Back Matter

APPENDIX I

Steering Operating Targets Under Uncertainty

As the monopolistic supplier of base money a central bank can set its price or quantity. In other words, it can pick any point on the banking systems’ demand curve for base money (see Figure 1). With stable market conditions at all times targeting the price or the quantity would just be two sides of the same coin. In Figure A. 1 point A could be achieved by either setting i0 or B0.

Figure 1:
Figure 1:

Alternative Operating Targets

Citation: IMF Working Papers 2001, 149; 10.5089/9781451856897.001.A999

Uncertainties and instability in the demand or the supply of base money lead to fluctuations in money market rates if the central bank targets quantities and fluctuations in quantities if it targets an interest rate (see Figure 1). Under both operating procedures central banks have to conduct liquidity forecasts to be in a position to offset undesired fluctuations of the interest rate or a quantity variable. In the case of interest rate targeting, the central bank would accommodate any shifts in the demand or autonomous supply of base money to avoid the interest rate moving away from its target level (Figure l.A and 1.B). In the case of base money targeting, shifts in the demand for base money would not be accommodated and could cause interest rate volatility (Figure l.C). These are particularly large when the interest rate elasticity of the demand for base money is low (i.e., the demand curve is steep). Shifts in the autonomous supply components (in particular the net position of the government) would have no effect on the money market rate or the level of base money, since they could be entirely compensated by adjustments in central bank balance sheet components that are under the central banks’ control (Figure l.D).

APPENDIX II

Deriving NDA Ceilings in Fund-Supported Programs

NDA ceilings are derived as part of the financial programming exercises in Fund-supported programs. The theoretical foundation is provided by the Polak model.21 It is based on the monetary approach to the balance of payments, which views balance of payments fluctuations as a monetary phenomenon. In its simplest version, the Polak model centers around 4 identities—the monetary survey, the central bank balance sheet, the money multiplier, and the balance of payments constraint—and 1 behavioral equation—the demand for money.

The first step of a financial programming exercise is to set objectives for the balance of payments, real GDP growth, inflation, and the fiscal deficit. The balance of payments target is expressed as a change in net international reserves (ΔNIR*). This results from the fact that the change in net international reserves equals the sum of the current account (CA) and the change in net foreign indebtedness (ΔFI) (equation 1).

(1)ΔNIR*=CA+ΔFI.

The second step is to project the change in money demand (ΔMD). A very simple way would be to use the estimated velocity of money (v) and use the target value for nominal GDP (ΔY*) which can be derived from the real GDP growth target and the inflation target (equation 2).

(2)ΔMD=1vΔY*.

In a third step, the level of net domestic assets of the banking system (ΔNDABS) needed to adjust to satisfy the projected money demand change given the NIR target is calculated. For this, the money stock identity from the monetary survey is used (equation 3, in which AM* stands for the change in money stock). In addition, it is assumed that changes in net foreign assets of the banking system (ΔNFA) are identical to changes in net international reserves of the central bank (ΔNIR).

(3)ΔM*=ΔMD=ΔNFA=ΔNIR*+ΔNDABSorΔNDABS=ΔM*ΔNIR*.

The fourth and final step is to calculate the ceiling for the change in net domestic assets of the central bank (ΔNDA*) that corresponds with the change in net domestic assets of the banking system (ΔNDABS). For this calculation, the central bank balance sheet identity,

which defines the change in base money (ΔB) as the sum of ΔNIR and ΔNDA, and the money multiplier relation (m) are used (equations 4 and 5).

(4)ΔB=ΔNIR*+ΔNDA.
(5)ΔB=1mΔM*.

Setting equations (4) and (5) equal, yields the following maximum amount by which the central bank may change its NDA position to comply with the financial programming exercise:

(6)ΔNDA*=1mΔM*ΔNIR*.

APPENDIX TABLES

Table 1.

Interest Rate versus Base Money as Operating Targets

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Table 2.

Preferred Operating Target Under Alternative Monetary Policy Frameworks

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Table 3.

Preferred Policy Instruments Under Alternative Operating Targets 1/

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For a similar categorization see Bofinger (forthcoming).

References

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1

This paper has benefited greatly from comments by Agnes Belaisch, Mariano Cortes, George Iden, Timothy Lane, Bernard Laurens, Lorenzo Perez, Robert Price, Christine Sampic, Mark Stone, Mark Swinburne, Piero Ugolini, Mark Zelmer, and participants of an internal IMF seminar (May 24, 2001).

2

In this paper foreign exchange interventions always refer to unsterilized interventions. Sterilized interventions normally have other than monetary policy purposes.

3

A few countries have in the past used a combined index of a money market rate and the exchange rate as an operating guide, the so-called monetary conditions index (MCI) (Canada and New Zealand; Sweden has used it as an indicator for future demand and inflation). Since the use of an MCI has some caveats, however, it is to-date not used as a formal operating target by any country.

4

The discussion on the role of instruments, targets, and indicators dates back to the early 1970s. See, for example, Friedman (1975).

5

For a tabular summary of the pros and cons of price versus quantity operating targets see Appendix Table 1.

6

Nevertheless, even central banks that target a short-term interest rate continue to monitor and forecast the development of central bank balance sheet items, in particular banks reserves, since they indicate how much liquidity the central bank needs to withdraw or inject into the banking system.

7

.Prominent exceptions have been Switzerland and New Zealand. Until 1999 Switzerland targeted the monetary base, as operating and intermediate target, and New Zealand the level of excess reserves (settlement balances). In the United States, the Fed targeted unborrowed reserves during the brief period from 1979-1981.

8

For an overview on alternative monetary policy frameworks see Mishkin (1999), for a discussion on exchange rate targeting see Mussa and others (2000), for inflation targeting see Bernanke and others (1999) and Schaechter and others (2000).

9

In this case to achieve the desired monetary base effects will require sizable interest rate adjustments. Also, shifts in base money demand can result in large interest rate swings with possibly negative impacts on the financial sector.

10

Other determinants for the choice of policy instruments are the development of the financial sector and historical or political factors. For an overview on the design and merits of alternative monetary policy instruments see Baliño and Zamalloa (1997) and Alexander and others (1995). For country practices with operating procedures and policy instruments see Borio (1997) and Van’t dack(1999).

11

A downside of the more flexible procedure is that signaling is no longer unambiguous. Setting a minimum bidding price when the central bank auctions liquidity and a maximum price when it auctions deposits is a possibility to enhance the signaling role for interest rates, but it also has disadvantages. Some central banks have also announced a range of liquidity, instead of a specific amount, they are willing to allot in the auction. While this gives counterparts some indication on the quantity the central bank aims to inject or absorb, it also allows the central bank room to avoid too strong fluctuations of interest rates.

12

Exchange rate variations itself should not have any impact on the central bank’s balance sheet and the liquidity situation of the banking system. While they are booked in the revaluation account, they have a counter position in the central bank’s capital. In some countries, revaluation gains are transferred monthly to the government and if used for transactions will effect liquidity.

13

See Blejer and Schumacher (2000) for a discussion of the rationale for a central bank to engage in operations involving contingent liabilities. The authors also argue for a portfolio approach that would aggregate all on and off-balance sheet transactions to obtain “economic” rather than “accounting” values of all items.

14

Under floating exchange rates, external objectives are usually viewed in broader terms such as medium-term current account sustainability.

15

For an overview on the motivation, design, and experience with Fund conditionality see Schadler and others (1995) and Mussa and Savastano (1999).

16

As of end-June 2001 an NDA ceiling for the central bank has been applied for more than 80 percent of the countries supported by an IMF program. This excludes countries with currency broad arrangements or no separate legal tender for which this type of monetary conditionality is not applied. Moreover, in three cases the NDA ceiling related to the entire banking system. The monetary base has only been used in four cases as a performance criterion, sometimes in addition, sometimes in place of an NDA ceiling. NIR floors for the central bank, on the other hand, have been applied in all cases.

17

Strictly speaking, NDA is not a pure “net” variable. Claims against banks are mostly gross, since bank reserves are excluded from NDA. Banks’ deposits with the central bank are only part of NDA insofar as they result from a deposit facility or auctioned deposits.

18

For the model that underlies the Fund’s financial programming exercise and its extensions see, for example, Polak (1957, 1997), IMF (1987) and Fischer (1997).

19

See also Blejer and others 2001 who argue that NDA ceilings are problematic for inflation targeting countries. The central bank’s operating target predominantly determines the appropriateness of NDA ceilings as a performance criterion. What type of operating target a central bank chooses to steer is closely related to the monetary policy strategy as described in Section II.C.

20

NIR floors, however, can retain their function as performance even when central banks target short-term interest rates. NIR floors ensure that central banks do not draw down their foreign reserves to an extent that jeopardizes the external viability.

Implementation of Monetary Policy and the Central Bank's Balance Sheet
Author: Ms. Andrea Schaechter