The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.

Abstract

The IMF Research Bulletin, a quarterly publication, selectively summarizes research and analytical work done by various departments at the IMF, and also provides a listing of research documents and other research-related activities, including conferences and seminars. The Bulletin is intended to serve as a summary guide to research done at the IMF on various topics, and to provide a better perspective on the analytical underpinnings of the IMF’s operational work.

Alessandro Rebucci

“Rules” rather than “discretion” may have conquered inflation worldwide over the past 30 years or so, but when it came to implementation, which types of monetary rules guided policymakers, or should have guided them? Following the seminal work by Taylor (1993), a large literature has documented that good monetary policies in advanced economies may be represented by simple interest rate rules. With a broad-based shift toward monetary stability in the developing world, researchers have started asking which interest rate rules may work best in those economies. This article summarizes recent IMF research in this area and highlights some issues for future analysis.

The literature on advanced and open economies—based on models with monopolistic competition and price rigidity (the standard new-Keynesian framework)—concludes that there is no role for the exchange rate in the interest rate rule unless pass-through to import prices is incomplete. Targeting consumer price index inflation already controls for exchange rate changes (Batini, Harrison, and Millard, 2003; and Corsetti and Pesenti, 2005).

Developing economies, however, seldom allow their currencies to float freely, even when the exchange rate regime is flexible. So, how should the interest rate rule respond to the exchange rate in these economies?

Parrado (2004), calibrates a small open-economy version of the new-Keynesian model to an emerging economy and finds that including the exchange rate in the interest rule is desirable only if domestic monetary shocks dominate. Laxton and Pesenti (2003) calibrate a richer version of the standard framework and, even when pass-through is incomplete, find no gains from including the exchange rate in the interest rule. The high degree of openness and the very small size here dominate pass-through considerations.

However, Morón and Winkelried (2005) analyze a small open economy with liability dollarization and find that, unlike in the standard case, there is a clear role for the exchange rate in the interest rate rule. Elekdag and Tchakarov (2004) also find that rules implementing fixed exchange rate regimes deliver higher welfare than rules implementing flexible exchange rate regimes if there are balance sheet effects. Ghironi and Rebucci (2002) analyze alternative interest rate rules in a small open economy in which currency risk is a distinct source of volatility from, but correlated with, default or credit risk. They find that the welfare gains of the rule implementing official dollarization exceed those associated with the flexibility value of rules supporting other types of fixed exchange rate or inflation targeting regimes.

The literature on advanced and open economies generally assumes that the interest rate rule is fully credible. This cannot be taken for granted in developing economies, where credibility is often the problem. Rabanal (forthcoming) shows that if agents underestimate the true parameters of the interest rate rule, the central bank needs to react more aggressively to deviations of its objectives from targets, including inflation targets. Isard, Laxton, and Eliasson (2001) study interest rate rules for inflation targeting in a small macro model with uncertainty related to the nonaccelarating inflation rate of unemployment (NAIRU) and alternative specifications of the evolution of policy credibility. They find that when inflation expectations and credibility respond endogenously to the policymaker’s track record of inflation, forward-looking interest rate rules (i.e., rules based on future inflation) work better than backward-looking rules (i.e., rules based on past inflation). Interestingly, both Ghironi and Rebucci (2002) and Laxton and Pesenti (2003) find that interest rate rules for inflation targeting that place a larger coefficient on inflation perform better in quite different settings.

Model uncertainty is more pervasive in developing economies because of continued structural change. The problem is that interest rate rules that have desirable theoretical properties might induce undesirable outcomes when implemented in slightly different economic environments. Batini and others (forthcoming) show that designing policy rules robust to indeterminacy has negligible welfare costs when the central bank is not excessively forward-looking in response to inflation. Demertzis and Tieman (2004) investigate the conditions under which robust rules are preferable to optimal rules when there is model uncertainty. They find that the higher the expected loss from applying robust rules to an incorrectly specified model, and the more risk adverse the policymaker, the more the robust rules are preferable to optimal rules.

Monetary policy implemented by means of interest rate rules might be inconsistent with the IMF’s traditional monetary conditionality. Blejer and others (2001) discuss the extent to which traditional IMF conditionality—a ceiling on net domestic assets of the central bank or base money and a floor on net international reserves—can be reconciled with the requirements of an inflation-targeting framework with the money market interest rate as the instrument. They conclude that the traditional monetary performance criteria are not well suited to monitor monetary policy implementation, and they suggest that simple interest rate rules (such as a Taylor rule) could be used to evaluate the policy stance and trigger consultations with the authorities on the appropriate level of the short-term interest rate. There are cases, however, in which it remains desirable to also monitor monetary aggregates, such as when the zero-bound in the nominal interest rate is binding or when asset price inflation or deflation are sources of concern for the policymaker.

Several issues remain open for future research, but a few stand out for their operational relevance. A high degree of interest rate smoothing is often a feature of optimal monetary policies for advanced economies “under discretion,” as it enables replication of “commitment” outcomes by inducing history-dependence in policy behavior. It would be interesting to see how these results would be altered by a high level of external volatility, including sudden stops of capital flows, which, all else being equal, might require relatively less interest rate persistence (see Espinosa-Vega and Rebucci, 2003). More generally, implementing monetary policy by interest rate rules assumes high substitutability between alternative forms of households and firm financing. So it would be useful to understand the extent to which standard interest rate rules would fare in the presence of financially-constrained households and firms, such as when the only source of financing is the domestic banking system.

References

  • Batini, Nicoletta, Richard Harrison, and Stephen P. Millard, 2003, “Monetary Policy Rules for an Open Economy,” Journal of Economic Dynamics and Control, Vol. 27 (September), pp. 205994.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Batini, Nicoletta, Alejandro Justiniano, Paul Levine, and Joseph Pearlman, “Robust Inflation-Forecast-Based Rules to Shield Against Indeterminacy,” IMF Working Paper, forthcoming.

    • Search Google Scholar
    • Export Citation
  • Blejer, Mario I., Alfredo M. Leone, Pau Rabanal, and Gerd Schwartz, 2001, “Inflation Targeting in the Context of IMF-Supported Adjustment Programs,” IMF Working Paper 01/31; also published in IMF Staff Papers, 2002, Vol. 49, No. 3, pp. 31338.

    • Search Google Scholar
    • Export Citation
  • Corsetti, Giancarlo, and Paulo Pesenti, 2005, “The Simple Geometry of Transmission and Stabilization in Closed and Open Economies,” Federal Reserve Bank of New York Staff Report No. 209, May (New York: Federal Reserve Bank of New York).

    • Search Google Scholar
    • Export Citation
  • Demertzis, Maria, and Alexander F. Tieman, 2004, “Robust versus Optimal Rules in Monetary Policy: A Note,” IMF Working Paper 04/96.

  • Elekdag, Selim, and Ivan Tchakarov, 2004, “Balance Sheets, Exchange Rate Policy, and Welfare,” IMF Working Paper 04/63.

  • Espinosa-Vega Marco, and Alessandro Rebucci, 2003, “Retail Bank Interest Rate Pass-Through: Is Chile Atypical?” Analysis and Economic Policies Series, Vol. 7, October (Santiago: Central Bank of Chile), pp. 14782; also issued as IMF Working Paper 03/112.

    • Search Google Scholar
    • Export Citation
  • Ghironi, Fabio, and Alessandro Rebucci, 2002, “Monetary Rules for Emerging Market Economies,” IMF Working Paper 02/34.

  • Isard, Peter, Douglas Laxton, and Ann-Charlotte Eliasson, 2001, “Inflation Targeting with NAIRU Uncertainty and Endogenous Policy Credibility,” IMF Working Paper 01/07; also published in Journal of Economic Dynamics and Control, 2001, Vol. 25, pp. 115148.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Laxton, Douglas, and Paulo Pesenti, 2003, “Monetary Rules for Small, Open, Emerging Economies,” Journal of Monetary Economics, Vol. 50, No. 5, pp. 110946.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Morón, Eduardo, and Diego Winkelried, 2005, “Monetary Policy Rules for Financially Vulnerable Economies,” Journal of Development Economics, 2005, Vol. 76, pp. 2351; also published as IMF Working Paper 03/39.

    • Crossref
    • Search Google Scholar
    • Export Citation
  • Parrado, Eric, 2004, “Inflation Targeting and Exchange Rate Rules in an Open Economy,” IMF Working Paper 04/21.

  • Rabanal, Pau, “Monetary Policy Uncertainty,” IMF Working Paper, forthcoming.

  • Taylor, John B., 1993, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy, Vol. 39 (December), pp. 195214.

    • Crossref
    • Search Google Scholar
    • Export Citation

IMF Study Adopting the Euro in Central Europe: Challenges of the Next Step in European Integration

Susan Schadler, Paulo Drummond, Louis Kuijs, Zuzana Murgasova, and Rachel van Elkan

The first wave of transition countries to join the European Union (EU) are turning their attention to the next step in European integration—replacing national currencies with the euro. This Occasional Paper examines the economic developments and policy challenges in this process. The focus is on five central European nations that joined the EU in May 2004—the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—and for which the change will entail a move from a flexible to a fixed exchange rate regime.

Accession to the EU implies a commitment to adopt the euro, although countries can choose when to request to do so. This study examines arguments for and against early euro adoption, the macroeconomic and structural preconditions for a successful experience in the euro area, and more narrowly, the policy frameworks needed to achieve the Maastricht criteria. The authors conclude that participating in the euro area will yield benefits through higher exports and faster economic growth, provided structural characteristics are broadly in line with the other EU economies. Countries will, however, face potential vulnerabilities inherent in relinquishing monetary autonomy, such as the risks of fixing the exchange rate at an inappropriate level and having to cope with large and volatile capital flows and possible credit and demand booms.

Among the conclusions of the study are that policies should largely be in place to meet the Maastricht criteria before entering the rather exacting framework of ERM2 (an exchange rate band arrangement designed to test exchange rate stability). The five countries score relatively well in terms of labor market flexibility, but substantial progress is needed with fiscal adjustment, and maintaining a high standard of financial sector supervision will be critical. With careful preparation in these areas, the flexibility and resilience of the economies should provide ample means for adjusting to country-specific shocks in the absence of monetary policy.

This study was issued as IMF Occasional Paper No. 234.

IMF Research Bulletin, June 2005
Author: International Monetary Fund. Research Dept.