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serves to initially lower interest rates (by increasing money supply) but after a time the extra money in the economy would lead to higher inflation and invariably to higher interest rates. Governments might be liable to follow unsuitable monetary policies prior to elections to increase the likelihood of re-election but central bank independence mitigates this potential problem.

7.9.1DIFFICULTIES IN TARGETING MONEY SUPPLY

In designing its monetary policy, an economy could choose particular targets for its money supply, its inflation rate and its exchange rate. From the quantity equation, the relationship between money supply and inflation is described and this can be used as the basis to target the money supply and bring about the desired rate of inflation.

Unfortunately, this is not as simple as it sounds because the quantity theory relates to long-run changes in the price level and central banks are interested in stabilizing short-run inflation (among other things). Controlling inflation in the short run is difficult because:

•Not only are there different definitions of the money supply (M1, M2, etc.), but they do not always move together. This means that targeting a specific rate of growth of money supply is difficult and in practice central banks have often switched from targeting one measure to another

•Central banks have no way of ensuring that the commercial banking sector fully passes on changes in interest rates to their customers. If the central bank changes (i.e. drops) the interest rate expecting the money supply to increase, commercial banks may not fully pass this on and limit the extent of any increase in the money supply.

•Assumptions are made about aggregate supply. Given the quantity theory, the rate of change of money supply and its relationship to inflation involves taking account of the rate of growth of long-run output growth. Whether output growth is 1% or 4% makes a difference when planning on achieving a specific inflation target via targeting money supply growth. Furthermore, if an economy is operating at capacity or potential output, an expansion of the money supply should lead to an increase in aggregate demand (caused by a drop in interest rates) and the result would be a rise in the price level. However, in dealing with an economy in the short run, it may well not be operating at its potential output. Hence the results of a rise in aggregate demand would be both an increase in the price level and in national output.

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•Unexpected events – economic shocks – occur. Unexpected changes to aggregate supply, for example, imply that the best targeted policies may not have the desired outcome. The standard examples used are the oil-price shocks which resulted in aggregate supply contracting (moving leftwards) increasing the average price level and reducing equilibrium output. If such effects are short-term they are of less importance than if the effects endure over time.

7.9.2ALTERNATIVE TARGETS

Some economies use exchange rate targets as part of their arsenal of monetary policies. Many countries fix their exchange rate to the dollar (e.g. Argentina, Hong Kong), or a basket of currencies (the most important trading partners, for example), in the hope that they can control inflation. This could be achieved by officially depreciating or appreciating the currency by altering interest rates, as required.

If exchange rates are set by demand and supply they are known as floating exchange rates. If one country’s exchange rate is tied to another country’s rate, it follows a fixed exchange rate regime.

Fixed or floating exchange rates?

More precisely, countries usually fix their currency over a range rather than to one particular value, otherwise the central bank would be forced to intervene every time the currency was not at its fixed value. Only if the currency moves outside its range, its target zone, would the central bank intervene, buying up excess supplies of the ‘fixed currency’ if required or supplying additional currency in times of excess demand. If the central bank did not follow such policies then excess supply could lead to depreciation of the exchange rate or excess demand could lead to appreciation. Altering interest rates to create interest rate differentials could similarly be used to entice capital to flows into or out of the country, as desired by the central bank.

Countries with fixed exchange rates should have similar inflation rates as the country to which the currency is fixed because of how currency demand and supply function. For example, if two countries have different levels of inflation and are economically linked via trade, holders of currency in the high-inflation country can buy fewer goods and services domestically than in the lower-inflation country. People will have an incentive to sell some of their high-inflation currency for the other currency, causing supply of the high-inflation currency to increase – resulting in its depreciation. For an exchange rate to remain fixed and for markets to find this

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a credible monetary policy, holders of the fixed currency must have no preference for one currency over the other and, therefore, inflation would have to be similar. A lack of credibility in a fixed currency could generate speculation on the currency, as discussed earlier.

The business sector is generally in favour of fixed exchange rates because of the increased certainty generated. Speculators have no incentive to buy or sell the currency against the currency to which it is fixed. Governments with fixed exchange rates cannot follow irresponsible expansionary policies, fiscal or monetary. Since such polices lead to rising aggregate demand and a higher aggregate price level (inflation) they make exports more expensive and imports less expensive, creating a tendency towards a trade deficit. While this could be cleared by a devaluation of the currency (caused when the central bank allows it or forces it to depreciate) it is not a policy option when the exchange rate is fixed. Inflation cannot be out of line with competitors’ rates.

In floating exchange rate systems no such central bank intervention is required as market demand and supply alone determine equilibrium. This means no reserves of international currencies are required to purchase any excess supply. Governments have more discretion in selecting the level of aggregate demand it deems suitable while the central bank selects the interest rate it deems suitable given its targets.

A major difference between fixed or floating exchange rates is on how they can be used to bring about changes in the domestic economy. A country that has decided to fix its exchange rate but which might be at a different position in its business cycle to the country to which its currency is fixed is limited in how to deal with its domestic economy. One reason often voiced to explain the fact that the UK has not adopted the euro is that its business cycle is different to that of mainland Europe. Different interest rates being set by the ECB and the UK’s Monetary Policy Committee are indicative of the different needs of both economies.

There is consensus that exchange rate and money supply targeting are difficult tools to use to achieve the goal of stable prices and that strict rules on money supply targets or fixing (or quasi-fixing) of rates do not leave economies with much room for manoeuvre. Many central banks instead have explicit publicly stated goals for their inflation targets. Their expectation is that via public announcements and communication, markets can be reasonably sure what monetary policies will be used and why. This recent behaviour is in marked contrast to previous secretive and closed-door deliberations on monetary policy but points to and reflects an understanding of the important role played by expectations within the economic system.

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T A B L E 7 . 3 T A Y L O R R U L E

Nominal interest rate = equilibrium nominal interest rate plus a percentage of the output gap plus a percentage of the inflation gap

7.9.3TAYLOR RULES AND ECONOMIC JUDGEMENT

Because of the nature of the economic system, with so many separate features related to others, it is a difficult feat to control inflation. Rather than targeting any one measure, an alternative exists in the form of Taylor rules (Taylor, 1993). These rules describe how interest rates are set by a central bank. A general form of such a rule is shown in Table 7.3.

The rule indicates that three pieces of information feed into the determination of the nominal interest rate set by a central bank, each of which requires some clarification.

•The equilibrium nominal interest rate is the real interest rate plus the inflation target of the central bank.

•As identified in Chapter 5, the output gap is the difference between potential output (also known as full employment output) and actual output.

•The inflation gap is the difference between the actual rate of inflation (or some banks use the future expected rate of inflation) and the central bank’s target for inflation.

The decision on what percentages to use in the rule vary from bank to bank based on their assessment of how sensitive inflation and output are to changes in the interest rate. In the USA, 0.5 is the percentage of the output gap used and 1.5 is the percentage of the inflation gap used by the Federal Reserve. Essentially economic judgement is brought to bear on the expected relationships between output, the price level and nominal interest rates.

7 . 1 0 I N T E R N A T I O N A L M O N E T A R Y I N T E G R A T I O N

As we have already discussed in relation to trade (in Chapter 5) there are many signs to indicate that economies are becoming more interdependent. So too with

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money and currency markets which are intrinsically related internationally as goods, assets and services are bought and sold across borders. On the one hand if only one currency existed all international exchanges would be simpler. However, it is quite likely that different regions would have different requirements of monetary policy and interest rates. Forces leading to different business cycles might mean, for example, that Ireland requires policies appropriate to dealing with a boom at the same time as the USA requires policies to focus on recession, while the UK requires policies to deal with an expansionary phase of their business cycle.

Whether any single currency will be economically successful depends on whether the members constitute an optimal currency area (OCA).

Optimal currency area (OCA) theory identifies the factors that determine whether a single currency maximizes single-currency benefits for members given the costs generated.

Four factors have been identified as playing a central role in the determination of the success or failure of any common currency:

1.Extent of trade with currency partners.

2.Effect of economic shocks vis-a`-vis currency partners.

3.Extent of labour mobility between currency partners.

4.The extent of fiscal transfers between currency partners.

Countries that trade substantially with each other enjoy economic linkages that are enhanced by stability in their exchange rates. Exchange rate volatility has been found, in some cases, to increase the perceived costs of trading and so reduce the amount of trade that could take place if that volatility were removed.

If countries with the same currency do not experience similar effects of economic shocks, they have limited scope in how best they can react to deal with the shock. With one currency, monetary policy is guided by what is required by the majority or the largest countries – an example of a ‘one size fits all’ policy. Should another country require an alternative policy, they must bear the cost of not having an independent monetary policy.

With easy labour mobility between countries, the labour market becomes the short-run adjustment mechanism in the absence of monetary policy. If two countries experience differences in their business cycles at the same time with one booming and another in recession, both will have the same interest rate. The booming country cannot increase its interest rate and attempt to slow its economy down. Neither can the other cut the interest rate to create incentives for investment. With