Current Issues in Monetary Economics

342 Pages·1998·8.392 MB·English

by  Helmut Wagner (auth.), Prof. Dr. Helmut Wagner (eds.)

Current Issues in
Monetary Economics
Contributions to Economics
Christoph M. Schneider Michael Carlberg
Research and Development International Economic Growth·
Management: 1997. ISBN 3-7908-0995-0
From the Soviet Union to Russia
1994. ISBN 3-7908-0757-5 Massimo Filippini
Elements of the Swiss Market for
Bernhard BohmlLionello F. Punzo Electricity
(Eds.) 1997. ISBN 3-7908-0996-9
Economic Performance
1994. ISBN 3-7908-0811-3 Giuseppe Gaburro (Ed.)
Ethics and Economics
Lars Olof PerssonlUlf Wiberg 1997. ISBN 3-7908-0986-1
Microregional Fragmentation
1995. ISBN 3-7908-0855-5 Frank HosterlHeinz Welsch!
Christoph Bohringer
Emesto FellilFurio C. Rosati!
Giovanni Tria (Eds.) CO2 Abatement and Economic
Structural Change in the European
The Service Sector:
Internal Market
Productivity and Growth
1997. ISBN 3-7908-1020-7
1995. ISBN 3-7908-0875-X
Giuseppe Munda Christian M. Hafner
Multicriteria Evaluation Nonlinear Time Series Analysis
in Fuzzy Environment with Applications to Foreign
Exchange Rate Volatility
1995. ISBN 3-7908-0892-X
1997. ISBN 3-7908-1041-X
Giovanni Galizzi!
Luciano Venturini (Eds.) Sardar M. N. Islam
Economics of Innovation: Mathematical Economics of
The Case of Food Industry Multi-Level Optimisation
1996. ISBN 3-7908-0911-X 1998. ISBN 3-7908-1050-9
David T. Johnson Sven-Morten Mentzel
Poverty, Inequality and Social Real Exchange Rate Movements
Welfare in Australia 1998. ISBN 3-7908-1081-9
1996. ISBN 3-7908-0942-X
Lei DelsenlEelke de long (Eds.)
Rongxing Guo The German and Dutch Economies
Border-Regional Economics 1998. ISBN 3-7908-1064-9
1996. ISBN 3-7908-0943-8
Mark Weder
Oliver Fratzscher Business Cycle Models with
The Political Economy of Trade
Indeterminacy
Integration
1998. ISBN 3-7908-1078-9
1996. ISBN 3-7908-0945-4
Ulrich Landwehr Tor R~dseth
Models for Multispecies Manage
Industrial Mobility and Public Policy
ment
1996. ISBN 3-7908-0949-7
1998. ISBN 3-7908-1001-0
Arnold PicotlEkkehard Schlicht (Eds.)
Firms, Markets, and Contracts Michael Carlberg
1996. Corr. 2nd printing 1997. Intertemporal Macroeconomics
ISBN 3-7908-0947-0 1998. ISBN 3-7908-1096-7
Thorsten Wichmann Sabine Spangenberg
Agricultural Technical Progress and The Institutionalised Transformation
the Development of a Dual Economy of the East German Economy
1997. ISBN 3-7908-0960-8 1998. ISBN 3-7908-1103-3
Ulrich Woitek Hagen Bobzin
Business Cycles Indivisibilities
1997. ISBN 3-7908-0997-7 1998. ISBN 3-7908-1123-8
Helmut Wagner (Ed.)
Current Issues in
Monetary Economics
With 26 Figures
and 16 Tables
Physica-Verlag
A Springer-Verlag Company
Series Editors
Werner A. MUller
Martina Bihn
Editor
Prof. Dr. Helmut Wagner
Chair of Macroeconomics
University of Hagen
Feithstr. 140
D-58084 Hagen, Germany
Cataloging-in-Publication Data applied for
Die Deutsche Bibliothek - CIP-Einheitsaufnahme
Current issues in monetary economics: with 16 tables / Helmut Wagner (ed.). - Heidelberg;
New York: Physica-Verl., 1998
(Contributions to economics)
ISBN-13: 978-3-7908-1127-8 e-ISBN-13: 978-3-642-99797-6
DOl: 10.1007/978-3-642-99797-6
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Contents
Introduction 1
Helmut Wagner
Monetary Policy: Recent Theory and Practice 13
James Tobin
Part I: Central Bank Design
1. Game Theoretic Analysis of Monetary Policy Institutions
Mechanism Design for Central Banks -Results and 27
Unsolved Issues
Gerhard Illing
Comment 53
Hans-Peter Gruner
2. Outline of Two Controversial Positions on Central Bank
Autonomy
Central Bank Autonomy and Political Decision Process 63
Dietmar Kath
For a Monetary Policy that is Independent, yet Subject to 77
Rules
Wolfgang File
Part II: Monetary Policies: Strategies and
Implementation
3. Theoretical Considerations on Strategies in Monetary
Policy
Monetary Policy Strategies: From Rules to Central Bank 93
Contracts under Contingent Target Agreements
Alexander Karmann
Comment 109
Norbert Funke
4. Conceptual Problems of Monetary Policy
Central Bank Policy Rules: Conceptual Issues and 121
Practical Considerations
Stephen G. Ceeehetti
VI Contents
Implementation Problems of Monetary Policy Strategy 141
Gabriel P. Fagan
Comment 163
Lukas Menkhoff
Part III: Theoretical Aspects of Exchange Rate Policy
and Monetary Union
5. Problems of Flexible and Fixed Exchange Rates
Controversies on Exchange Rate Systems 177
Michael Frenkel
Comment 243
Manfred Willms
6. Approaching European Monetary Union: On Conversion
Rates
The Indeterminacy of the Euro Conversion Rates. Why It 251
Matters and How It Can Be Solved
Paul De Grauwe
Comment 273
Ansgar Belke
Part IV: Monetary and Exchange Rate Policy in
Developing and Transition Countries:
Selected Issues
7. Some Explanation on Recent Currency Crises
Issues in Monetary and Exchange Rate Policy of 289
Developing Countries
Friedrich Sell
8. Monetary System Design: On Currency Boards
Towards a General Theory of a Currency Board System 309
Wi/fried Fuhrmann
Comment 327
Rainer Schweikert
Conclusion and Supplements 341
Helmut Wagner
Notes on Contributors 353
Introduction
Helmut Wagner
University of Hagen, Feithstr. 140, D -58084 Hagen
In the last few years decisive methodological and thematic focal points which are
important for practical economic policy have been developed in the theory of
monetary and exchange rate policy. This book is concerned with these
developments, their assessment and the open questions which have still not been
solved. It is divided into four parts. The first part deals with central bank design,
the second with strategies of monetary policies and their implementation. Part III
is concerned with theoretical aspects of exchange rate policy and monetary union,
and part IV with selected issues of monetary and exchange rate policy in
developing and transition countries. In the following pages I will provide an
overview of the individual articles1. With the exception of the article by Nobel
Laureate James Tobin, the contributions contained in this book were all
introduced and discussed at an academic symposium I organized in Castrop
Rauxel on 8 and 9 September 1997. James Tobin agreed spontaneously to my
suggestion that he should write a comprehensive article especially for this
publication.
A short summary of the comments or supplementary papers and of the general
discussions will be given in the last section of this book, titled "Conclusion and
Supplements". There I will also provide some supplements respecting the issues
which were the subject of the greatest amount of debate at the symposium.
Following the introduction, the book starts with a survey of the recent theory
and practice of monetary policy by James Tobin. It deals with several key issues
of monetary economics. Tobin commences with an assessment of the rise and fall
of monetarism. Then he turns to the current orthodoxy in monetary and fiscal
policy which he views as dedication solely to price stability (representing the
dominant trend in the theory and practice of monetary policy over the last two
decades) and official indifference to real macroeconomic outcomes that, as he
emphasizes, refers to fiscal policy as well. Afterwards he considers the
macroeconomic theories underlying these policies.
In a further chapter Tobin presents the United States as a striking exception to
the "fashion" of designating price stability as the target of monetary policy and
explains the US's obviously better macroeconomic results over the past years as
against Europe and Japan by means of the non-orthodox policy there. Tobin then
1 I would like to stress here the help provided by my assistants, namely Wolfram
Berger, Claudia Goldschmidt, Friedrich Killmer, Ralf Sonnenfroh and Florian Splite.
2 Helmut Wagner
turns to the question of "rules versus discretion" in monetary policy. He argues
that a mechanical rule blind to actual economic events and outcomes cannot
work. And in fact even supporters of rules such as John Taylor would interpret
"rules" in a way that requires large doses of discretion in their application. Tobin
also emphasizes that, if the Fed had implemented the so-called Taylor-rule, as
good as it is, from 1993 through 1997, the US economy would have suffered
unnecessarily high unemployment and output losses, so that the Fed was right to
use discretion.
In the last chapter, Tobin analyzes the "spectacular" success of the US
economy over the last years and discusses the question, or as he states the
"mystery, fully understood by neither central bankers nor economists", why and
how monetary policy rules the economy. In his tentative answer, he refers to two
lines of explanation: substitution chains and policy expectations, whereby
expectations are claimed to be very powerful, but unable to work unless chains of
asset substitution really do occur. Finally he states that nowadays, where fiscal
policies are no longer eligible for counter-cyclical stabilization, and the
globalization of financial markets threatens national financial sovereignty,
innovative thinking about the tactics and the structure of monetary operations is
urgently necessary, in particular in Europe.
The first part of the book deals with central bank design. A central
methodological focal point of modem economic theory is the game theoretic
approach. The essay by Gerhard Dling is concerned critically with solutions
based on game theoretic models of central bank design. He refers in particular to
two empirical trends: the increase in the independence of central banks in many
countries, and the transition to inflation targeting in a series of countries. Illing
shows that both trends can be supported by game theoretic models; but he also
points out that the suspected credibility problems cannot be solved simply through
the institutional implementation of these policies. It is claimed in particular that
the previously much-discussed solution concepts of Rogoff and Walsh in part
displace the credibility problem to another level. Illing first analyzes the time
inconsistency problem of monetary policy in the Barro and Gordon (1983) model,
and then goes on to discuss different options of institutional solution. Following a
comparison of the results achieved by monetary targeting with those achieved by
strict inflation targeting, Illing then turns his attention to two rival concepts of
central bank independence. He first discusses the solution in the Rogoff (1985)
model, which provides a rationalization for an independent central bank that sets
its own policy goals and chooses its policy instruments independent from
government interference. His criticism of this approach concerns the fact that the
government still has an incentive to renege on delegation. Rogo:frs approach
assumes implicitly that the costs of doing so are infinitely great. The credibility of
delegation is therefore only assumed and not substantiated. In addition, the costs
of longer-term delegation are not specified.
Finally, Illing turns to Walsh's (1995) approach, in which the central bank is
given instrumental independence but no goal independence. In addition,
Introduction 3
the contract design itself is assumed but not substantiated. The lack of government
credibility is replaced by the assumption, that the government is able to commit to
keep contracts. An adequate analysis must take the costs of reneging the contract
into account. But this means that the analysis must take into account the
verifiability of different policies. Illing then comments on the Persson and
Tabellini (1993) fmdings on the theory of incomplete central bank contracts. Once
again he criticizes the constitutional solution (i.e. an incomplete contract) for
merely assuming the government's capability of commitment. Illing shows that
the theory of incomplete central bank contracts stresses above all the trade-off
between democratic accountability and robustness against political distortions.
Following Illing's extensive theoretical representation of the "Central Bank
Design", Dietmar Kath and Wolfgang File provide an outline of their
controversial assessment of the question of central bank autonomy.
Kath pleads in his paper for strict independence of central banks. First of all he
takes up the theoretical discussion on the pros and cons of central bank autonomy
and puts forward arguments for both positions. The most important argument of
opponents of central bank autonomy consists in the danger of stabilization policy
conflicts between the monetary and the fiscal authority. Supporters of central bank
independence on the other hand deny that there is a (long term) conflict between
macroeconomic targets. They also argue that even an existing trade-off does not
support the above position, because it would be exploited by selfish politicians
maximizing their individual utility. Kath states that the results of such a policy
consist in exclusively temporary increases to output and employment which are
purchased in the long term by accelerating inflation.
With these arguments in mind, the autonomy of central banks, combined with
the statutory commission to keep the price level stable, appears to be the rational
solution. However, Kath goes on to argue that central bankers also act to
maximize their own self-interest and that therefore central bank autonomy cannot
guarantee a monetary policy orientated towards social welfare. He draws the
conclusion, therefore, that the independence of central banks should not be
anchored merely in a statute, but that it should encompass additional elements.
With this in mind he defmes the term independence using three criteria. Firstly, the
central bank must be statutorily obliged to aim for price level stability; secondly,
decision-makers must be independent; and thirdly, there must be a prohibition on
granting the government credit and complete freedom to make decisions on
exchange rate policy. In the light of these criteria, Kath regards the foundation of
the autonomy of the European Central Bank in the Maastricht Treaty as
inadequate, and sees the risk that future European monetary policy will be
predetermined by national governments.
File on the other hand argues in favor of only a "conditional independence" of
central banks. He criticizes the fact that Kath's approach focuses exclusively on a
microeconomic consideration of central banks from the point of view of the
economic theory of bureaucracy and ignores macroeconomic problems. In
particular with regard to the European Central Bank, Filc demands that banks
4 Helmut Wagner
should not be simply given the aim of monetary stability, but that it should also be
charged with concerning itself with growth and employment. In his opinion,
monetary policy autonomy must be restricted to prevent the target of price stability
being pursued irrespective of the (social) costs. Central banks should not be
subject to government directives, but at the same time the inclusion of additional
macroeconomic variables in the catalogue of targets should be used to prevent
central banks taking up an isolated position. Filc therefore favors cooperation
between monetary, fiscal and income policy. In his opinion, this is the only way to
achieve a combination of interest rates, exchange rate and wage levels which will
enable inflation-free growth with high employment. As the foundation of a
cooperative strategy of this nature Filc formulates a "code of economic behavior"
which replaces the delegation of each of the macroeconomic targets in the sphere
of responsibility of only one of the stabilization policy authorities.
Summing up, Filc pleads for a monetary policy that is not subject to any
government directives but which is orientated towards socially desirable
macroeconomic targets and follows a simple, operational and systematic rule here,
whereby he proposes a modified Taylor rule.
The second part of the book is concerned with monetary policy strategies and
their implementation. At first, the article by Alexander Karmann deals with the
question of how the proposal for simple linear central bank contracts can be
modified so that the contract becomes more credible as an institutional
mechanism. With recourse to McCallum (1995) and with reference to recent
experience with the Central Bank Act in New Zealand, Karmann recognizes a
credibility problem for simple contracts in the lack of an ex-post incentive for the
government actually to impose the prescribed sanctions in the event that the
contractual targets are not reached. Karmann argues that the structure of the
underlying distribution of information between the central bank and the
government must be taken into account when the contract is drawn up, so that
more flexible and therefore more credible solutions can be found.
The article begins with a general introduction to linear rational-expectations
models, in the scope of which central bank policies are usually examined in a
formal way. Following the tradition ofBarro and Gordon (1983) the commitment
solution is contrasted with the discretionary solution and simple rules are
introduced, which can be found in the literature, in order to come closer to the
commitment solution. In the third section the results are compared that are found
when these rules are applied in the scope of an AS/AD model. Karmann points out
that the relative assessment of the rules depends to a great extent on the respective
model parameters and on the type of shock that is assumed. In addition, the
question must be put with all these rules as to how a central bank can be obliged
credibly to comply with the rules if it always fmds itself exposed to a subsequent
incentive to deviate from them.
The fourth section then presents contractual agreements which extend the loss
function of the central bank by a transfer element as a possible approach to the
solution of this credibility problem. This contractual transfer may be interpreted as