- Carlo Cottarelli, and Curzio Giannini
- Published Date:
- December 1997
- Grau, teurer Freund, ist alle Theorie, Und grun des Lebens goldner Baum. (Grey, dear Friend, is all theory, and green is life’s golden tree.)
- —Goethe, Faust
- The whole point of the Doomsday Machine is lost if you keep it a secret! Why didn’t you tell the world, eh ?
- —Stanley Kubrick, “Dr. Strangelove”
During the last quarter of a century, the theory and practice of monetary policy have undergone momentous changes. At the practical level, a world in which monetary policies had to be managed, at least in principle, within the code of conduct of the Bretton Woods system was replaced 25 years ago by a world where the rules of the game—the monetary framework, in current economic jargon—are markedly different across countries and bear little resemblance to those prevailing during the Bretton Woods era.
The evolution of monetary theory has been equally dramatic. At the end of the 1960s, mainstream macroeconomics regarded monetary management (and more generally economic management) mostly as a “game against nature” in which the optimal setting of monetary instruments could be determined by solving the economy’s econometric model after imputing desired policy targets. There had been debate between supporters of discretion-based policies and of rule-based policies (a la Friedman) on the degree of knowledge of the model’s parameters, and hence on the feasibility of activist policies. But the concept that monetary discretion could, in principle, be optimally used was virtually undisputed. Since the mid-1970s, this view has been gradually abandoned: in a change that bears some similarities with the “quantum mechanics” revolution in physics during the 1920s, the “state of nature” (certain key parameters of the economic model reflecting the response to policy actions) stopped being regarded as independent from the actions of the observer (the policymaker). Of course, economic models are still formulated in terms of fixed coefficients, but these mostly describe the agents’ (including the authorities’) utilities functions rather than fixed responses to policy instruments. Since then, monetary policy has been described primarily as a game between the policymaker and one or more representative agents (trade unions, enterprises, and, sometimes, the “government” as distinct from the monetary policymaker). Concepts and theories borrowed from politics and warfare theory—such as credibility and deterrence—became increasingly common.
This paper provides a chronicle of the evolution of the theory and practice of monetary policy during the last 25 years. It focuses on monetary frameworks, that is, on the announced basic principles and institutional rules guiding the execution of monetary policy. There have been previous attempts to discuss the evolution of monetary frameworks, but only in individual countries or in a limited number of countries, typically industrial countries (Bernanke and Mishkin (1992)). The first novelty of this paper lies in the breadth of the data base. The paper monitors the evolution of the monetary framework in 100 countries or country unions between 1970 and 1994 (a total of 2, 500 observations, see Appendix). The sample includes almost all independent nations in existence during that period, with the exclusion of centrally planned economies and countries disrupted by wars or civil strife.
A second novelty is methodological. Most empirical studies of monetary policy take both society’s preferences and the overall institutional environment as given. This assumption clearly will not do when one wants to investigate the long-run factors leading to a change of monetary framework. Indeed, the fundamental function performed by a monetary framework is to facilitate monetary exchange while preserving the trust in price stability or, more precisely, in the predictability of the future price level. How well a given monetary framework is going to perform this task will depend on prevailing perceptions and preferences, the structural features of the economy, and the nature and performance of a whole set of other institutions. All these factors, of course, change over time.
The paper argues that during the last 25 years, monetary practice in most countries has increasingly been characterized by the attempt to achieve credibility of purpose while expanding the freedom of monetary authorities in controlling policy instruments. Thus, the world has gradually moved toward monetary frameworks in which, through appropriate institutional devices, a better trade-off between credibility of goals and flexibility of instruments could be achieved. This attempt, discernible in most countries surveyed in the paper, has taken different forms, depending on the countries’ economic, institutional, and cultural specificities.
The structure of the paper is as follows. Section II highlights the driving forces behind the changes in monetary frameworks in the post-Bretton Woods period and points at the increasing relevance in monetary theory of the credibility issue in the context of fiat standards. It also notes the emerging concept of “delegation” as a way to improve the credibility-flexibility trade-off. Against this background, Section III describes the evolution of monetary frameworks in the sample countries, highlighting the gradual shift away from rule-based frameworks toward more discretion-based policies. Section IV contrasts the decline of rule-based frameworks with the spreading of frameworks in which credibility is achieved through alternative institutional devices, centered on delegation and increased transparency. In industrial countries, these devices have taken the form of increased central bank independence and inflation targeting, while in developing countries, delegation to the International Monetary Fund has become increasingly common. The role of reputational equilibria is also discussed. Finally, this section focuses on the interrelation between monetary institutions and the development of an ethos of price stability, without which these institutions would not be viable in the long run. Section V looks more closely at some features of the rule-based frameworks, and in particular at the relative role of monetary and exchange rate-based frameworks, discussing the future of foreign exchange anchors in a world of increased capital mobility. Section VI summarizes the main findings of the paper.1