Conditionality in Evolving Monetary Policy Regimes
Author: International Monetary Fund
Publication Date:
03 May 2014
eISBN:
9781498343695
ISBN:
9781498343695
Language:
English
Keywords:
PP; monetary policy regime; transmission mechanism; monetary policy conditionality; Fund-supported program; monetary policy stance; monetary policy implementation
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With single-digit inflation and substantial financial deepening, developing countries are adopting more flexible and forward-looking monetary policy frameworks and ascribing a greater role to policy interest rates and inflation objectives. While some countries have adopted formal inflation targeting regimes, others have developed frameworks with greater target flexibility to accommodate changing money demand, use of policy rates to signal the monetary policy stance, and implicit inflation targets.

Abstract

With single-digit inflation and substantial financial deepening, developing countries are adopting more flexible and forward-looking monetary policy frameworks and ascribing a greater role to policy interest rates and inflation objectives. While some countries have adopted formal inflation targeting regimes, others have developed frameworks with greater target flexibility to accommodate changing money demand, use of policy rates to signal the monetary policy stance, and implicit inflation targets.

Motivation

1. Monetary policy frameworks in a number of countries with IMF-supported programs are evolving toward more flexible operational targets and more forward-looking policies. Many developing countries have moved away from operating monetary policy frameworks centered solely on periodic quantitative targets for money aggregates to greater reliance on policy rates to signal the monetary policy stance. Several other countries with Poverty Reduction and Growth Trust (PRGT)- or General Resources Account (GRA)-supported programs have adopted some form of an inflation targeting (IT) regime, where the inflation forecast is the intermediate target and a short-term policy interest rate typically serves as the operational target/policy instrument, although some of those countries have not committed to an explicit inflation target. Looking ahead, many other developing countries that seek support under Fund facilities intend to modernize the conduct of monetary policy by using a more flexible framework.

2. This shift reflects the evolution of global thinking and practice, and the increasing sophistication of domestic financial markets in developing countries. Targets on monetary aggregates have been the traditional nominal anchor in most Fund-supported programs, and they have played an important role in helping stabilize inflation in the late 1990s and early 2000s and in supporting external stability. The liberalization of domestic financial markets has nevertheless expanded the scope for active management of market interest rates, while lower levels of inflation, frequent and large exogenous shocks, and increasing instability in money demand, among other factors, have weakened the relationship between money and prices and increased the priority on more nuanced policy frameworks as opposed to just “holding the line.” Further, several GRA-supported program countries that were forced off pegs after sudden reversals of capital inflows have introduced hybrid frameworks, with a significant role for inflation alongside exchange rate and money objectives. The observance of reserve money performance criteria or indicative targets in Fund-supported programs has weakened, with more than half of the targets not observed, while at the same time there is no association between monetary target misses and inflation overshoots in low-inflation countries. Conversely, when monetary targets were observed, real GDP and inflation often differed significantly from projections. In other cases, adherence to the monetary program has led to unwarranted volatility of interest rates, thereby undermining a country’s objectives of strengthening the role of policy rates in communicating the stance of monetary policy. The fundamental question is not whether money matters, but whether money targets continue to remain reliable indicators of the monetary policy stance, given financial innovation and shocks to money demand.

3. The evolution of monetary policy frameworks has implications for monetary conditionality in Fund-supported programs. There are clear guidelines and established practices for monetary conditionality for money targeting and IT frameworks. However, guidance is limited and practice has varied for countries with evolving monetary policy frameworks. For money targeting frameworks, conditionality consists of a floor on net international reserves (NIR) and typically a ceiling on net domestic assets (NDA) or reserve money (RM), and in some cases net credit to government (NCG).1 For IT frameworks, normally a review-based approach is employed under which a floor on NIR is maintained (to ensure external sustainability), while performance criteria on net domestic assets or reserve money are replaced with an inflation consultation clause (ICC).2

4. However, neither of these existing conditionality frameworks is well-suited for countries with evolving monetary policy regimes (countries experiencing increasing financial deepening, where policies are becoming more forward looking, including the nascent use of short-term policy interest rates to adjust the monetary policy stance). In such circumstances, relying on monetary aggregates alone is not sufficient, as policies become increasingly forward looking. A more comprehensive approach that analyzes monetary policy along a number of dimensions, and is not limited to an assessment of monetary aggregates alone, could achieve the objectives of conditionality while responding to the changing needs of members.

5. This paper proposes a review-based monetary conditionality framework as an option for countries with evolving monetary policy regimes. Under this approach, the Fund-supported program would introduce a set of quarterly or semi-annual (depending on the frequency of program reviews) monetary or inflation bands that the member would be expected to observe during the arrangement. This would replace the current performance criteria on reserve money and/or net domestic assets of the central bank, even though they may still serve as a tripwire depending on country-specific risks. Under the review-based framework, a deviation from the target band would trigger a formal consultation with the Executive Board in the context of a program review. Access to the Fund’s resources under the relevant arrangement would be interrupted until the required consultation with the Executive Board takes place and the relevant program review is completed. This consultation would be informed by staff’s assessment of (i) the reasons for deviations from the monetary policy objectives, taking into account compensating factors, and (ii) in light of this assessment whether or not remedial actions are needed to bring policies back on track.

6. The proposed review-based approach would be appropriate for countries with scope for independent monetary policy.3 Specifically, the review-based approach would normally be appropriate for members that have made significant progress in achieving central bank independence along with other supportive institutional features, including minimal fiscal dominance, a solid quantitative understanding of the inflation process, and an increasing focus on achieving an inflation objective. In some cases, enhanced policy advice and technical assistance (TA) would be needed to meet these conditions or to further develop central bank capabilities for effective monetary policy analysis prior to the adaptation of the review-based approach. The decision to implement the review-based approach in a particular country would be made on a case-by-case basis, based on discussions between staff and the authorities. However, the review-based approach to monetary conditionality should not be interpreted as necessarily implying an eventual move to an inflation targeting regime. This review examines the changing landscape in countries with evolving regimes, assesses the performance of the current monetary conditionality framework in Fund-supported programs, and reviews the practical application of conditionality in several case studies of Fund-supported programs. Concluding sections discuss operational modalities of the review-based approach and the implications for the Fund’s resources and technical assistance delivery.

The Changing Landscape of Monetary Policy in Developing Economies

7. Many developing countries are moving toward more flexible monetary policy frameworks and more forward-looking policies. From 2003 to 2011, the number of countries implementing money targeting has declined by about 25 percent—about 40 percent of the emerging market (EM) countries and 20 percent of low-income countries (LICs) have moved away from money targeting (Figure 1).4 Most of these countries (for example, Albania, Armenia, Ghana, Georgia, Moldova, Serbia, and Uruguay) adopted a formal inflation targeting framework, while a few have started to implement mixed regimes such as monetary targeting and an exchange rate anchor.5 Moreover, among money targeting countries, two evolving policy regimes—flexible money targeting and IT-lite/informal IT—have recently been implemented. Uganda (2009–2011) and, more recently, Rwanda (since 2012) were among the countries that experimented with some form of flexible money targeting; Uganda has recently adopted an IT-type framework.

Figure 1.
Figure 1.

Monetary Policy Regimes in Developing Countries: 2003–2011

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

Source: IMF AREAER Database.1/ The exchange rate anchor includes regimes where the exchange rate serves as the nominal anchor or intermediate target of monetary policy and includes pegs (with or without bands), crawling pegs, currency board arrangements, no separate legal tender regimes, and other managed arrangements.2/ Other monetary framework includes regimes with multiple objectives, typically inflation or money target together with an exchange rate anchor.

8. The change of policy regimes reflects significant changes in the monetary landscape in many developing economies over the last decade. Countries have generally been more successful in anchoring inflation expectations and limiting the impact of domestic and external shocks on inflation—the mean inflation rate has declined from 18.6 percent in 1990–2002 to 9.3 percent in 2002–2012 (Table 1). Average inflation has fallen in both EM countries and LICs. Inflation volatility has also decreased—the average standard deviation of inflation declined more than half during the same period. The frequency of cases with high inflation volatility was also significantly lower in the more recent period (Figure 2).6

Table 1.

Inflation: 1990–2002 vs. 2002–2012

(Average of end of period consumer price inflation, in percent)

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Sources: World Economic Outlook and IMF staff calculations.Note: Data are for 64 countries (35 EMs and 29 LICs) with some scope for an independent monetary policy. LICs are defined as countries eligible to use PRGT resources. EM countries are defined as non-PRGT eligible EM and developing countries in the WEO classification.
Figure 2.
Figure 2.

Inflation and Inflation Volatility Distribution, 1990–2012

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

9. Fast developing financial systems have also contributed to changes in the policy landscape over the last decade. Median bank deposits and credit to the private sector (both expressed as a share of GDP) in developing countries have increased by close to one-third between 2002 and 2010 relative to 1990–2002 (Figure 3). In particular, LICs experienced a rapid financial deepening during this period—bank deposits and private credit almost doubled as a share of GDP. Interest rate spreads, which reflect amplified borrowing costs, declined by about 400 basis points in EM countries and 300 basis points in LICs. More developed financial markets in developing countries over the last decade have increased both the feasibility and the desirability of using short-term policy interest rates to steer the monetary policy stance while increasing the importance of managing expectations in monetary policymaking.

Figure 3.
Figure 3.

Financial Deepening (LICs and EMs)

(Medians, from 1990–2012)

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

Sources: Finstat, WDI, and IMF staff calculations

10. Velocity and money multipliers have been subject to frequent and large fluctuations that have complicated the conduct of monetary policy. Over the last two decades, about half of the countries in the sample have experienced two or more structural breaks in money multipliers and velocity.7 These breaks imply (i) an unstable relation between the intermediate target (broad money) and the policy tool (reserve money) and hence a limited control of the money supply under a money targeting framework, and (ii) unstable and/or unpredictable money demand, potentially altering the co-movement between monetary aggregates and inflation or the real economy.

11. The long-term relationship between broad money growth and inflation has weakened over time, especially in low-inflation countries. Cross-section regressions were used to characterize the relation between inflation movements and changes in monetary aggregates, while controlling for other factors including the impact of output growth (Appendix II). A long-run relation between inflation and money growth for developing countries was confirmed. However, the estimated coefficient of money growth decreases from 0.64 in 1990–2002 to 0.29 in 2002–2012 (Table 2). The regression coefficient for money growth in high-inflation countries is about 30 percent and 50 percent larger than for low-inflation countries, respectively, for the two periods.8, 9 Moreover, in countries with higher financial development, the association between money growth and inflation is weaker in the more recent period.10 These findings do not imply that increases in money supply are not inflationary. Rather, they indicate that in countries with low inflation, long-run money growth has been driven by factors other than monetary policy (particularly changes in money demand) thereby lowering the predictability of the relationship between the two variables.

Table 2.

Money Growth and Inflation: Cross-Section Estimation (OLS) 1/

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Sources: World Economic Outlook and IMF staff calculations.

Values of t-statistics reported in the parentheses are calculated using heteroscedasticity-consistent standard errors; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

12. The shorter-term relationship between broad money growth and inflation has also progressively weakened. Across LICs and EM countries, the correlation between yearly broad money growth and inflation has been steadily falling from 0.63 in 1990–2002 to 0.33 in 2002–2012 (Figure 4). This is also supported by panel estimates—over shorter horizons (a year), the estimated coefficients of money growth and its lags are lower in the more recent period (Appendix II, Table II.2). The short-term relation between money and inflation was stronger for countries with high inflation and low financial development in the earlier period, but it declined across the board over the last decade.

Figure 4.
Figure 4.

The Relation Between Broad Money Growth and Inflation, 1990–2012

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

Source: World Economic Outlook

13. The observed weaker short-term link between money growth and inflation points to some limitations in relying solely on monetary aggregates to anchor and signal the policy stance. As broad money growth has become an increasingly weak indicator of the evolution of inflationary conditions, its usefulness as an intermediate objective has been significantly reduced for some countries while remaining relevant in others, particularly those with high-inflation rates or low levels of financial development. Without question, money still “matters” for inflation in that an exogenous increase in the money supply is likely to be expansionary. And money aggregates should continue to be used as one of the many indicators to assess the monetary policy stance. Analysis of monetary aggregates provides one piece of information for central banks in assessing inflationary conditions. However, in this environment, it is more difficult for nominal monetary targets to signal the stance of monetary policy; this could impair the link between monetary policy actions and their impact on economic activity and inflation.

14. The weakening link between monetary aggregates and inflation does not imply that monetary policy is ineffective. Some empirical evidence suggests that the monetary policy transmission mechanism—the set of channels through which policy decisions influence real activity and inflation in the short-to-medium term—is weak or unreliable in developing countries (Mishra and Montiel, 2012). Although there may be specific country circumstances where this is the case, regression-based assessments often struggle to disentangle the cause and effect of policy decisions. In addition, the transmission mechanism is often endogenous to the events in the economy and the policy framework. For example, as discussed later, Berg and others (2013) find evidence that monetary policy has stronger effects in countries where policy is more clearly signaled to financial markets through a meaningful policy rate, such as Kenya and Uganda.11

Performance of Program Monetary Conditionality

15. This section reviews the characteristics of monetary conditionality in Fund-supported programs between 2002 and 2012. Since 2002, there have been 105 Fund-supported programs (63 PRGT and 42 GRA-supported programs)12 for countries with scope for independent monetary policy. This section documents the landscape of conditionality and analyzes program performance in achieving monetary and inflation objectives, taking into account country-specific characteristics. Country case studies shed light on how monetary policy conditionality in Fund-supported programs has responded to developments in monetary policy frameworks (see Appendix IV).

16. The majority of Fund-supported programs include the traditional net domestic asset target (alongside net international reserves), although close to half also included a target on reserve money. Since 2002, performance criteria (PC) on NDA have been set for about 70 percent of Fund-supported programs. Adherence to NDA ceilings has been generally good in Fund-supported programs. Reserve money is targeted in 44 percent of programs, as a PC in one-third of these cases and an indicative target in the remainder. All Fund-supported programs had Net Foreign Assets (NFA)/NIR targets, and most programs that cite reserve money as an indicative target already include NDA as a PC. Many programs included structural conditionality to track efforts to strengthen monetary operations and produce high-frequency indicators.

17. There is increasing adaptation to the growing diversity in monetary policy frameworks in GRA-supported programs as compared to PRGT-supported programs (Figure 5). More GRA-supported programs are shifting away from money targeting to the use of review-based conditionality through ICCs (about 30 percent of GRA-supported programs include ICCs). As a result, the proportion of programs targeting reserve money is lower in the case of GRA-supported programs (under 27 percent) than in PRGT-supported programs (about 55 percent). However, most GRA-supported programs continue to use the NIR/NDA framework in addition to other forward-looking indicators, including the use of short-term interest rates, to assess the monetary policy stance, while only two Fund-supported programs had no NDA or reserve money targets.

Figure 5.
Figure 5.

Conditionality Landscape in GRA and PRGT Programs, 2002–2012

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

1/ There are also cases (Turkey 2005 and Armenia 2009) where conditionality was defined in terms of reserve money and NDA despite the existence of an ICC at the time.

18. Adherence to reserve money targets in Fund-supported programs over the past decade has been weak, although money target misses have not been correlated with inflation deviations at low inflation levels. Estimates from 89 program reviews (based on 38 programs for 25 countries) that had an explicit target on reserve money (either as a PC or indicative target) show that the reserve money target was not observed in 51 percent of such reviews.13 Considering PCs alone, about 20 percent of reserve money targets were not observed. In high-inflation countries, reserve money target misses were positively and significantly correlated with higher-than-programmed inflation, while proportionately large deviations in reserve or broad money growth are associated with generally small deviations in inflation.14 In both PRGT- and GRA-supported low-inflation countries, however, reserve money target deviations and inflation deviations are not correlated (see Figure 6).15 Similar results hold for the relationship between broad money and inflation target deviations.16 This lack of correlation implies not just that money target misses are uninformative about inflation in low-inflation countries, but also that money target achievement can be relatively uninformative about inflation.17

Figure 6.
Figure 6.

Money and Inflation Target/Projection Misses in Fund-Supported Programs, 2002–2011

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

19. Money target misses peaked during the onset of the global financial crisis, but they had been elevated throughout the past decade (Figure 7). The proportion of misses, relative to the number of program reviews, peaked in 2009 (at about 90 percent), during a period of extreme financial turbulence, price volatility, and rapidly shifting macroeconomic policies that were difficult to incorporate in short-term program projections. However, the proportion of target misses ranged between 30 and 60 percent in other years during the past decade.

Figure 7.
Figure 7.

Proportion of Annual Reserve Money Target Misses for PRGT- and GRA-Supported Programs, 2002–2012

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

20. Most of the non-observance of reserve money targets can be explained by higher-than-projected net foreign assets of the central bank (Figure 8). However, neither NDA misses nor NFA misses, individually, are statistically significantly related to inflation deviations from projections. Staff estimates show that higher-than-programmed deviations in NFA are not fully offset by reductions in NDA, resulting in reserve money target misses.18

Figure 8.
Figure 8.

NDA Deviations and NFA Deviations in Programs with Reserve Money Target

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

21. Program projections of velocity and the money multiplier are on average close to outturns, although the averages mask a great deal of volatility that contributes to money target misses. On average, programs project a 3 percent annual decline of velocity reflecting, inter alia, a projected increased demand for money, while actual data also show a 3 percent velocity decline (Figure 9). However, there is considerable volatility in the projections, reflected in a root mean squared error (RMSE) of 9. Similarly, while on average, programs project an increase in the money multiplier of 1.5 percent compared to an outturn of 1.7 percent, volatility—exhibited by a RMSE of 9—is also considerable (Figure 10). While there is no trend bias in velocity or multiplier projections, the compounded impact of volatility in both factors would explain difficulties in accurately projecting reserve money demand in relation to broad money demand and nominal GDP.

Figure 9.
Figure 9.

Projected and Actual Changes in Velocity

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

Figure 10.
Figure 10.

Projected and Actual Changes in Multiplier

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

22. These changed circumstances have led to some limited experimentation with a more flexible monetary conditionality, including setting narrow bands on reserve money (Tanzania and Rwanda). In practice, the focus in these programs remained on the upper side of the reserve money band (PCs were set on the upper band). The overall implementation experience of more flexible monetary conditionality has been mixed and has generally not provided sufficient flexibility in the view of some country authorities, while contributing to interest rate volatility that has obscured the signaling of the policy stance (see Box 1).

Interest Rate Volatility and the Monetary Policy Transmission Mechanism in East Africa

Strict adherence to the announced monetary target in the face of money demand shocks can generate substantial, but often temporary, movements in interbank rates that do not signal policy intentions. Evidence from Kenya, Uganda, and Tanzania (from January 2005 to December 2012) shows that short-term volatility of the interbank interest rate (measured as the frequency of greater-than-1-percent deviations from a moving average) varies considerably according to their monetary policy regimes (text box).

Sum of Square Deviations from the 1 % Band

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Source: Berg and others (2013)

Tanzania adheres closely to its de jure money targeting regime, and this is reflected in higher volatility in interest rates during the period. Uganda also experienced very volatile interest rates prior to its move away from strict money targeting. Since October 2009, however, the Bank of Uganda has allowed more flexibility in daily money market operations in order to smooth short-term money market rates. This immediately reduced the volatility of interbank rates. In July 2011, the Bank of Uganda officially adopted an IT-lite regime and introduced the Central Bank Rate (CBR) to target the interbank rate, described in Appendix IV. After the switch, interest rates in Uganda have been relatively stable.

Kenya has been paying increasing attention to short–term interest rates, which is reflected in less volatile interest rates since the mid 2000s. Following policy implementation challenges in 2010–2011, the Central Bank of Kenya (CBK) introduced a new framework for monetary operations in October 2011, centered on its CBR, supported by greater use of open market operations (Andrle and others, 2013).

The monetary policy regime has an impact on the strength of the transmission mechanism. Using a narrative approach following Romer and Romer (1989), Berg and others (2013) analyze a significant tightening of monetary policy that took place in 2011 in Kenya, Uganda, and Tanzania. The event study suggests that the transmission mechanism in these economies is alive and well: after a large policy-induced rise in the short-term interest rate, lending and other interest rates rose, the exchange rate tended to appreciate, output fell, and inflation declined. However, there are differences in the strength of the transmission among countries, largely explicable in terms of the nature of the policy adjustment and regime.

In particular, the transmission was the clearest in Kenya and Uganda, where the regimes used policy rates to signal changes in the monetary policy stance and explicitly prioritized the inflation objective. It was less clear in Tanzania, where the effects on some interest rates, activity, the exchange rate, and inflation were still broadly evident, but lending rates failed to respond, perhaps reflecting the fact that the money targeting regime led to highly volatile short-term interest rates and hence made it harder to discern the stance of policy.

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Source: Berg and others (2013).

23. Several country case studies suggest that Fund conditionality has not consistently provided an appropriate policy anchor for some countries with evolving monetary policy regimes (Box 2 and Appendix IV). While program conditionality also evolved, there were challenges. In some cases, there was a lag: the Fund-supported programs targeted different intermediate targets than those that were the primary focus of the authorities, which led to a lack of clarity on monetary policy objectives, limited gains in building central bank credibility, and conflicting signals to market participants (Armenia, Uganda, and Moldova). In the case of the Dominican Republic, during the period preceding the adoption of IT, traditional monetary conditionality was deemed appropriate since the monetary policy framework was in fact not significantly changing. In Tanzania, minor changes such as period average rather than end-period reserve money targets were useful in making money targeting more effective, and there may be scope within this framework for the type of discussions envisaged in a Monetary Policy Consultation Clause (MPCC) on assessing implications of reserve money target misses.

Enhancing the Monetary Policy Conditionality Toolkit

24. The Fund’s monetary policy conditionality is intended to assist members in resolving their balance of payments problems, while safeguarding the use of the Fund’s resources. Program conditionality aims to ensure that: (i) recourse to Fund resources is temporary; (ii) Fund resources will be used to help members solve their balance of payments problems and achieve medium-term external viability while fostering sustainable economic growth; and (iii) members using Fund resources maintain the capacity to repay the Fund.

25. The “traditional” monetary policy conditionality has two standard PCs derived from the Polak 1950 model and the monetary approach to the balance of payments. The floor on NIR and a ceiling on NDA were originally designed to ensure external sustainability in a world of fixed but adjustable exchange rates. The PC on NIR (floor) aimed to ensure external sustainability, while the ceiling on NDA of the central bank reinforced this objective by ensuring that future sustainability was not derailed by excessive expansion in credit. While containing excessive credit expansion supported the viability of the exchange rate as an inflation anchor, the NDA ceiling was not primarily set for inflation control (Box 2). The combination of a floor and ceiling on the components of reserve money does not provide an automatic safeguard against excessive monetary expansion because sustained overperformance on the external position can result in excessive monetary expansion if not offset by reductions in NDA.

26. When disinflation became a key objective of most Fund-supported programs, an additional PC (or indicative target) on reserve money (base money) was often introduced. Reserve money targets then acquired greater prominence in Fund-supported programs during the 1990s, particularly among LICs seeking to lower inflation rates. However, there are conceptual and practical problems for evolving regimes that use money targeting. Key issues that arise are: (i) whether the framework gives enough weight to inflation (or disinflation) objectives; (ii) whether its focus on the monetary base remains appropriate as countries move toward greater operational reliance on short-term interest rates; and (iii) whether it provides a coherent framework for monetary policy analysis in these countries.

Monetary Targeting in Fund-Supported Programs

The monetary regime in Fund-supported programs typically includes a framework for quarterly projections of key monetary aggregates—referred to as a broad monetary program (BMP). Operationally, the central bank focuses weekly and daily projections of the main items of the central bank’s balance sheet—or reserve money program (RMP). The BMP is based on the premise of a stable relationship between money and the price level (i.e., in the form of a money demand equation) over the medium term. It provides an assessment of the monetary stance (via broad money targets) in relation to the fiscal accounts and the balance of payments. The RMP is based on the premise of a stable relationship between broad money and base money (the money multiplier). It supplies the central bank with an operational tool to guide the calibration of its monetary operations when base money is used as the operating target for monetary policy.

27. In recognition of the adoption of inflation targeting, the reserve money/NDA PC was replaced with a review-based approach to monetary policy conditionality. This approach to monetary conditionality was implemented through the ICC to respond to tensions between the practicalities of IT implementation and the requirements of the NIR/NDA/RM conditionality framework (Box 3). Since 2000, a number of Fund-supported programs applied the review-based approach to monetary policy conditionality through the inclusion of ICCs in the relevant Fund arrangements, mostly in advanced and EM economies along with a handful of developing economies (mostly lower middle-income countries).19

28. The review-based approach to monetary policy conditionality involves setting bands around a target inflation variable, and a consultation with staff or the Board is triggered if actual inflation deviates outside the band.20 The target variable was adjusted at the time of some program reviews, but generally the width of the band has not been adjusted. Consultations with the Board took place relatively infrequently (See Appendix V).

29. Neither the “traditional” conditionality nor the IT review-based conditionality (ICC) is necessarily well suited for evolving regimes.21 Traditional monetary targets set as program PCs continue to serve many countries well and can be flexibly applied, including through the use of adjustors that anticipate exogenous shocks, the application of waivers, and the subsequent modifications of targets.22 However, the benefits of these nominal monetary anchors can be undermined if they are frequently missed when policy objectives are being achieved or when they are subject to complex mechanical adjustments. Evolving regimes have unique challenges: they need to use considerable judgment regarding money targets; monetary policy is becoming increasingly forward looking; and yet there is no clear commitment to a numerical inflation target within a pre-set time horizon. There are clear benefits from modifying monetary policy conditionality for evolving regimes. A modification to the conditionality framework would in effect be catching up with actual practice while at the same time providing a framework for coherent monetary policy analysis to prevent a situation where “anything goes.” However, countries that have adopted an effective inflation targeting framework would be typically expected to use the review-based approach through the inclusion of ICCs in Fund arrangements.

Inflation Consultation Clause and Fund Conditionality

The Fund’s 2000 policy on monetary conditionality under inflation targeting switched from the NIR/NDA/RM framework to a review-based conditionality for IT countries. This review-based conditionality was implemented in practice through the introduction of ICCs in the arrangement to replace the PCs on NDA and RM. The review-based conditionality had the following key components:

  • An introduction of a periodic (usually quarterly) review with emphasis on assessment of current inflation against forecast and implications for inflation outlook;

  • Where there are deviations from the targeted inflation path, following the assessment above, Fund staff and authorities would reach an understanding ex ante on a timely remedial monetary policy response;

  • The use of the floor on NIR to maintain external sustainability and safeguard the use of Fund resources; and

  • A mechanism to deal with country-specific risks. This mechanism could be allowance of enough room in setting of the NIR floor for unprogrammed intervention or the use of NDA ceilings where necessary. Where NDA ceilings are maintained, it is required to make clear to the public the relationship between NDA and inflation targets.

Since 2000, a number of Fund-supported programs applied the review-based approach to monetary policy conditionality through the inclusion of ICCs in Fund arrangements, mostly in advanced and EM economies with a handful of developing economies (mostly lower middle-income countries).

Although assessment of monetary policy during reviews need not be confined to a narrow set of variables, it was necessary to define a set of indicators on which such an assessment would be primarily based, hence the introduction of the inflation bands and the ICCs triggered by the member’s deviation from the outer band. Under the ICC, an inflation target (usually the target of the authorities), as well as a tolerance band, is set as a basis to guide monetary policy assessment and reviews. Typically, programs would specify an inflation path (mostly quarterly) consistent with authorities’ inflation targets, and current and projected inflation would be assessed against these target paths, and an understanding on specific remedial action would be expected whenever the outlook suggested that future inflation objectives were likely to be missed by a pre-specified margin. Consultation bands introduced in Fund-supported programs since 2000 have generally taken the following form:

  • Annual central inflation target + a quarterly path with a two-tier consultation band around central target.

  • Outer band: ±X percent around central target. Consultation with the IMF Executive Board if actual 12-month chosen inflation index falls outside outer band.

  • Inner band: ±Y percent around central target; (Y<X). Informal consultation with IMF staff if actual 12-month chosen inflation index falls outside inner band.

  • The authorities would have to present remedial measures for consultation with the Executive Board for approval when outer band consultation is triggered.

A total of 13 Fund-supported programs with six members have used the review-based approach to monetary policy through the inclusion of ICCs in Fund arrangements since 2000. Overall, some flexibility has been applied in the choice of the target variable and width of bands, while central paths have been frequently adjusted in some programs particularly where there was a disinflation objective. More recently, some countries have been using single bands under the ICC framework. Out of a total of 70 reviews under these programs, about 27 percent have triggered a monetary policy consultation, of which 10 percent were consultations with Fund staff (informal consultation) and 17 percent were consultations with the Executive Board. The latter have taken place through consultation letters from country authorities explaining the causes of a deviation from the inflation target range and remedial measures, if any, that were taken or are to be taken (see Appendix V, Table V.1).

30. For these evolving regimes, the paper proposes a review-based MPCC framework with two objectives :

  • To provide flexibility and incentives for the development of a coherent framework for monetary analysis and monitoring under Fund-supported programs. Under the MPCC, monetary conditionality would include a quantified macroeconomic framework with a set of quarterly or semiannual monetary or inflation targets set within a tolerance band. Deviations from the band would trigger a consultation with the Executive Board which would focus on: (i) a broad-based assessment of the stance of monetary policy and whether the Fund-supported program is still on track; and (ii) the reasons for program deviations, taking into account compensating factors and proposed remedial actions if deemed necessary.

  • To maintain external sustainability while safeguarding the use of Fund resources. This would be served by maintaining the use of the NIR floor as a PC to ensure external sustainability. The performance criterion on NIR would also reinforce the country’s commitment to some exchange rate flexibility, ensuring that the Fund’s resources provide support for the adjustment needed to lead a sustainable external position. If, however, a significant margin for intervention were appropriate, an accompanied tightening of monetary conditions could be needed to limit inflation pressures. Additional tripwires (as indicative targets) may be needed to address country-specific risks, e.g., external stability or fiscal dominance concerns. The need and choice of tripwires would be determined on the basis of understandings reached with country authorities, and would not rule out the continued use of NDA or monetary aggregates as tripwires, if warranted for these purposes.

31. The MPCC would be an option under the review-based conditionality framework (Figure 11).23 The decision to implement the MPCC would be the outcome of discussions between staff and the authorities, while remaining the responsibility of Fund staff. While it would normally be adopted at the start of a program, authorities could also request to modify the type of monetary conditionality and adopt an MPCC during the program if circumstances change. Consistent with the guidelines on conditionality, the authorities are responsible for the selection, design, and implementation of economic policies while the Fund is fully responsible for the establishment and monitoring of all conditionality including the MPCC. The introduction of the MPCC does not affect the design or operation of the ICC.

Figure 11.
Figure 11.

Proposed Outline of the Modified Monetary Conditionality Framework

Citation: Policy Papers 2014, 024; 10.5089/9781498343695.007.A001

32. The MPCC would be based on a specified central path for the target variable (i.e., monetary aggregate or inflation). The central path should be consistent with, or on a convergent disinflation path to, any formal or informal public inflation objective. However, the central path would not necessarily be tied to a formal inflation target and hence, unlike the review-based monetary conditionality that works through ICCs, the authorities would not have to publicly announce and commit to an inflation target. The choice of variable for the central path would reflect monetary policy practice in the program country. Countries in which policy discussions are de facto centered on the inflation outcome and prospects could use inflation as the trigger variable, whereas those countries in which policy discussions continue to focus on monetary aggregates could choose monetary aggregates as the trigger variable. In program discussions, staff and the authorities would reach understandings on the framework that underpins the authorities’ approach to monetary policy implementation: the key monetary policy objectives; operating and intermediate targets; and the available monetary policy instruments. These understandings would shape the design of the MPCC—making it country specific. The design of the central path (inflation or monetary aggregates) would have to be consistent with an inflation objective over a relatively short-time horizon, e.g., 12 months.24 For regimes that choose inflation as the central path, either a headline or a core inflation measure could be used, depending on which one would best communicate the monetary policy stance to the public. For economies aiming to reduce inflation, the path could be designed to decline by a certain proportion over time. This path could either be a disinflation path or a monetary aggregate path set to achieve a specific inflation objective over a given time horizon.

33. The target variable subject to a monetary policy consultation would normally have a single tolerance band. This parsimonious approach would provide a clear signal of the monetary program objectives. However, in regimes that select inflation as the target variable, as in the ICC framework, in addition to an outer band, a narrower inner band could be used as an early warning to check that monetary policy is not veering off track. A deviation from the inner band triggers a staff consultation, but there would be no interruption of purchases if the consultation is not held. An inner band in the case of regimes that select money as the target variable may limit the additional flexibility the MPCC is meant to provide, as it would place excessive attention on monetary aggregates instead of the desired broader assessment of the policy stance.

34. The width of the tolerance band would be set sufficiently wide to provide adequate flexibility on a case-by-case basis, balanced against the need to steer monetary policy toward achieving its objective. Several factors would be relevant in setting the width of the band including the recent volatility of the target variable, the level and path of the target variable, and the choice and effectiveness of monetary instruments. The considerations in deciding the width of the band would also differ somewhat for a country choosing a band for inflation versus a band for a monetary aggregate. In general, a narrowly defined band would have a clear benefit of more strongly anchoring expectations than a broad band, but has to be weighed against the potential reputation costs for frequent deviations. This benefit would be particularly important for countries using an inflation band. For monetary target bands, when there are significant structural changes in the demand for money, narrow bands for monetary targets could be associated with higher interest rate volatility, with undesirable implications when trying to strengthen the role of policy rates to signal the policy stance. Ultimately, the band width would have to be determined based on country-specific circumstances and reviewed regularly to ensure it provides an adequate anchor and flexibility for the implementation of monetary policy.

35. Program reviews would include enhanced monetary policy assessment in the context of a clearly defined monetary policy objective. Reviews would involve assessing ex post outcomes for recent inflation or money as well as the near-term outlook, using a given set of indicators. Staff would also assess the authorities’ capacity to implement the monetary program going forward, including maintaining the MPCC target variable within the band.25 The set of indicators used in the review would include, but not be limited to, developments in monetary aggregates, interest rates, recent inflation outcomes (both headline and core), leading and coincident indicators of inflation and economic activity, survey-based indicators (business and consumer confidence surveys), and other available forward-looking variables.26 The analysis would, among other things, discuss the drivers of inflation, the inflation outlook, and implications for the inflation objective. It would also be important to consider interactions between fiscal and monetary policy as the absence or limited scope of direct monetary financing does not imply that fiscal pressures have disappeared. Coordination of fiscal and monetary policy is also particularly important for countries with large aid or natural resource inflows.

36. Fund staff could draw on the ongoing work by RES, ICD, and MCM to develop a system that would help organize the underlying economic information in a structured way to support monetary policy implementation in developing economies (Appendix VI and VII). This analysis and the related training and TA could help with both the setting of the target and the interpretation of target misses, and whether a target miss reflects an excessively accommodative policy or other factors, e.g., money demand shocks. The analysis of target misses would be automatically complemented by a broader analysis of the state of the economy. Model use, however, would be optional, as other methods (including the use of leading and coincident indicators) could be used for forward-looking policy analysis. In addition, a focus on improving short-term monetary operations and liquidity management is critical for developing countries working to modernize their monetary policy frameworks.

37. A formal consultation with the Executive Board would be triggered should the observed outcome of the target variable deviate from the band. In these cases, access to Fund resources would be interrupted until the consultation with the Executive Board takes place and the relevant program review is completed. The program review would not be completed unless the Executive Board is satisfied that the member’s monetary policies are consistent with program objectives. In regimes that select inflation as the target variable, a deviation from the outer band would trigger consultation with the Executive Board, and if a narrower inner band is included, deviation from this band would trigger a consultation with staff.

38. The formal consultation with the Executive Board would be informed by staff’s assessment of the monetary policy stance. Staff would assess whether deviations from bands are explained by compensating factors (including exogenous shocks) and make judgments as to the appropriate actions and policy commitments needed to correct program slippages. Staff reports would include the authorities’ views in cases where there is divergence of views between staff and authorities on the assessment of monetary policy. The authorities would also be expected to present their assessment of the monetary policy stance as part of the Memorandum of Economic and Financial Policies (MEFP) or in a letter to the Managing Director, explaining reasons for the deviation from the target bands and remedial actions introduced where necessary. In the event of weak policy commitments to correct slippages, and in the context of an overall assessment of a member’s economic and financial policies, staff and management could decide not to recommend completion of the relevant program review. Implementation of remedial actions could result in delay in completion of reviews. The review process will follow the normal review cycle of the Fund-supported program. However, staff will continue to maintain a dialogue with the authorities between program reviews (as is the standard practice) to monitor monetary policy developments.

39. The MPCC would provide flexibility attuned to the changing monetary policy frameworks in evolving regimes. It would provide the needed structure for organizing economic information to support the conduct of monetary policy, as well as the necessary safeguards for use of Fund resources and the country’s capacity to repay the Fund by maintaining the NIR floor as a PC as well as, where necessary, a tripwire on NDA or other indicators.27 It would provide a predictable and credible nominal anchor that is aligned with a members’ monetary policy framework. Unlike the existing review-based approach to monetary policy conditionality through ICCs for countries with IT regimes, the proposed MPCC would provide the option to choose either a monetary aggregate or an inflation objective as the central path in the design of the consultation clause (see Table 3). This would particularly appeal to evolving regimes that are often experimenting with multiple (flexible) operating targets and have not explicitly committed to an inflation target. The MPCC would provide additional flexibility by not tying the central path of the consultation clause to a publicly announced inflation target and thus create room for evolving regimes to build credibility while structures are put in place to enhance transparency and accountability.

Table 3.

Comparison of Conditionality: Traditional Money, MPCC, and ICC

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40. The proposed MPCC framework will have implications for misreporting risks and safeguards on the use of Fund resources:

  • The replacement of NDA and/or RM as performance criterion with an MPCC would reduce program monetary data that are subject to misreporting, while NIR data and other program targets will continue to be subject to the misreporting framework.28

  • To address this risk, a formal consultation with the Executive Board would be a condition for completing the program review and thus for resuming purchases or disbursements under the terms of the relevant Fund arrangement, and the Fund’s GRA and PRGT misreporting frameworks would continue to apply in the context of the target variable subject to a consultation (including the application of the de minimis misreporting policy).29

  • Risks relating to use of Fund resources could arise from removing the PC (ceiling) on NDA. In cases where the NIR floor is set with a considerable margin for intervention, there is a risk that in the event of un-programmed reserve losses, the contractionary impact on monetary aggregates is sterilized by an expansion of NDA, when in fact, a tightening of monetary policy might have been appropriate, depending on the nature of the shock. To avoid unnecessarily accommodative monetary policy under the MPCC where there are significant margins used in setting the NIR floor, there would be a commitment not to loosen monetary conditions and to consult with staff if accumulated intervention reached a pre-defined threshold over any fixed time period. Where margins are relatively modest, indicating generally flexible exchange rates, such a commitment would normally be unnecessary. Even in these cases, however, an NDA ceiling could be retained as an indicative target if there are significant risks to external stability.

  • Another risk that might arise is that over-performance of NIR leads to pressures to expand one or more elements of NDA for policy purposes, e.g., quasi-fiscal operations. This risk should be addressed through a thorough staff assessment of the independence of the central bank prior to adoption of the MPCC, including the staff assessment of the legal framework and autonomy that features in safeguards assessments, if available.

41. Staff anticipates that the MPCC would be introduced in countries after consideration of country-specific circumstances relative to a “standard.” In particular, there would be clear benefits from adopting an MPCC in countries that can more clearly signal the monetary policy stance through the policy rate, and have the capacity to adjust policies in a flexible way to achieve their monetary policy objectives. In contrast, there could be costs to introducing an MPCC and monetary targets may be appropriate in countries where commitment to low and stable inflation is often compromised by other objectives and data quality is weak. Evidence supporting the position that this “standard” was met in particular countries would include a strong track record of policy implementation, a relatively low and stable inflation rate, and progress toward basic institutional and structural guideposts in these areas:

  • Central bank institutional set up: de facto central bank autonomy in monetary operations and setting the policy rate; price stability as the de facto primary objective of monetary policy; structures to enhance communication and transparency of monetary policy decisions well aligned with the way monetary policy is designed and implemented;

  • Macro and financial development and stability: absence of high dollarization, a set of monetary and foreign exchange instruments for policy implementation allowing the central bank to be in a position to effectively manage liquidity; sound financial relationship between the central bank and the government that eschews monetary financing; stable financial sector, in particular the absence of systemic weaknesses; and,

  • Data and analytical capacity: availability of high-frequency data; quality of other macro data; liquidity forecasting, and developing understanding of inflation and the transmission channels of monetary policy.

42. Programs could also support a strengthening of performance to meet the “standard” required for an MPCC. In cases where the policy implementation track record has been lacking in some respects or where moderate gaps in the institutional set-up exist, the MPCC could be considered provided that the authorities are undertaking, or are committed to undertake, reforms that would address these limitations.30

43. There will also be cases when, in the staff’s judgment, members have not made sufficient progress toward the guideposts for adopting a more flexible conditionality framework. When advising against premature adoption of the framework and maintaining monetary performance criteria, staff could consider advising structural benchmarks focused on adoption of institutional reforms in central banks, strengthening the operation of financial markets, and building statistical and analytical capacity in the form of a road map to modernizing monetary policy.

44. Most countries with evolving monetary policy regimes are already introducing reforms to support adoption of flexible monetary policy implementation. An illustrative case is Armenia, where there have been clear drawbacks to the traditional monetary targeting and the authorities are developing a more flexible monetary framework, backed by reforms in key areas (Box 4). As Armenia has demonstrated a strong policy implementation track record over the years, a new Fund-supported program envisages a move toward a consultation clause framework centered around inflation, while initially maintaining a performance criterion on NDA (with a margin) and dropping the indicative target on reserve money.

Armenia—Transition to Flexible Monetary Policy

In the mid-2000s, the Central Bank of Armenia’s efforts to sterilize foreign exchange purchases slowed the pace of appreciation brought about by rising remittances and capital inflows. Moreover, in the context of favorable macroeconomic conditions and elevated confidence in the domestic currency, money demand was changing rapidly, making it difficult to pin down the relation between money and inflation. The reserve money targets were repeatedly not observed, due to foreign exchange purchases and the injection of dram, but inflation remained low due to higher money demand. The frequent non-observance of reserve money targets in the presence of low inflation led to a loss of credibility for the money targeting regime; to continue to follow the target would have implied that monetary policy was too tight. Accordingly, in 2006 the Central Bank of Armenia elected to move to full-fledged IT over the medium term, subject to a transition period of IT-lite.

Since then, there have been a number of institutional and operational reforms. First, the repurchase rate was chosen as the operational target, with an interest rate corridor using standing facilities. With the support of Fund TA, the Central Bank of Armenia has progressively strengthened the new policy framework. It has developed its modeling/forecasting capacity, started issuing quarterly inflation reports, and published minutes of its board meetings. The Central Bank of Armenia has also made efforts to improve the transmission mechanism by enhancing liquidity management, narrowing the interest rate corridor, promoting activity on the interbank market, and taking steps to reduce dollarization.

The Fund team and authorities plan to build on the significant gains made through the reforms introduced by moving toward a review-based monetary conditionality in the next Fund-supported arrangement. Staff has reached understandings with the authorities on key components of the new Fund-supported program that would: drop the reserve money as an indicative target and introduce an indicative target band on headline inflation, retain the NIR PC, and retain the NDA PC but introduce a small margin to limit the need for abrupt operations to meet targets. Reserve money would, however, continue to be shown in the PC table as a memorandum item.

There are also plans to continue to strengthen both institutional and operational capacity to support the eventual move toward an MPCC or ICC framework. The focus of reforms would be on monetary operations (possibly further narrowing the interest rate corridor and development of longer-term instruments) and improving market and public communications.

45. The traditional framework for monetary conditionality would continue to be an option in countries where it has proven to be effective in achieving program objectives. Even in those countries that maintain traditional money targeting conditionality, however, there could be scope for enhanced monetary policy analysis, as these countries strengthen their policy frameworks.

Implications for Technical Assistance and Resources

46. Enhanced central bank capacity for monetary policymaking is needed in evolving monetary regimes. Building institutional capacity for monetary policy analysis and implementation in countries with evolving monetary policy frameworks requires in-depth training and TA (see Appendixes VII and VIII on data requirements and existing capacity-building activities for monetary policy frameworks). Coordinated interdepartmental TA and training are already ongoing in SSA countries, where RES, MCM, and ICD work with country teams and SSA central banks to strengthen capacity in model-based forecasting and policy analysis, and monetary policy implementation. For example, RES has a pilot program with the Central Bank of Kenya, involving the training of staff to prepare reports for the monetary policy committee; MCM and RES are collaborating with the authorities in Uganda and Mozambique to develop forward-looking monetary policy frameworks. ICD has also stepped up its offerings of the Monetary and Exchange Rate Policies (MERP) course, in support of SSA central banks’ staff and is exploiting synergies with TA efforts from other departments. Complementing these efforts, a large increase in MCM TA in FY14 reflects increased assistance to central banks in introducing elements of forward-looking monetary policy. SSA has received almost half of MCM’s TA in central bank modernization in the last four fiscal years.

47. Training and TA (capacity development) are also being provided in other regions. ICD’s MERP, and the more advanced model-based monetary policy analysis (MPA) course, have been offered in a range of developing countries. MCM offers TA on a broad range of issues related to monetary and foreign exchange policy and operations, central bank governance, reserves management, and development of financial market infrastructure.

48. Continued efforts at strengthening capacity development in this area are ongoing and planned. In 2014, ICD will offer the MPA course to Fund staff at an SSA regional training event, and as a global course at headquarters. RES is extending its pilot program to at least three additional SSA countries (Mozambique, Rwanda, and Tanzania). MCM is placing several resident advisors in regions and countries with significant central bank reform programs, and is conducting assessments of operational arrangements for monetary policy conduct in several countries covered by AFRITAC South. An interdepartmental committee will look at ways to enhance synergies between training, TA, and peer-to-peer learning to support operational priorities of country teams and authorities, possibly through a product jointly developed by area and functional departments.

49. The proposed review-based approach to monetary policy conditionality through the MPCC could have some resource implications for capacity development. However, since relatively few Fund arrangements are expected to adopt this new conditionality framework in the near term, the resource implications are expected to be manageable within existing budget envelopes. As the new framework is a response to developments already occurring in many countries, in these cases it would likely not be a catalyst for new capacity development demands. Since in other cases, however, there may be an increased demand for resources, departments providing capacity development in consultation with area departments could seek to prioritize resources for this area.31 Developing ways to leverage current resources—such as online collaborative sites for peer-to-peer learning and in-depth training of a small number of staff in an area department who could assist their colleagues—could also help. However, resource implications, particularly for area departments, should be monitored for initial Fund arrangements with the MPCC option.

Issues for Discussion

50. Directors may wish to discuss the following issues:

  • Do Directors see merit in employing a review-based approach to program monetary conditionality in the form of an MPCC for assessing monetary policy in place of performance criteria, for members with an evolving monetary policy regime that have developed a good track record of policy implementation underpinned by operational autonomy and technical and institutional development of the central bank?

  • Do Directors agree to a measured approach to the introduction of the MPCC option, subject to review after sufficient experience has been gained?

  • Does the proposed framework provide sufficient safeguards on the use of Fund resources, including through the misreporting framework?

  • Do Directors believe that the provision of TA and capacity building for monetary policymaking is presently adequate, providing that efforts are made to prioritize such assistance in line with members’ needs?

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Appendix I. Country Classification by Monetary Policy Regimes (Based on 2013 AREAER) 1/

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Countries in this table have monetary policy regimes (in 2011) that provide scope for independent monetary policy. These countries would have to be assessed to have made significant progress toward meeting the guideposts before adopting an MPCC framework.

Excludes Somalia (no relevant information on the monetary policy framework was available) and Sudan (the monetary policy framework is primarily a nominal exchange rate anchor vis-à-vis the U.S. dollar.

Countries with crawling peg or crawl-like arrangements (monetary policy framework classified as exchange rate anchor) but with scope for independent monetary policy.

Appendix II. Additional Empirical Analysis for the Landscape and Performance of Program Conditionality

The relation between inflation and money growth is investigated over a long period (about 10 years) and a shorter period (1 year) using cross section ordinary least squares (OLS) and panel generalized least squares (GLS) regressions respectively, for the period 1990–2012. The variables used in the regression analysis are inflation (defined as the year over year (y/y) change in Consumer Price Index (CPI), money growth (y/y change in broad money), output growth (y/y change in real GDP), financial development (domestic credit to the private sector as a share of GDP), public debt (gross general government debt as a share of GDP), and commodity price inflation (y/y changes in commodity fuel price index). All data is from the World Economic Outlook database of the IMF except for domestic credit to private sector, which comes from the World Bank’s World Development Indicators.

Table II.1 presents results for the cross section regressions. First, following the existing literature, inflation period averages are regressed against money and income growth period averages. Although estimated coefficients for both variables have the expected sign and are significant for the whole period as well as for the sub-periods (1990–2002 and 2002–2012), the estimated coefficient for money growth declines by more than 40 percent in the recent period (Specification I). This result holds when the presence of countries with high inflation (defined as countries with inflation greater than or equal to the sample median of 10 percent) and low financial development (countries with domestic credit to the private sector as a share of GDP lower than or equal to the sample median of 18 percent)—which generally leads to a significantly stronger relation between inflation and money growth—are accounted for (Specifications II and IV). Estimated coefficients for high and low money growth countries (countries with money growth greater than or equal to the median of 17 percent), high and low public debt (countries with public debt as a share of GDP greater than or equal to the sample median of 46.5 percent), and EM countries and LICs are not statistically different from each other (Specifications III, VI, and VII).

Table II.1

Inflation and Money Growth: Cross Section Estimates 1/

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Sources: World Economic Outlook and IMF staff calculations.

Value of t statistics reported in the parenthesis are calculated using heteroscedasticity-consistent standard errors; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.

The results for the panel estimates are shown in Table II.2.32 First, a fixed effect model is estimated using yearly observations of inflation, money, and income growth for all countries in the sample. In line with the cross section results, the coefficients for money growth and its lags are positive and highly significant for 1990–2012, but decrease over time by about half in the last decade (Specification I).33 This result is not driven by the inclusion of high inflation/high money growth/low financial development countries (Specifications II, III, and IV), and is robust to adding commodity prices (Specification VII). In general, the association between inflation and money growth does not vary significantly with the country classification by high debt level (Specification V) and by income level (Specification VI).

Table II.2

Inflation and Money Growth: GLS Estimates 1/

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Sources: World Economic Outlook and IMF staff calculations.

Value of t statistics reported in the parenthesis are calculated using heteroscedasticity-consistent standard errors; * significant at 10 percent; ** significant at 5 percent; *** significant at 1 percent.