As on previous occasions, the debate was stimulating and constructive and was enriched by the synergies arising from bringing together the experiences of many different countries. We are grateful to all those who, inside and outside the Fund, contributed to the success of the seminar. I also would like to thank the members of the Fund’s Executive Board who kindly assisted in obtaining the participation of the speakers and of the seminar participants.

    Michel Camdessus

    Managing Director

    International Monetary Fund


    Central banking is a rapidly changing activity. Central bankers have to keep abreast of developments in a world in which new financial instruments appear practically every day and in which a global financial market is rapidly becoming a reality. These two factors have made communication and exchanges of views among central bankers increasingly important. The central banking seminars that the Monetary and Exchange Affairs Department and its predecessor, the Central Banking Department, have organized in cooperation with the IMF Institute are a key contribution of the IMF to the conversation among central bankers.

    Participation in this conversation has been growing over the years, as the IMF has welcomed new member countries, a process that has accelerated over the last few years and has made the IMF a truly universal institution. It has required a special effort to make the discussions relevant to central bankers, who come from different backgrounds and face diverse circumstances.

    We believe that the issues discussed in the central banking seminars are of interest to a broad audience. The authors of the papers presented at these seminars have made them interesting not only to central bankers, but also to government officials, monetary economists, commercial bankers, and others interested in monetary issues. Therefore, we decided that publishing the papers in a book would make those seminars even more useful.

    As of the entry into force of the Maastricht Treaty on November 1, 1993, some changes have been introduced in the terminology regarding the European Community and some of its institutions, some of which appear in this book. The European Union has replaced the European Community as the umbrella term. (The European Community, however, continues to exist within the broader framework of the Union.) The European Commission will replace the Commission of the European Communities in all but legal and formal contexts. In this volume, we have used both the old and the new terms: the old terms when discussing pre-Maastricht events and the new terms when discussing current events.

    In addition to the authors of the papers, many people in the IMF have contributed to the production of this book. In particular, I wish to note the work of Tomás J.T. Baliño and Carlo Cottarelli in organizing the seminar and editing the book, the editorial assistance provided by Ella Wright and Elisa M. Diehl of the External Relations Department, and the secretarial support provided by Marie-Carole St. Louis.

    J. B. Zulu


    Monetary and Exchange Affairs Department




    The steady decline of inflation rates in many countries in recent years is often interpreted as evidence that the battle against inflation has been won at last. The success is, from some aspects, startling. During the decade ending in 1993, the growth rate of consumer prices in industrial countries averaged about 4 percent, versus almost 10 percent in the preceding ten years. Inflation fell below 3 percent in 1993 and is expected to decline further in 1994 (International Monetary Fund, 1994). Thus, at the close of a century in which inflation soared to unprecedented levels in many industrial countries, the goal of price stability finally appears to be within reach.

    A closer look at the facts should, however, caution against complacency. On the one hand, the remarkable success in containing price increases in the industrial world in the past decade was favored by the absence of exogenous shocks comparable to those experienced during the 1970s (such as the two oil shocks). On the other hand, inflation in the developing world has had a considerably less favorable record. The average inflation rate in developing countries exceeded 40 percent in 1984–93, against an average of 23 percent in the preceding decade. These figures do not include the so-called economies in transition, where inflation in 1990–93 has remained in the three-digit range. Thus, from a global perspective, inflation is still a problem.

    At the same time, failure to narrow the dispersion of inflation rates across countries or country groups has led to continued exchange rate instability. Thus, the objective of monetary stability—that is, of a stable value of money both at the domestic level (price stability) and at the external level (exchange rate stability)—is, from a global perspective, still far from being attained.

    To some extent, this failure to achieve monetary stability reflects the limited development of economic theory in this area, although it has been helpful for two reasons. First, economists now recognize that the trade-off between inflation and growth is short-lived and that, on the contrary, inflation involves real costs in the long run (Driffill, Mizon, and Ulph, 1990). This realization has strengthened the resolve of policymakers to fight inflation.1 Second, economists have provided clear means on how to stop hyperinflation. For example, it is now accepted that reckless increases in the money supply (often used to finance large public sector deficits) inevitably fuel inflation. The present careful abandonment of monetary targets casts a doubt on this belief.

    But, despite the recognition of a tight relation between excessive money supply increases and inflation, progress has been slow in defining a detailed operational framework for monetary policy and, particularly, in providing simple recipes to reduce the short-run costs of disinflation. Many questions still remain unanswered. For example, under what circumstances is pegging the exchange rate an appropriate component of a disinflation package? How stable should monetary aggregates be to serve as an intermediate monetary policy target? What criteria should be followed to select the appropriate intermediate target? How important is it to grant independence to the central bank to enhance its credibility and thus reduce the costs of disinflating the economy? What is the appropriate balance between rules and discretion in the implementation of monetary policy?

    At the same time, monetary theory—as well as monetary practice—has been confronted by new challenges posed by the development of the economic environment in which monetary policy takes place. Four developments have recently attracted attention. The first is the rapid increase of capital movements, not only at the regional but also at the global level, which has tightened the link between monetary developments in different countries and between monetary and exchange rate policies. The second is financial innovation, which has altered the statistical relation between monetary aggregates and the final objectives of monetary policy and has in turn required the introduction of new and more market-oriented monetary instruments. The third is the increased size and sophistication of the instruments for government debt management that are used either by the central bank as government fiscal agent or directly by the government treasury. The fourth is the increased complexity of the financial structure, which has posed new challenges to the central bank as manager of the payment system and as supervisor of the financial sector.

    Owing to the complexities of the problems involved, it has been impossible to identify a single optimal framework for monetary stability. Economic theory now offers a “menu” of frameworks for monetary stability and identifies some of the factors that might affect the choice of the appropriate framework. The existence of this multiplicity of approaches to monetary stability was the theme of the sixth seminar on central banking organized by the International Monetary Fund. This report brings together the papers presented in that seminar. This introduction describes below the structure of the report, gives a short summary of each paper, and discusses the links to be found between them.

    The Structure of the Report

    The papers included in this report can be grouped in two categories. The first set of papers (Parts II-V) reviews the various frameworks for implementation of monetary policy that economic theory has suggested or that policymakers have adopted in practice. The second set of papers (Parts VI-IX) focuses on how monetary policy should be implemented in practice, taking into account some complications relating to the environment in which the central bank operates, as well as its “secondary” responsibilities such as debt management, bank supervision, and the payments system. The report concludes with a “postscript” containing Manuel Guitián’s concluding remarks at the seminar, as well as three previously unpublished papers that served as background material for the seminar.

    Overview Papers

    Two overview papers discuss strategic issues in the choice of a monetary regime. Manuel Guitián takes a fresh look at the long-standing debate on whether monetary policy would best be conducted under a regime based on rules or in a framework where discretion prevails. He points out that, in the real world, the dichotomy between the rule-based and the discretion-based regime is largely artificial. Both at the national level and at the international level, the choice is not between rules and discretion, but between discretion-cum-rules and rules-cum-discretion. With this caveat, he clearly leans toward rule-based regimes, which have the advantage of enhancing the credibility and predictability of monetary policy. He adds that this advantage may become more relevant in the present world of deregulated capital movements. Capital mobility enforces discipline on policymakers acting in both rule-based and discretion-based regimes, as movements away from fundamentals become rapidly unsustainable. But, discretion-based regimes, at least at the national level, may become more easily prey to speculative pressures and are exposed to the risk of having to validate otherwise temporary vagaries of capital and financial markets.

    Robert Flood and Michael Mussa offer a different taxonomy of monetary regimes. Rather than looking at the split between rule-based and discretion-based regimes, they emphasize the distinction between regimes targeting the price level, such as the gold standard, and regimes targeting the inflation level, such as the various regimes prevailing after the abandonment of the gold standard. The shift toward the second type of regime is responsible for the emergence of an upward trend in price levels of both the United States and the United Kingdom following World War I. The authors also address the issue of what determines the choice of the regime and then look at the role of inflation as a source of government revenue. They conclude that heavy reliance on the inflation tax is extremely risky for governments. Maintaining the inflation tax at a level that is sufficiently high (for example, in terms of gross domestic product (GDP)) without falling into a spiraling hyperinflation has not proved to be feasible in most countries. Finally, Flood and Mussa look at the choice of the different regimes aimed at price stability. By comparing results based on simulations of macroeconometric models, they conclude that the targeting of nominal income outperforms the targeting of the exchange rate and the money supply in terms of reducing both output and inflation instability.

    Flexible Exchange Rates, Domestic Anchors, and Discretion

    The next set of papers focuses on the features of different monetary frameworks on their own merit. Two papers look at the experience of countries where monetary policy was formulated in the presence of a floating exchange rate and therefore relied largely on discretionary policies (Japan) or, at least for some time, on domestic anchors (the United States).

    Kuniho Sawamoto and Nobuyuki Ichikawa review the conduct of monetary policy in Japan during the 1980s and 1990s. They stress that during this period monetary policy was guided primarily by pragmatism and discretion, rather than by the pursuit of a single intermediate target or by a specific set of targets. However, there were shifts in the relative importance of the various variables used by the Bank of Japan to guide its decisions. Until the 1980s more emphasis was given to broad money, while after that time interest rates assumed more importance. As to the relation between discretion and inflation performance, the authors draw attention to two conflicting facts. On the one hand, consumer price inflation in Japan was very low through the 1980s. On the other hand, in the absence of binding “monetary rules,” monetary policy was molded, to some extent, by considerations of business cycles, which may have influenced the asset price inflation that Japan experienced during the late 1980s.

    In his paper, Brian Madigan notes that during the late 1970s and most of the 1980s monetary policy in the United States relied on intermediate monetary targets. This reliance was to some extent influenced by a provision of the 1978 Humphrey-Hawkings Act requiring the Federal Reserve to establish annual targets for monetary and credit aggregates, but the use of intermediate targets also reflected the belief, firmly held by the Federal Reserve, that simple and transparent rules have clear advantages. In the absence of intermediate targets, it is more difficult for the central bank to select the appropriate stance of monetary policy, and it is more difficult for borrowers, lenders, the Congress, and the public generally to interpret the behavior of the central bank. Unfortunately, relying on intermediate targets has been increasingly difficult in the United States on account of financial innovation that has destabilized the income velocity of monetary and credit aggregates. The Federal Reserve has therefore shifted to a discretionary approach similar to the Japanese one, relying on a number of indicators and information variables, including quantities of money and credit, interest rates, the slope of the yield curve, and commodity prices.

    These two papers describe very aptly the problem faced by many central banks. Even if it is recognized that rule-based approaches to monetary policy are preferable, it may not be possible to find a domestic monetary or credit aggregate with a sufficiently stable relation to the final monetary policy target. This factor has led many central banks to adopt a discretionary approach. Admittedly, economic theory does not provide clear indications on when a monetary aggregate should be considered as excessively unstable. Typically, instability is assessed by looking at the statistical properties of a money demand equation. While it is possible to adopt a statistical definition of instability (such as the failure to pass some statistical tests on the stability of the coefficients of the money demand equation), it is not clear how the costs of anchoring monetary policy to a relatively unstable aggregate should be compared to the costs (in terms of credibility and transparency) of shifting to a discretionary approach.

    The Exchange Rate as Nominal Anchor

    A way out of the dilemma between discretion and domestic nominal targets, however, exists for those countries that are willing to anchor monetary policy to the exchange rate. Some variants to this approach that may be particularly appealing for small open economies are discussed in the papers by Griffiths and McDonald, Kiguel and Liviatan, Bennett, and Viñals.

    Mark Griffiths and Donogh McDonald review the experience of exchange rate pegging of the countries participating in the exchange rate mechanism (ERM) of the European Monetary System. The performance is mixed. During the 1980s, inflation declined in all ERM countries, but so did inflation in non-ERM countries. Moreover, it is not clear whether the costs of disinflation were lower in the ERM than elsewhere. The authors also stress that the virtual breakdown of the ERM at the end of 1992 shows that pegging the exchange rate, on its own, is not an effective tool to control inflation. Despite these shortcomings, even after the September 1992 crisis a number of core-ERM countries have continued pegging their currencies to the deutsche mark, a choice that may have been influenced by the lack of better alternatives (money demand instability having emerged recently in many European countries).

    Miguel Kiguel and Nissan Liviatan take a somewhat more sanguine view of the benefits of pegging the exchange rate. After looking at the experience of Chile and Argentina, they conclude that exchange rate stabilizations were more effective than money-based programs. The main drawback of pegging the exchange rate is the risk of a large, and eventually unsustainable, real appreciation. They argue that this risk can be substantially reduced if the peg is accompanied by additional measures aimed at strengthening the credibility of the stabilization program. These measures may include, in addition to fiscal adjustment, institutional changes such as those introduced by the 1991 Convertibility Law in Argentina (legalization of payments in dollars, exchange rate parity regulated by law, the virtual prohibition of central bank credit to the government and a quasi-currency board arrangement). At the same time, the authors warn against excessive rigidity in pursuing an exchange rate target. Timely exchange rate adjustments may be necessary to avoid an unsustainable real appreciation and have limited inflationary effects if they move the real exchange rate toward its long-run equilibrium value.2

    The experience of Argentina has attracted much attention in the last few years not only because the authorities managed to deflate the economy at a relatively contained cost, but also because Argentina was the first large country to introduce a currency board arrangement, a particularly binding form of exchange rate pegging. Bennett’s paper describes the operational details, as well as the advantages and drawbacks, of this type of arrangement, under which all base money is created through purchases of foreign currency at a fixed exchange rate. Bennett regards the experience of the three currency boards reviewed in his paper (those of Estonia, Hong Kong, and Argentina) as largely positive. As to other countries, he notes that the constraints set by a currency board are appropriate under extreme conditions (such as very high or chronic inflation) or when the central bank is inexperienced. However, currency boards are likely to evolve toward more conventional arrangements as conditions improve.

    José Viñals looks at the implications of currency unions, which can be considered as the most extreme form of exchange rate pegging among the countries participating in an economic union. Viñals looks at the potential benefits in a currency union that arise from eliminating the deadweight loss of exchanging different currencies, from removing exchange rate variability within the union, and from increased market integration. As to inflation performance, Viñals notes that the benefits of a union will be more substantial if its monetary policy is aimed at price stability, as stipulated in the Maastricht Treaty in the case of the European Union.

    While the provisions of the Maastricht Treaty provide stronger institutional barriers against inflationary policies, it could be argued that assigning monetary policy responsibilities to a supranational institution may per se favor price stability, because such an institution would be in a better position to resist political pressures of individual governments to inflate the economy. The favorable inflation performance of the existing currency unions (the Eastern Caribbean Currency Area and the two CFA currency unions) seems to support such a conjecture.

    Commodity Standards

    Rather than fixing the value of the domestic currency in terms of a foreign currency—as in the case of an exchange rate peg—the monetary authorities may fix the value of the currency in terms of a given commodity, the so-called commodity standard. The main drawback of a commodity standard is the fact that the value of the currency becomes subject to the vagaries of the relative price of the good that is used as a standard commodity (gold in the case of the gold standard). As a solution to this problem, Warren Coats revamps a proposal initially put forward by Irving Fisher in the first quarter of this century: that of fixing the value of money in terms of a basket of commodities. Coats notes that such a commodity standard could hardly be introduced by a single country, and he discusses how the special drawing rights issued by the International Monetary Fund could be used to stimulate the spread of the proposed standard.

    Central Bank Independence

    Three papers discuss central bank independence. Strictly speaking, granting independence to the central bank does not per se imply the choice of a specific monetary framework. However, independence, within a clear mandate to pursue price stability, may be particularly important when monetary policy decisions are not anchored to a clearly visible nominal anchor (such as the money supply or the exchange rate). In these circumstances, central bank independence can be seen as an institutional device to increase the credibility of the monetary authorities, thus reducing the cost of attaining price stability.3

    In his paper, Robert Effros describes the features of the European System of Central Banks envisaged by the Maastricht Treaty. He singles out a number of aspects of central bank legislation that are relevant components of central bank independence, including the precise definition of the central bank’s mandate, the responsibility for determining and implementing monetary policy, the prohibition of central bank credit to the government, and the rules concerning term of office, appointment, and dismissal of central bank managers. He also assesses to what extent the central bank legislation in the countries of the European Union conforms to the prescriptions of the Maastricht Treaty.4

    Carl-Johan Lindgren and Daniel Dueñas look at the new central bank legislation granting independence to the central bank in Chile, Argentina, and Venezuela. They note that the new central bank laws exhibit some common traits that relate to the features of independence already discussed by Effros (a clear mandate for price stability, long terms for central bank board members, high technical requirements for board membership, constraints on central bank credit to the government, and financial autonomy). However, the degree of independence in the formulation of monetary and exchange rate policies differs across the three countries. In Argentina, the central bank is constrained by the exchange rate policy set by Congress. In Chile, the law grants the central bank great independence in the formulation of monetary and exchange rate policies. In Venezuela, the central bank and the government have to coordinate their policies, but no formal procedure exists for the resolution of conflicts between the two policymakers.

    The issue of who controls monetary and exchange rate policies is the focus of Carlo Cottarelli’s paper. While it is recognized that an independent central bank should be responsible for the control of monetary policy, Cottarelli notes that many “independent” central banks do not control exchange rate policy, for which the government remains responsible. He argues that this may substantially constrain central bank independence, because monetary and exchange rate policies, particularly in the absence of capital constraints, are not independent instruments. If monetary and exchange rate policies are assigned to two different agents (the central bank and the government), a conflict may arise and eventually one policymaker will have to give up its independence. Even if the central bank eventually prevails, the conflict may involve delays in policy implementation, and therefore the central bank may lose its independence in either the nature or the timing of the policy actions. Cottarelli adds that, if the legislative power wishes to constrain the independence of the central bank, rather than separating monetary and exchange rate responsibilities, it would be desirable to include an “overriding clause” allowing, in some special cases, a political overruling of central bank decisions.

    Capital Movements

    Capital movements have become a major factor in the economic environment in which monetary stability has to be attained. In principle, capital inflows have positive economic effects, as they allow a higher level of investment to be financed and thus promote growth. However, surges in such flows can cause an economy to overheat. Thus, several countries have faced the policy question of whether the observed reactions to capital inflows, such as inflation and a deterioration in the current account of the balance of payments, are temporary phenomena that are part of the process of profitably absorbing the capital inflow or whether they are signs of overheating that require a policy response. At the broader level, capital account convertibility has gained prominence as a policy objective and as a way to facilitate the integration of the world’s financial markets.

    In her paper, Susan Schadler discusses the recent experience of six countries in dealing with large capital inflows. She distinguishes between foreign and domestic causes of inflows and also between the various domestic causes, stressing that differences in causes often entail differences in the likelihood of the flows being reversed. All these influences were at play in the countries she analyzes; however, their relative importance varied significantly. The six countries dealt with the inflows by adopting various mixes of sterilization, exchange rate adjustments, and fiscal tightening. All six countries partially sterilized the inflows; however, their exchange rate adjustments differed. Spain made its peg more fixed, while Chile and Mexico made theirs more flexible. Schadler underscores the importance of fiscal tightening to curb excess demand and inflation. Microeconomic measures were also important. Restrictions on capital inflows, trade liberalization, and financial sector reform affected reserve accumulation in the short run and the efficiency of absorption of the inflows.

    Most industrial countries have attained capital account convertibility, in a movement that gained momentum after the change to flexible rates in the early 1970s. Developing countries have made much less progress in this regard. Quirk’s paper analyzes the experiences of several developing countries, with particular emphasis on Indonesia. He concludes that the financial liberalization and international integration of financial systems that most industrial countries have implemented is also an appropriate strategy for developing countries. He finds little support for the notion that such policies might weaken the capital account; rather, the evidence is to the contrary. As to the sequencing of liberalization, he notes that fiscal adjustment, interest rate liberalization, and a market-clearing exchange rate (which can require floating) are mutually supporting elements of a successful reform package. Trade liberalization can best be introduced at the same time but the timing is not crucial.

    Intermediate Targets, Instruments, and Indicators for Monetary Control

    Financial innovation has brought into question many economic relationships, requiring a re-examination of monetary policy implementation. Questions such as the role of banks, targets and instruments, and indicators need to be reassessed.

    William Alexander and Francesco Caramazza discuss the particular functions of banks and the role of credit in monetary management. Pronounced credit cycles are a source of economic fluctuation, as witnessed by the experience in the 1980s when the credit boom that took place during the first half of the decade was reversed in the second half. Moreover, financial innovation has been transforming the links between credit and real sector variables. Furthermore, developments in the theory of imperfect information have shed light on the asymmetric relationship between borrower and lender and its application to banks. Credit can serve as an intermediate target or as an indicator variable; empirical analysis is crucial in establishing which of these roles credit aggregates should play. The authors conclude that the credit view should be considered as a supplement to (and not a substitute for) the money view of the monetary policy process. Integrating both views not only provides a richer analysis of many monetary policy issues, but also facilitates the integration of the microeconomic and macroeconomic dimensions of that policy.

    Countries making the transition from central planning to a market economy face special challenges in the monetary area. Not only must they replace the monobank with a two-tier banking system but they also must introduce new instruments and develop a commercial mentality among banks and their clients. In his paper, Péter Bod examines how monetary policy can be implemented in such a context, based on Hungary’s experience. He argues that the ongoing structural changes and macroeconomic stabilization require the central bank to rely on multiple intermediate targets, in order to adjust to changes in the transmission mechanism. A key challenge is to revise targets while preserving clarity and credibility relating to policy actions. At the same time, the authorities must shift from compulsory to market financing of fiscal deficits, attain current account convertibility, liberalize interest rates, and introduce new financial instruments and operations, such as repos and other open market operations. However, he cautions about the limitations of monetary policy and argues for consistency between fiscal and monetary policy.

    The shift from direct to indirect instruments of monetary control is one major element of the financial reforms that have taken place throughout the world. Several Asian countries have implemented such reforms. Robert Carling’s paper discusses the experiences of Indonesia, Malaysia, the Philippines, and Thailand. He stresses the need for the development of indirect monetary instruments and financial market deregulation to proceed at the same pace. This aim was not always achieved in the countries he analyzes, with the reform of monetary instruments lagging behind financial deregulation at several points. On those occasions, either monetary control suffered or second-best monetary instruments had to be introduced to keep it. He also discusses three specific instruments: (1) government securities; (2) central bank paper; and (3) recycling of government deposits, comparing the extent of their use in the four countries and noting their advantages and disadvantages.

    An effective use of monetary instruments—and indeed an effective monetary policy—requires the monetary authority to have an appropriate framework to formulate and implement policy. Charles Freedman’s paper discusses such a framework, which links the ultimate target of policy with the instruments through the use of operational and intermediate targets and of policy indicators. He defines these concepts and explains their role in the conduct of monetary policy, focusing on Canada’s experience. The Bank of Canada has been using a variety of instruments to carry out monetary policy, but the main one has been changes in the supply of settlement balances to directly clearing financial institutions. While the ultimate target—price stability—has been the same, the Bank of Canada has had to change both its intermediate and its operational targets. Financial innovation led to the abandonment of the narrow money target in 1982, after it was used for about seven years.5 After using a short-term interest rate as operational target for many years, the Bank of Canada has switched to a monetary conditions index, which combines a short-term interest rate and the exchange rate. Freedman concludes that, if used with care, such an index can be very helpful in guiding monetary policy actions. He cautions, however, that it does not capture other shocks that sometimes may be even more important than exchange rate changes.

    Public Debt Management and Monetary Policy

    Public debt management and the development of money and securities markets are closely linked to monetary policy. The ability of a government to finance itself by issuing voluntarily held debt, instead of money, reduces the short-run inflationary effect of deficit financing. Moreover, an active money market greatly facilitates the capacity of the central bank to implement its policy by using indirect instruments. Carlos Augusto Dias de Carvalho discusses Brazil’s experience in developing a market for public debt in a context of high inflation and large fiscal deficits. Moreover, he notes the initial difficulties of implementing monetary policy when central banking functions in this area were split between two institutions: the Banco do Brasil (a government-owned commercial bank) and the Banco Central do Brasil (the central bank). In his view, the success of Brazil in developing a large market for public debt under those conditions was largely due to the vast powers granted to the central bank for managing the public debt and to the capacity of both the authorities and the market to introduce new instruments and techniques as needed to cope with changing conditions.

    C. Rangarajan’s paper discusses the development of India’s financial market, focusing in particular on its experience with financial liberalization. He notes the gradualism of that liberalization. It started in 1985, in a context dominated by large fiscal disequilibria that the Reserve Bank and the rest of the banking system financed. This financing was mostly done at administered interest rates and relied on compulsory means, such as the statutory liquidity requirement set on banks and the placement of nonmarketable securities with the Reserve Bank. Financial liberalization gained momentum when an overall reform cum stabilization program was initiated in 1991. The program comprised, inter alia, fiscal consolidation, a revamping of government financing, and financial sector liberalization. Treasury bills bearing market rates were introduced, and the government began to convert the Reserve Bank’s holdings of nonmarketable treasury bills into securities bearing market rates. An active secondary market in government paper developed, in which the Reserve Bank has conducted its open market operations. Rangarajan notes that further progress in financial reform should be underpinned by further fiscal consolidation and should include a strengthening of banks’ portfolios, further liberalization of interest rates, and the development of the money and securities markets, on which the Reserve Bank would increasingly rely to implement its policy.

    Monetary Policy and Financial Structure

    Tommaso Padoa-Schioppa discusses the changing nature of central banks. He analyzes the evolution of central banking, which started as a way to ensure government financing and changed as the key means of payments moved away from commodity money and as countries began to use monetary policy to attain macroeconomic goals. Central banks presently have to deal with three groups of issues: (1) keeping monetary control to attain price stability; (2) adapting regulation and supervision to preserve the soundness of the financial system and the safety of the payments system; and (3) making central banking international to adapt to the growing globalization and integration of the world economy. Of these three challenges, Padoa-Schioppa considers that the first two are closer to being met. A sharper focus on price stability and greater central bank independence have made it easier to attain the first objective. The second objective has been facilitated by a greater awareness that as financial innovation blurs the lines between various financial institutions, central banks have to take a broader view of their prudential responsibilities. In contrast, making central banking an international activity raises more problems, many of a political nature. Padoa-Schioppa observes that monetary sovereignty and political sovereignty have always gone together. Thus, it is not surprising that a supranational central bank will be established in the context of European integration.

    David Klein’s paper discusses Israel’s experience in financial liberalization. The process started about three years after a strong anti-inflationary program was put in place in 1985, aiming at drastically bringing down the inflation rate from a range of 15 to 20 percent per month. The financial liberalization implemented during 1988–91 led to the abolition of existing credit ceilings, elimination of the minimum maturity restrictions on financial transactions, gradual lowering of reserve requirements, phasing out of government-directed credits, freeing of bank interest rates, and liberalization of exchange controls. Klein further notes that the Bank of Israel simultaneously began to introduce new instruments to carry out monetary policy. Auctions of short-term central bank credit have become the Bank’s chief instrument, complemented by other credit facilities and a modest use of open market operations. Also, a more flexible exchange arrangement (a band) was adopted. These measures succeeded in lowering interest rate spreads, including those between long-term and short-term operations and between domestic and foreign rates. Klein also emphasizes the importance of fiscal and monetary discipline in facilitating financial reform and in creating the opportunity for Israel to become a regional financial center.

    The growth of financial derivatives has received increasing attention in recent years, particularly as policymakers have become concerned about how to monitor and control the risks that those instruments can entail for financial institutions and to understand how they affect the conduct of monetary policy. David Folkerts-Landau’s paper discusses these developments, which he asserts are the most important changes in finance in industrial countries during the past fifty years. He stresses the explosive growth in the volume and variety of these instruments, causing risk to become another commodity that can be bought and sold in liquid markets. Thus, derivatives have led to efficiency gains, as they allow economic agents to choose the level of risk they wish to bear, which has been unbundled from the underlying asset. The gains result from a better pricing and allocation of risks. Also, savings can be better allocated. However, Folkerts-Landau cautions about the challenges that derivatives pose for public policy: in particular, in dealing with the various risks that derivative transactions involve. Changes in regulatory and supervisory practices and in market structure are required to deal with those risks. Finally, he notes that financial derivatives allow market participants to take large interest rate and currency positions very quickly, a factor which sharply constrains the authorities’ options regarding monetary and exchange rate policy.

    Payments systems are key components of a country’s monetary arrangements. Technological developments and financial innovation have led to increased attention to the design and operation of those systems. These issues become even more important in the case of economies making the transition from central planning to the market-based economy. In their paper, V. Sundararajan and Gabriel Sen-senbrenner discuss the case of the former Soviet Union and the Baltic countries.6 The countries they study faced enormous difficulties in adapting their payments system to the demands of a transforming economy and to the replacement of the monobank system by two-tier banking. As a result, those countries initially faced great difficulty in ensuring the security and reliability of payments; fraud, lost payments, and long delays in processing payments were common. This led to a large and variable float, high risks (especially for central banks), and large and volatile excess reserves in commercial banks. The volatility of the float and of banks’ excess reserves made it very difficult to implement monetary policy. The authors conclude that even before the reform of payments systems is completed, transitional measures can reduce the level and variability of central bank float, as was the case in Russia. They caution about the need to integrate the reform of monetary instruments with the reform of the payments system, pointing out that both will influence the supply of, and demand for, bank reserves.


      Baliño, TomásJ.T., JuhiDhawan, and V.Sundararajan, The Payments Systems Reforms and Monetary Policy in Emerging Market Economies in Central and Eastern Europe, IMF Working Paper, No. 94/13 (Washington: International Monetary Fund, January1993).

      Cukierman, Alex, StevenWebb, and BilinNeyapti, “Measuring the Independence of Central Banks and its Effect on Policy Outcomes,”World Bank Economic Review,Vol. 6 (September1992), pp. 35398.

      Driffill, John, GrayhamE. Mizon, and AlistairUlph, “Costs of Inflation,” inHandbook of Monetary Economics,ed. by BenjaminM. Friedman and FrankH. Hahn (ed) (Amsterdam: North-Holland, 1990).

      International Monetary Fund, Exchange Rate Volatility and World Trade, Occasional Paper, No. 48 (Washington: International Monetary Fund, Research Department, December1986).

      International Monetary Fund, World Economic Outlook (Washington: Staff of the International Monetary Fund, May1993 and May1994).

    There are also strong reasons to believe that exchange rate instability involves real costs in terms of distortion of trade and investment patterns, although the empirical evidence in this area is less definite (International Monetary Fund, 1986).

    This conclusion seems to be supported by the recent experience of the ERM countries that devalued their currencies during 1992–93 without any revival of inflationary pressures.

    Central bank independence is typically regulated by law. A less formal, but similar, alternative is to announce that monetary policy will be guided by specific inflation targets. A number of countries, including Canada, the United Kingdom, and New Zealand (see Chapter 3 in International Monetary Fund, 1993), have announced explicit inflation targets, an arrangement that is sometimes seen as an alternative to anchoring monetary policy to an intermediate target. The conduct of monetary policy under an inflation target is discussed in the paper by Charles Freedman.

    This paper also points out that the existence of a link between central bank independence and price stability is far from being established. Assessing the existence of such a link is certainly difficult because “legal independence” is not an easily measurable variable In what is probably the most thorough analysis of this issue available, Cukierman, Webb, and Neyapti (1992) find that, in industrial countries, legal independence can indeed be associated with better inflation performance (and that the former causes the latter). However, they are unable to find a significant link between independence and inflation in developing countries.

    No other intermediate target was chosen to replace it.

    A recent Fund paper discusses the case of countries in Central and Eastern Europe. See Baliño, Dhawan, and Sundararajan (1994).

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