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Levelling out currency fluctuations reduces uncertainty and thereby stimulates trade. However, it is
probable that the impact of such costs can be reduced
by enhanced methods for minimizing currency
risks.3 Secondly, a fixed exchange rate can serve as
the anchor of monetary policy and increase its transparency. It can also serve as a suitable mechanism for
bringing down inflation, as has been the case in
Iceland. Thus, if the fixed exchange rate policy itself
is credible, it is possible to benefit from the credibility of the area against which the currency is pegged
to bring inflation down to a comparable level to that
pertaining there. Thirdly, an imperfect foreign
exchange market can cause instability in the economy. Studies suggest that foreign exchange markets
are often characterized by herd behaviour and that a
currencys exchange rate does not always reflect the
economic fundamentals it is supposed to. Fixed
exchange rates, which rule out internal fluctuations
among participating currencies, reduce such behaviour and could have a beneficial impact on the economy.
However, a fixed exchange rate policy has various disadvantages too. Firstly, it deprives the central
bank of its ability to use monetary policy to respond
to domestic idiosyncratic shocks.4 Likewise, economic shocks in the country against which the currency is pegged will inevitably be reflected in
domestic interest rates. In the event of misalignment
in business cycles, this can lead to problems.
Secondly, countries with fixed exchange rate regimes
become prone to speculation against their currencies.
If the fixed exchange rate policy lacks credibility
there is a risk that investors will seek to rid themselves of that currency, forcing the central bank to
buy it back on a large scale in order to defend the peg
with rising domestic interest rates. This can prove
very expensive and trigger a domestic crisis. Thirdly,
a fixed exchange rate policy can reduce the flow of
information. A currencys exchange rate contains
important information about the countrys monetary
position and the credibility of domestic monetary
3. This cost must not be underestimated. For example, the provinces of
Canada conduct considerably more trade among themselves than with
their neighbouring US states, despite the longer distances involved. See
McCallum (1995). The most probable explanation is the use of different currencies in Canada and the USA.
4. For developing countries or countries with a history of poor monetary
management, however, this can be an advantage.
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7. The trend towards more flexibility in formulation of exchange rate policy is also reflected in the extension of currency fluctuation bands by
many countries. Of the 40 countries that have used fluctuation bands at
some time, 21 remain. Of the others, 8 have adopted more flexible
Proportion
(%)
1991 1999
1991 1999
14
8
21
30
7
80
31
14
17
13
6
81
9
5
14
20
5
52
17
8
9
7
3
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Managed floating
(6) De facto exchange rate target1 ......
(7) Crawling peg2................................
(8) Crawling bands2 ............................
(9) No pre-announced path3................
Total...............................................
7
13
3
8
31
15
3
9
26
53
5
8
2
5
20
8
2
5
14
29
36
38
20
45
14
25
23
27
15
15
26
14
45
63
26
14
53
5
25
35
14
48
27
26
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1. Formally no exchange rate objective, but the exchange rate remains the
main anchor of monetary policy. 2. Exchange rate or bands regularly adjusted according to predetermined rule. 3. Frequent government intervention in
the foreign exchange market to influence the rate of the domestic currency,
even though there is no statement of what the exchange rate target should be.
4. Exchange rate of domestic currency almost entirely determined in the
market; government intervention rare and then generally only in order to
even out exchange rate fluctuations. This is the closest form to a pure float.
Sources: IMF (1999) and IMF, International Financial Statistics, August
1999. The classifications in (10)-(16), however, are the authors own.
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practice. The first chief characteristic of this arrangement is that price stability is formally designated as
the main objective of monetary policy, which clearly
signals the monetary stance and the criteria for
assessing central bank performance. Secondly, a declaration is issued stating a numercial target for inflation within a specific horizon. Thirdly, the government chooses the target, either unilaterally or jointly
with the central bank which is granted instrumental
independence to achieve the target. Finally, transparency of monetary policy and flow of information
from the central bank to the public and government
are increased. At the same time, central bank accountability is often outlined in more detail.
When monetary policy is based on an inflation
target, no formal intermediate target such as a fixed
exchange rate or a specified growth in money supply
is used. However, given the key role that the central
bank inflation forecast plays in a monetary policy
with inflation targeting, the forecast itself can be
thought of as an intermediate target (see, for example,
Svensson, 1999 and Berg, 1999). In practice, the procedure is that the central bank makes an inflation forecast based on unchanged monetary policy. If the forecast suggests that inflation (for example over the following two years) will move outside the target band,
the central bank is obliged to respond. The central
bank then decides on the mix of actions which it considers most favourable for achieving its objectives.
The experience of countries which have adopted
inflation targeting seems positive. They have managed to reduce the inflation rate and inflation expectations, in excess of what could probably have been
expected if no formal inflation target had been set
(see Bernanke, Laubach, Mishkin and Posen, 1998).
Subsequently, these countries have also successfully
contained inflation despite upswings in their
economies. The impact of unforeseen price shocks
has also apparently been dampened. However, the
opportunity cost of a reduced inflation rate (in the
form of increased unemployment) has not been lower
among countries with inflation targets than those
with other monetary regimes.
3.2. Which countries have formal inflation targets?
Table 2 presents a summary of countries using inflation targeting. These countries have adopted inflation
targeting for a variety of reasons. Some, such as the
UK and Sweden, originally operated a fixed
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Target reference
Target band
Australia (1993)
2-3%
Britain (1992)
Lower limit
1-4% until 1997;
0-2% afterwards
Israel1 (1991)
8-11% to 1998;
7-10% afterwards
Canada (1991)
CPI excl. food, energy prices and direct impact of indirect taxes
1-3%
CPI excl. indirect taxes and officially determined prices, major changes in
the terms of trade, mortgage interest payments and impact of natural
catastrophes
Switzerland (1999)
CPI
0-2%
Sweden (1993)
1-3%
Czech Republic
(1997)
CPI excl. officially determined prices, impact of indirect taxes and subsidies
5-6% in 1998;
4-5% in 1999;
3-4% in 2000
CPI is the consumer price index. All countries use annual inflation as a reference point except Australia, which uses inflation over the business cycle.
1. Also employs a fixed exchange rate regime within a 30% band.
Sources: Bernanke and Mishkin (1997), Bernanke, Laubach, Mishkin and Posen (1998) and central banks websites.
11. If another reference than the CPI is used, it is crucial for the central
bank to explain to the public the reason for choosing it and its relationship to the CPI. This is important in order to prevent public misconceptions that the index has been chosen to present central bank performance in the most favourable light. Thus it is desirable for the index
to be compiled not by the central bank itself, but by an independent
agency, such as Statistics Iceland in Icelands case.
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cidence that countries whose central banks were previously relatively unindependent have made radical
reforms to their central bank legislation and
increased their independence considerably. These
include New Zealand, the UK, Sweden, Canada,
Australia and all the European countries which are
currently members of the ECB, which is modelled on
the German Central Bank, formerly considered the
most independent central bank in the world. Similar
developments have occured in South-America and
Eastern Europe.
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