This paper discusses instruments and operating procedures of the conduct of monetary policy in the major industrial countries. The exchange rate mechanism of the European Monetary System (EMS) provides clear evidence of the role of exchange rates in influencing monetary policy; the commitment of EMS participants to maintain their exchange rates within agreed limits has often led them to undertake policy measures aimed at exchange rate objectives. The procedures for implementing monetary policy in the five countries examined here exhibit numerous common features; the dissimilarities that exist do not appear to be fundamental, but rather are attributable primarily to differences in institutional conditions. This paper describes the procedures employed by these monetary authorities so that changes in policy stances can be identified.
With the increased integration of world financial markets, developments in these markets are exerting more influence on exchange rate movements. Indeed, models of exchange rate determination usually include interest rates as one of the primary explanatory variables.1 Consequently, an understanding of the operation of financial markets in general, and the factors determining interest rates in particular, is essential for analyzing the behavior of exchange rates. Furthermore, monetary policies in the major industrial countries have a significant impact on financial markets. It is thus important to be able to identify these monetary policy actions in order to interpret the economic and financial ramifications of the actions. This paper contributes to the understanding of financial and exchange market developments by examining and comparing the instruments and procedures for implementing monetary policy in the short run that are currently employed by the central banks of the five major industrial countries—France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States. Such an investigation of the procedures for implementing monetary policy helps to distinguish movements in variables that reflect changes in the current stance of monetary policy from those that do not, and thereby provides a better understanding of monetary policy actions and their links to exchange market developments.
In January 1987, the French monetary authorities replaced the previous mechanism of monetary policy implementation that was based on credit restrictions, quantitative allocations, and administered interest rates with a more market-oriented approach based on instruments aimed at influencing the level of interest rates and on a wider use of reserve requirements. The reforms stemmed from the authorities’ desire to allow market forces to play a greater role in the determination of interest rates and overall credit conditions, complementing the gradual trend toward financial deregulation of the preceding few years.8
The Bundesbank Act of 1957 stipulates that the fundamental task of the central bank is to safeguard the currency by regulating “the amount of money in circulation and of credit supplied to the economy,” which has been considered a principal prerequisite for maintaining a high level of employment and adequate economic growth over the medium term. Since 1974, this broad objective has been pursued within a framework of monetary targeting in which the growth of key monetary aggregates has been regulated in accordance with a target set for each year.16 Until recently, the intermediate target was established in terms of the central bank money stock17 in view of its closer relationship with developments in nominal income and its limited responsiveness to cyclical movements in short-term interest rates, compared with more narrowly defined monetary aggregates. In early 1988, however, the central bank money stock was replaced by M3 as the intermediate target variable, mainly because of unexpected shifts in currency demand in response to changes in interest rates that had not been experienced by M3.18
The Bank of Japan Law states that “The Bank of Japan has for its object the regulation of the currency, the control and facilitation of credit and finance, … in order that the general economic activities of the nation might adequately be enhanced.” The primary objectives of monetary policy pursued by the Bank of Japan in accordance with this law have evolved considerably since the early 1970s. Prior to that time, monetary policy was primarily directed at supporting the rapid growth in output and productivity and maintaining the yen at a fixed exchange rate, consistent with an acceptable rate of inflation and a manageable balance of payments position. With the move to floating exchange rates and the inflationary consequences of the first oil price shock in the early 1970s, the Bank has accorded high priority to price and exchange rate stability, although the maintenance of economic growth and low unemployment have remained important objectives.32
The principal objective of U.K. monetary policy is to influence the growth of nominal gross domestic product (GDP) over the medium term as a means of achieving price stability.51 From the mid-1970s until quite recently, the Bank of England has pursued this objective by employing monetary aggregates as intermediate targets. However, as in a number of other countries during the 1980s, the relationships between some of the targeted monetary aggregates and economic activity have been found to be generally unstable and unpredictable. Consequently, the targeting of a broad monetary aggregate (M3)52 was suspended in March 1987. Moreover, while the authorities still place importance on limiting the growth of the narrowest published monetary aggregate (M0)53 to a target range, the openness of the U.K. economy, the extremely large volume of flows into and out of the London capital market, and the associated increased uncertainty surrounding the link between the monetary aggregates and economic performance have led to a more broadly based approach to the implementation of monetary policy. In particular, a range of indicators other than monetary aggregates, such as the exchange rate, indicators of the real economy, estimates of real interest rates, the behavior of markets in financial and other assets, and the current course of nominal GDP, have also been used more recently as guides for the stance of monetary policy.54
Since the mid-1970s, monetary aggregates have been the intermediate targets of Federal Reserve policy. Targeting the growth in monetary aggregates implicitly assumes that the relationship between changes in growth in the monetary aggregates and economic activity is sufficiently reliable that the ultimate goals of monetary policy can be achieved by using monetary aggregates as intermediate targets. The Federal Reserve generally has established target ranges for the growth rates of Ml, M2, and M3 during the calendar year.59 With the Full Employment and Balanced Growth Act of 1978, Congress mandated that the Federal Reserve set annual target ranges for growth in monetary and credit aggregates and report these targets to Congress twice each year.
The procedures for implementing monetary policy in the five countries examined here exhibit numerous common features; the dissimilarities that exist do not appear to be fundamental, but rather are attributable primarily to differences in institutional conditions.78 It should be noted, however, that this conclusion could not have been drawn if this paper had been written ten years ago. Especially in France and Japan, the implementation of monetary policy has evolved considerably from primary reliance on quantitative credit controls to intervention in financial markets to influence the availability and the price of reserves of the banking system. While the change has not been quite as dramatic in the Federal Republic of Germany and the United Kingdom, the convergence among the five to market-oriented procedures is nonetheless clear and marked.