CENTRAL BANKS AND MONETARY POLICY STRATEGY( Chap. 14; Chap 17, 434-444…454-457)

2

Principles of Monetary Policy Strategy Pt. I. Why Price Stability?

1. There is no long-run tradeoff between unemployment and inflation.

2. Price stability has important benefits.

3. Inflation is always and everywhere a monetary phenomenon.

4. A strong nominal anchor is the key to producing good monetary policy outcomes.

Expectations, Policy Credibility, and Transparency2

Mishkin, Monetary Policy Strategy After the Crisis

1. No Long Run Tradeoff: The Phillips Curve• Overall goal of government economic policy is to increase wealth in the economy

• High Real Economic Growth• High Employment Levels• Economic Consensus: Central banks cannot directly impact long-run real growth on the basis of decision to produce more (or fewer) bank notes but they can affect real output & employment in the short-run.

4

World Development Indicators

Outline

2. Benefits of Price Stability

• High inflation leads to• Increased transactions costs• Tax on Cash Holdings• Distortions of economic decisions• Uncertainty• Over-investment in financial sector

5

3. Inflation is Always a Monetary Phenomena

• Trite at some level. Inflation is growth rate of prices. Prices are measured in money. QED.

• Relevant Meaning – Monetary authorities own inflation.• Central Banks are monetary authorities in modern

economies.

• Central Bank: A special

governmental organization or quasi-governmental institution within the financial system that controls the medium of exchange.

Economy Central Bank

HK Hong Kong Monetary Authority

USA Federal Reserve

EU European Central Bank

PRC People’s Bank of China

UK, Canada, Japan, Korea

Bank of ….

What is a central bank?

• Central banks have two main roles:• Banker to the government

• Manage many financial assets of the government.• Monopoly on the issue of banknotes/currency (true

almost everywhere, but not HK)• Arm of government policymaking

• Banker to commercial banks.• Operate the Payment System• Regulate Banking System• Lender of Last Resort during a crisis

Powers & Purpose

• Unlike private sector banks which maximize profits, the central bank attempts to increase wealth of the entire society.

• Main powers of central bank:• Deciding the quantity of the monetary base

• Use this power to set short-term interest rates (?)

• In some economies, including HK, will regulate the banking system.

Focus on Stability• Central banks can have much more impact by stabilizing the economy in the short-run (which may have indirect positive impact on growth).

• But the central goal of most central banks is to maintain a stable price level meaning low inflation. Why?• Making an effort to keep inflation low overcomes key flaw

of paper money or fiat money, its unlimited supply.

Policy Framework• Fed Objective Humphrey Hawkins Act (1978): Fed

instructed by Congress to be “conducting the nation's monetary policy .. in pursuit of maximum employment, stable prices, and moderate long-term interest rates “

• ECB Objective “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.”

• Japan Objective: Bank of Japan Act Article 2 Currency and monetary control by the Bank of Japan shall be aimed at achieving price stability, thereby contributing to the sound development of the national economy

12

Genberg, H and D He (2009): “Monetary and financial cooperation among central banks in East Asia and the Pacific”, in R Rajan, S Thangavelu and R Parinduri (eds), Exchange Rate, Monetary and Financial Issues and Policies in Asia, World Scientific Publishing Co, pp 247 – 70

13

More GoalsMongolia Price stability and

exchange rate stability “The main objective of Bank of Mongolia is to sustain stability of national currency tugrug” and this statement can be interpreted in two manners. For instance, stability of tugrug in the external market refers to the stability of exchange rate of tugrug in foreign currencies, whereas stability of tugrug in domestic market refers to the stability of Consumer Price Index.

Sri Lanka Economic and price stability

One of the core objectives of the Central Bank of Sri Lanka is economic and price stability… Economic and price stability is a situation where there are no wide fluctuations in the general price level in an economy which helps to achieve sustainable economic growth.

Nepal Price and Balance of payments stability

Key objectives of the Bank are to achieve price and balance of payments stability, manage liquidity and ensure financial stability, develop a sound payments system, and promote financial services.

Afghanistan Price Stability As enshrined in DAB law (Article 2, Para.1), the primary objective of DAB is to achieve and to maintain domestic price stability

Brunei Exchange Rate Stability

The country’s monetary discipline of having a currency board system has ensured the full convertibility of base money with the exchange rate pegged at par to the Singapore Dollar.

Myanmar Macroeconomic Stability

The main objective of monetary policy in Myanmar is to maintain macroeconomic stability in the economy while promoting domestic savings.

Cambodia Price Stability determine and direct the monetary policy aimed at maintaining price stability".

14

• “Thirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to "keep up" with inflation. … The episode highlights the crucial importance of keeping inflation expectations low and stable, which can be done only if inflation itself is low and stable.” Bernanke, 2006

4. A strong nominal anchorThe Wage Price Spiral

Expectations, Policy Credibility, and Transparency14

15

The importance of the nominal anchor.

• If workers expect high inflation they will demand high wage growth. But if firms experience growth in labor costs, they will price in high inflation. A self-fulfilling prophecy!

• Only if central bank displays a strong commitment to low and stable inflation, will expectations be anchored toward low and stable inflation.

Expectations, Policy Credibility, and Transparency15

Quantitative Anchors

• Monetary Targets – Growth in monetary aggregates

• Exchange Rate Targets• Inflation Targets

16

Fatas, Mihov, and Rose (2006) find that countries with explicit targets have less inflation. They find that meeting pre-announced numerical targets leads to an improvement in macroeconomic outcomes; this matters more than the nature of the regime

17

What is Inflation Targeting?• An increasingly popular choice of monetary policy framework first adopted in New Zealand in 1989.

• Many inflation targeting countries have successfully lowered inflation and inflation expectations.

• WEO (2005) presents an optimistic view.• Gürkaynak, Levin, and Swanson (2006) show long-

term inflation expectations are more stable under inflation targeting indicating better anchoring.

18

19

List of Inflation Targeting CountriesRose, 2006 A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed

Outline

New IT

• Italics indicate possible non-FFIT.

• Reference: IMF Working Paper; Bank of England Handbook; Various central banks.

Country Adoption DateGeorgia 2009Dom. Rep. 2012Paraguay 2011Albania 2009Armenia 2006Ghana 2007Guatemala 2004Moldova 2010Serbia 2009Uruguay 2007Japan 2013

INFLATION TARGETING

Characteristics1.

An explicit central bank mandate to pursue price stability as the primary objective of monetary policy,

2. Explicit quantitative targets for inflation; 3. Policy actions based on a forward-looking ass

essment of inflation pressures, taking into account a wide array of information;

4. Increased transparency of monetary policy strategy and implementation.

5. Mechanisms of accountability for performance in achieving the objective;

22

Laxton and Freedman, 2009, Why Inflation Targeting

23

1. Commitment to Price stability as primary goal

• Central Bank has commitment to achieve low and stable inflation in the short-run and in the long-run

“Like most other central banks, the Bank of Korea takes price stability as the most important objective of its monetary policy. The current Bank of Korea Act clearly sets out price stability as the purpose of the Bank of Korea's establishment and stipulates that it should seek to bring about price stability by setting an inflation target in consultation with the government and do its utmost to attain this target.” BACK

Numerical goal subject to change

2. Medium term numerical targets for inflation.

• Based on Article 6, Clause 1 of the 「 Bank of Korea Act」 , the Bank of Korea sets the mid-term inflation target to be applied for three years in consultation with the government. The inflation target measure during the period from 2013 to 2015 is set at 2.5~3.5%, based on consumer price inflation (year-on-year). 

24

Public announcement of specific inflation rate goal (w/ room for error) over specific term or period.

BACK

25

3. Policy actions based on a forward-looking assessment of inflation pressures• Forward looking operating procedure – monetary instruments operate only with some lag. Targeting medium term inflation means setting today’s policy for tomorrow’s economy.

• Must inevitably target the forecast.

The Bank reduced the Base Rate that had been held at 2.75% a year since November 2012 by 0.25 of a percentage point in May this year against the background in which not only there were large downside risks to growth owing to the slow pace of the world economic recovery,…, but also inflation pressures were expected to stay at a moderate level for some time to come due to the unexpected stability of oil and agricultural product prices. LINK

26

Garcia-Herrero and Remolena, http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1457506

Back

Inflation Reports

• Central bank publishes its inflation forecast with probability distributions to indicated degree of uncertainty.

27BACK

28

4. Transparency 1. Learning about policymakers’ plans can cause shifts in

expectations

2. The more unstable are market expectations, the greater will be the instability in macroeconomic performance

3. Keeping agents’ expectations aligned with policymakers’ plans helps avoid big surprises

4. Credible central bank communications has calming impact on agents’ expectations

This approach stands in sharp contrast to previous central banking practice.

4 Things for the Central Bank to Communicate About

i. Goals and InstrumentsFun Fact: Until 1994, U.S. Fed did not reveal policy instrument was Fed Funds Rate

ii. Policy Decisions and their Basis• Policy Statements & Meeting Minutes

iii. Economic Forecasts

iv. Monetary Policy Outlook• Specific or suggestive

29

5. Mechanisms of Accountability• Under IT, central bank retains instrument independence but must thereby retain responsibility for achieving objectives.

• Many IT regimes include an accountability mechanism.

30

Mechanisms

Open Letter to the PresidentTo ensure accountability in cases where the

BSP fails to achieve the inflation target, the BSP Governor issues an Open Letter to the President outlining the reasons why actual inflation did not fall within the target, along with the steps that will be taken to bring inflation towards the target. Open Letters to the President have been issued on 16 January 2004, 18 January 2005, 25 January 2006, 19 January 2007, 14 January 2008 and 26 January 2009.For 2010, the BSP met the target and no open letter was issued.

Bank of England Handbook

32

What measure of Inflation should be used? Headline Consumer Price Index

• ‘Core’ versus ‘headline’ CPI• Headline CPI ~ Index of All Consumer Goods• Core Inflation ~ Index of Consumer Goods less volatile

price goods (i.e. food and energy). • Tradeoffs

• ‘core’ more stable and better predictor of future inflation• Food and Energy large share of emerging market consumer

baskets and hard for public to ignore.

Back

Targeters and theirTargets

Bank of England Handbook

34

Over what horizon should inflation be measured?

• Usually over a range of 1 year at the shortest to 3 years at the outside.• Keeping inflation near target even in the short-run offers

greater credibility…if it can be accomplished.

Short-term programs often adopted for disinflation. • Longer term targets allow the economy more flexibility to

adjust to temporary shocks.

Horizon CountriesYearly Brazil, Guatemala (End of Year),

One-Two Years Canada (6-8 Quarters), Czech Republic (12-18 Months), Ghana (18-24 Months),

Two Years Chile (around two years), Israel (within two years), Sweden (normally two years), Thailand (8 quarters)

Medium Term Armenia, Australia, Colombia, Hungary, Indonesia, Mexico, New Zealand, Norway, Philippines (2012-2014), Poland, Romania, Serbia, Iceland (on average), Peru (at all times), UK (at all times), South Africa (on a continuous basis).

Three Years South Korea, Turkey (Multi year)

35

Bank of England Handbook

Korea Adopts Inflation Targeting in 1998

Q1-1983 Q2-1985 Q3-1987 Q4-1989 Q1-1992 Q2-1994 Q3-1996 Q4-1998 Q1-2001 Q2-2003 Q3-2005 Q4-2007 Q1-2010 Q2-20120

2

4

6

8

10

12

Korea: YoY CPI Inflation

IT Lite• Some central banks will use inflation as a nominal anchor,

even announcing numerical goal for inflation without adopting full-fledged inflation targeting (FFIT defining targets, ranges, horizons, accountability mechanisms).

• Ex. U.S. Federal Reserve Monetary Policy Strategy The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

FOMC Monetary Policy Strategy & Longer Run Goals• How much credibility will this build.

THE STRUCTURE OF CENTRAL BANKSChapter 17

39

Principles of Monetary Policy Strategy Pt. II

Building Credibility

5. Monetary policy is subject to the time-inconsistency problem;

6. Central bank independence helps improve the efficacy of monetary policy.

Expectations, Policy Credibility, and Transparency39

Mishkin Monetary Policy Strategy: How Did We Get Here?

40

5. Time Inconsistency

• Central banking goals benefit from anchoring inflation expectations but if inflation expectations become successfully anchored, a myopic policymaker might take advantage to push up output.• Low inflation targets might not be time consistent.

• Since gov’t often has a short-term focus, it might be difficult to build credibility for low inflation expectations.

Expectations, Policy Credibility, and Transparency40

Four Principles of Central Bank Design

• Society should design the state such that central bank is able to resist the short-run imperatives of government but still implement the goals of society

• Independence• Decision Making by Committee• Accountability and Transparency• Policy Framework

Principles of Central Bank Design1. Independence

• Strategies for Insulation• Policy Independence: Central Bank sets day-to day monetary policy free of direct government control. Policy not reversible.

• Personal Independence: Long-terms of Office for Central Bank Policymakers, difficult for Central Bankers to be Fired.

• Revenue Independence: Central Bank has independent sources of revenue.

Federal Reserve StructureBoard of Governors

Washington D.C.(Direct Policy)

Regional Banks(Monitor Regional Economy, Local Interbank Payments) New York Fed

(ImplementMonetaryPolicy in Financial Markets,

Handle FXTransactions)

Independence of US Federal Reserve• Policy Independence: Monetary policy set by directors of

Federal Reserve of USA controlled & Regional Bank • Personal Independence: Chairman of Fed serves across

Presidential terms. Presidents appointed by executive and approved by legislature. Other policymakers serve terms of either 5 or 14 years. They cannot be fired without votes of ⅔ of Congress.

• Revenue Independence: Fed earns profits through its payment operations which constitute its budget.

Formation of a New Currency

• The countries of Euroland needed to replace national central banks with a single policy maker.

11 Countries adopt a single currency in 1998, 18 countries by 2013.

Structure of the ECB

ECB Website

Independence of ECB• Policy Independence: Monetary policy of ECB controlled by

Executive Council & National Bank Presidents. Decisions cannot be reversed by national governments.

• Personal Independence: National Bank managers serve 5 year terms across Presidential terms. Board members serve 8 year terms.

• Revenue Independence: Budget provided by national central banks which conduct most profitable operations

Independence of Bank of Japan• Policy Independence: Monetary policy set by board.• Personal Independence: Governor and Board members

have terms of five years, appointed by Cabinet approved by Diet and House of Councillors.

• Budgetary Independence (?): Ministry of Finance must approve budget.

Trend toward Independence• 1998: Bank of Japan removed from direct control of Ministry

of Finance.• 1998 Bank of England removed from direct control of the

Chancellor of the Exchequer.• In 2003, Bank of Korea removed from direct control of

Ministry of Economy and Finance.

Monitoring the Monitors• Reducing the impact of short-term political considerations

on decision making is important.• But its also important in long-term to insure that central

bank serves goals of society and not own self interest.

Regulatory Capture• Regulator of any industry may end up responding to needs of industry rather than limiting them.

• Political influence or Hiring of Former Regulators.• Buiter: Cognitive Regulatory Capture• In USA, Regional Federal Reserves are governed by local banks. http://video.msn.com/video.aspx?mkt=en-us&vid=f52ef280-e022-4fbd-a9a8-2cdcde182235

More Principles of Central Bank DesignHow to monitor the central bank.

1. Decision Making by Committee• Power should be diffuse within the central bank.

2. Accountability and Transparency• Central Banks should make information about their intentions and actions.

3. Policy Framework• Banks should have a clear guideline for setting their policy which meets the consensus of society.

Decision Making by CommitteeInterest Rate Setting

• Each of the Big 3 central banks sets a key interest rate by committee. The decisions of these committees are closely watched.

Bank Committee Rate

Fed Federal Open Market Committee

Fed Funds Rate

ECB Governing Council Main Refinancing Operation Rate

BoJ Monetary Policy Committee

Uncollateralized Overnight Call Money Rates

Accountability and Transparency• Publication of Policy Minutes

• Fed: Minutes • ECB: Doesn’t Publish Critique • BoJ Minutes

• Data, forecasts other research materials, presentations to public and legislature. • Federal Reserve must present report to Congress twice per year.

Hong Kong Monetary Authority• HKMA formed in 1993 with merger of Exchange Fund and

Commissioner of Banking to perform role of the central bank.

• Regulation of the Banking System• Operation of the System of Payments• Control of the Monetary Base

Prior to 1988, interbank settlement done on the books of HSBC

Independence of the HKMA? • HKMA Policy Objectives

• “The HKMA is an integral part of the Hong Kong SAR Government. The Chief Executive , appointed by the Financial Secretary, remains a public officer….”

• “The Exchange Fund Advisory Committee …functions… as a management board of the HKMA. The HKMA is accountable to the public through the Financial Secretary.”

• Exchange Fund controlled by Financial Secretary. • Decision to continue or abandon exchange rate peg lies

with Financial Secretary. • Existence & Convertibility of HK dollar written into the

Basic Law.• HKMA has control over its own budget.

OTHER GOALS

Business Cycle Stability• Modern economies are beset by volatility in economic

output and employment. • Does the pursuit of price stability come at the expense of

business cycle stability or are the two goals complementary. Always?

1992

Q1

1992

Q4

1993

Q3

1994

Q2

1995

Q1

1995

Q4

1996

Q3

1997

Q2

1998

Q1

1998

Q4

1999

Q3

2000

Q2

2001

Q1

2001

Q4

2002

Q3

2003

Q2

2004

Q1

2004

Q4

2005

Q3

2006

Q2

2007

Q1

2007

Q4

2008

Q3

2009

Q2

2010

Q1

2010

Q4

2011

Q3

2012

Q2

2013

Q1

2013

Q4

0.000

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

Unemployment Rate %

China, P.R.: Hong Kong Korea, Republic of Singapore

Exchange Rate Stability• Hong Kong’s monetary policy emphasizes exchange rate

stability. • Monetary Policy in Hong Kong

• Convertibility Undertaking: An undertaking by the Central bank to convert domestic currency into foreign currency at a fixed exchange rate.

• Linked Exchange Rate System: Since October 17, 1983, Hong Kong has a convertibility undertaking with the US dollar.

• Why?

Exchange Rate Stability

Sep-1982 Sep-1985 Sep-1988 Sep-1991 Sep-1994 Sep-1997 Sep-2000 Sep-2003

8.5

8.0

7.5

7.0

6.5

6.0

5.5

5.0

4.5

HK: Spot Exchange Rate: HKMA: HK$ to US DollarHKD to USD

65

Principles of Monetary Policy Strategy Pt. III.

7. Developments in the financial sector have a far greater impact on economic activity than was earlier realized.

8. The cost of cleaning up after a financial crisis is very high.

9. Price and output stability do not insure financial stability.

10. The zero lower bound on interest rates can be a serious problem.

Expectations, Policy Credibility, and Transparency65 Mishkin, Monetary Policy Strategy After the Crisis

Financial Stability?

7. Increased Financialization in Developed Countries

IMF World Economic Outlook 2008 Chapter 3

9. The cost of cleaning up after financial crises is very high.

Challenges to Monetary Policy Effectiveness

67

Link

9. Financial Instability

Economist Guide to Global Housing Markets

Financial Stability• Financial Market Stability Financial markets and institutions

play an important role in moving funds from savers to borrowers. • Stock Market Stability• Real Estate Market Stability

In recent years, bubbles and busts have beset markets. • Interest Rate Stability: Businesses and consumers that rely on short-

term credit prefer a predictable exchange rate.

Zero Lower Bound

1990

0101

1990

1201

1991

1101

1992

1001

1993

0901

1994

0801

1995

0701

1996

0601

1997

0501

1998

0401

1999

0301

2000

0201

2001

0101

2001

1201

2002

1101

2003

1001

2004

0901

2005

0801

2006

0701

2007

0601

2008

0501

2009

0401

2010

0301

2011

0201

2012

0101

2012

1201

2013

1101

0

1

2

3

4

5

6

7

8

9

Zero Lower Bound

ECB Main Refinancing Rate

Japan Overnight Uncollateralized Call Money Rate

USA Federal Funds Rate

71

I. Two ViewsClean vs. Lean

• Macroeconomic impact of recent financial volatility has put renewed emphasis on the role of monetary policy in ensuring financial stability.

• Two Views (Kohn, 2006)A. Conventional View

B. Leaning against the Wind/Extra Action

71

Many Goals, Limited Powers• Central banks are granted a small number of powers by

society and have a wide variety of aims. • How do they use the powers they have to achieve all

goals. • Important Question: Do they have enough tools at their

disposal to achieve all aims? What trade-offs do they face?

INTEREST RATES

REAL INTEREST RATESCecchetti, P. 80-84

Nominal and Real Interest Rates• Nominal return represents how much money you will

receive after 1 year for giving up 1 dollar of money today• Real return represents how many goods you can buy if

you give up the opportunity to buy 1 good today.• Nominal interest rate is money interest rate. Real interest

rate is goods interest rate.

Interest on a Simple Loan

• Interest rates are always measured in annual terms.

• Set T = # of years of a loan (may be fraction)

A simple loan implies a loan of principal and a single repayment which is the principal plus interest.

(1 )t Tt+T t tRepayment i Principal

• Imagine a 1 year loan [T =1]: The lender gives up some goods to make a loan and will buy goods in the future with the repayment.

• If the price of goods at time t is Pt, the foregone current goods are

• The goods value of the future repayment is

t

t

PrincipalP

1 t+1t

t

Repaymenti

Principal

t+1

t+1

Repayment

P

Real Interest Rate

11

1

11

1

t+1 t+1

t+1 tt

t t+1

t t

tt t t t

t

Repayment RepaymentP Principal

rPrincipal P

P P

ir r i

• The real interest rate on the loan is defined as the future goods received relative to current goods foregone

Ex Ante Rate and the Fisher Effect

1EA FORECAST

t t ti r

• Savings and investment decisions must be made before future inflation is known so they must be made on the basis of an ex ante (predicted) real interest rate.

• Fisher Hypothesis: Ex ante real interest rate is determined by forces in the financial market. Money interest rate is just the real ex ante rate plus the market’s consensus forecast of inflation.

Great Inflation of the 1970’s

US Inflation Rates & Interest Rates

0.00

2.00

4.00

6.00

8.00

10.00

12.00

14.00

16.00

18.00M

ar-5

5

Mar

-58

Mar

-61

Mar

-64

Mar

-67

Mar

-70

Mar

-73

Mar

-76

Mar

-79

Mar

-82

Mar

-85

Mar

-88

Mar

-91

Mar

-94

Mar

-97

Mar

-00

Mar

-03

%

Interest Rates

Inflation

Source: St. Louis Federal Reserve http://research.stlouisfed.org/fred2/

• We can also examine the ex post real return on a loan as the money interest rate less the actual outcome for inflation.

• The gap between actual and forecast inflation determines the gap between the ex post (actual) and ex ante (forecast) return.

Ex Ante vs. Ex post

1ExP ACTUAL

t t tr i

1 1ExP ExA FORECAST ACTUAL

t t t tr r

Unexpected Inflation Winners and Losers

• Higher than expected inflation means ex post real rates are lower than ex ante. Borrowers are winners/lenders are losers.

• Lower than expected inflation means ex post real rates are higher than ex ante. Lenders are losers/borrowers are winners.

• Banknotes do not pay interest. • The real interest rate on banknotes is

• If inflation is high, currency has sharply negative returns. People will avoid holding money leading to society losing the convenience of money transactions.

The Inflation Tax

1CASH

t tr

Identifying the Ex Ante Rate• Calculating the ex post rate is straight-forward using

economic data. • Calculating the ex ante rate is harder since markets

expected inflation is not directly observable.• Option 1: Use survey data to elicit beliefs about inflation.

• Surveys of professional forecasters or perhaps consumers or corporate executives (better for short-term).

• Option 2: Use yields on inflation protected securities.• Many large countries treasuries issue bonds that guarantee a pay-

off in terms of purchasing power. The purchasing power yield that the market is will to accept should be similar to real yield on other assets (usually better for long-term).

Link

Importance of the Real Interest Rate• Real interest rate is the intertemporal price of purchasing

power.• If you buy 1 unit of purchasing power today, you give up 1+r units

of future purchasing power. • It is the direct cost of credit for borrowers.

• An important determinant of the intertemporal allocation

Structure of Monetary Policy Implementation

Nominal Anchor

Variable used to pin down the value of

currency.

OperatingInstruments

ToolsDirect powers of the

Central bank.

Policy Feedback

Policy/Operating Instruments• “A variable that is very responsive to the central bank’s

tools and indicates the stance of monetary policy” • Developed economies and emerging markets typically

choose between using a short-term interest rate or an exchange rate as the instrument.

• Determines the implementation of monetary policy.