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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 1 overview of the individual articles 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.

Inhaltsverzeichnis

Frontmatter

Introduction

Introduction

Abstract
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.
Helmut Wagner

Monetary Policy: Recent Theory and Practice

Monetary Policy: Recent Theory and Practice

Abstract
Milton Friedman’s monetarism provoked hot debates on the conduct of monetary policy from the 1950s through the 1970s. The monetarists wanted the central bank to stop setting interest rates and instead to target growth in a monetary quantity, a stock of money by one or another definition, from the monetary base to intermediate aggregates as inclusive as M2 and M3. For hitting at least some of these monetary targets setting a money-market interest rate might be the operating mechanism. (The alternative could be quantitative control of the bank reserves portion of the monetary base, as practiced by the Federal Reserve 1979–82.)
James Tobin

Central Bank Design

Frontmatter

Game Theoretic Analysis of Monetary Policy Institutions

Mechanism Design for Central Banks — Results and Unsolved Issues

Abstract
The question how monetary institutions should be designed attracted considerable attention during the past years. In the context of the Maastricht Treaty, there has been a surge of papers on the adequate design of the European Central Bank; the breakdown of the Rouble-zone created a strong demand for policy advice about what kind of monetary institutions should be adapted in Eastern European countries; finally, after the breakdown of stability of money demand in many countries, there was a need to redesign monetary policy instruments.
Gerhard Illing

Comment

Abstract
The time inconsistency of optimal policy plans is today’s most popular theoretical explanation for the existence of positive inflation rates. Among academics, incentive mechanisms for central bankers are becoming a very popular solution concept for this particular problem. The appealing feature of incentive mechanisms is that they solve the credibility problem of the central bank without reducing monetary policy flexibility. Gerhard Illing has provided an insightful survey of this recent literature. And he raises a couple of interesting questions for further research. In my comment I want to make some additional skeptical remarks.
Hans-Peter Grüner

Outline of Two Controversial Positions on Central Bank Autonomy

Central Bank Autonomy and Political Decision Process

Abstract
Since a couple of years central bank independence is a very popular topic in economic literature as well as in the political discussion. There are several reasons for this actual interest:
  • the different proposals concerning the institutional status of the European Central Bank (ECB) as a part of the European Monetary Union (EMU) during the time the Maastricht Treaty was prepared;
  • the critical analysis and the political discussion of the specific regulations of the treaty itself concerning the status of the ECB;
  • the necessity of reforming the banking system and to establish a new central bank law in post-socialist countries in accordance with the transformation of the economic system.
Dietmar Kath

For a Monetary Policy that is Independent, yet Subject to Rules

Abstract
Dietmar Kath gives an excellent digest of the arguments in favor of an independent central bank exercising its responsibilities without being subject to direction by government. Taking the Deutsche Bundesbank as an example he then points out deficiencies in the extent of its autonomy, for instance with respect to international currency agreements and in connection with monetary union between the two German states before reunification. However, intolerably high inflation in Germany — which is the concern of all those who, like Dietmar Kath, favor a central bank with unrestricted autonomy — did not result from this event. In the run-up to European Monetary Union, which is due to come into force in 1999, Kath pleads for a future European Central Bank which will have a greater degree of independence than the Deutsche Bundesbank currently has. He argues his case above all on the basis of the theories of Public Choice and of Institutional Economics. Both of these concepts are able to offer interpretations of the actions of bureaucracies; but to the analysis of developments in the economy as a whole they scarcely make any useful direct contribution. This requires macroeconomic paradigms. And so this article, on the basis of Keynesian elements of macroeconomics such as sluggish price adjustment and incomplete information, pleads for a future European Central Bank with conditional independence, which will be required to pay due regard not only to monetary stability but also to economic growth and employment.
Wolfgang Filc

Monetary Policies: Strategies and Implementation

Frontmatter

Theoretical Considerations on Strategies in Monetary Policy

Monetary Policy Strategies: From Rules to Central Bank Contracts under Contingent Target Agreements

Abstract
The rules-versus-discretion debate in monetary policy is at least 150 years old, as Stanley Fischer (1990) points out. For a long time, until 1977, the advocates of discretionary policy strategies could refer to the fact that, methodologically, any rule could be adopted by some discretionary policy. Due to the problem of time inconsistency, as in the Barro-Gordon model of 1983, a simple rule seems to be superior to discretionary policy, at least in deterministic models. But simple rules do not solve the trade-off between optimal, i.e. flexible, and credible policies in models with stochastic supply disturbances. The rules debate still touches on the recent discussion of credible institutional arrangements for monetary policy like central bank contracting in the presence of informational asymmetries (Walsh (1995a)). The question to be answered in designing optimal institutional mechanisms is to what extent discretionary power should be given to the central bank to engage in stabilization, based on its private information. McCallum (1995) already pointed out that even central bank contracting may not solve the credibility problem since there is no ex-post incentive for the government to realize the sanctions included into the contract when not achieving the contracted targets. This view seems to be supported by recent historical experience with the New Zealand 1989 Act.
Alexander Karmann

Comment

Abstract
There is no simple monetary policy rule that dominates all other strategies under all circumstances. This is one essential finding of traditional theoretical analyses, which have focused on the capacity of the various policy strategies to absorb micro- and macroeconomic shocks. The superiority of a specific rule depends on a number of factors, including the structure of the economy (the rigidity of labor markets), the objective function of the authorities and society, the size and correlation of shocks, as well as the openness of the economy. Under certain circumstances a discretionary policy may dominate simple rules, though discretion is typically associated with a higher average rate of inflation. More recently, a number of proposals have been made to reduce the inflationary bias with the help of institutional arrangements, such as the implementation of inflation contracts.
Norbert Funke

Conceptual Problems of Monetary Policy

Central Bank Policy Rules: Conceptual Issues and Practical Considerations

Abstract
Central bank policymakers are not primarily random number generators.1 Reading both the financial press and the work of academics, however, one might get the opposite impression. Reporters (and the readers of their stories) seem to attach considerable importance to each Federal Open Market Committee policy decision. Academic work on the impact of central bank policy gives a similar impression, as empirical identification yields a series of white noise innovations that are labeled “policy shocks.”2 But central bankers expend substantial energy attempting to tailor their actions to current economic conditions. In other words, policymakers are reacting to the environment, not injecting noise.
Stephen G. Cecchetti

Implementation Problems of Monetary Policy Strategy

Abstract
Monetary policy strategy may be defined, in broad terms, as the set of procedures according to which a central bank decides how to act in order to achieve its final objective. Since monetary policy faces a complex transmission process from policy actions to the final goals of interest to the central bank, it is now generally agreed that the monetary policy of the central bank should be both forward-looking and pre-emptive, with timely policy responses ensuring the achievement of the final objective. In addition, a clear framework, which guides the use of the central bank’s monetary policy instruments so as to achieve it’s final objective, is needed to establish credibility and consistency of the decision-making process over time. Against this background, the conduct of monetary policy poses formidable problems for central banks and raises a number of important practical issues in respect to implementation. These issues are the focus of this paper.
Gabriel P. Fagan

Comment (on Stephen Cecchetti and Gabriel Fagan)

Abstract
Although there are few issues regarding monetary policy strategy that are completely undisputed among academics, central bankers cannot wait for final insights but have to act now. Thus it is interesting to see how they make judgments — at least implicitly — on the basis of competing theories and inconclusive empirical evidence. Since we even have two statements by competent authors from the Federal Reserve System (Fed) and the European Monetary Institute (EMI), we also have the chance to compare them.
Lukas Menkhoff

Theoretical Aspects of Exchange Rate Policy and Monetary Union

Frontmatter

Problems of Flexible and Fixed Exchange Rates

Controversies on Exchange Rate Systems

Abstract
The vigorous debate between proponents of a fixed exchange rate system and proponents of a flexible exchange rate system has not decreased over the past 30 years. New theoretical and empirical research and new reform proposals have continued to fuel the dispute which regime is the best for an individual country and which serves best the task of an international monetary system, which is to provide a stable environment for international trade and investment. The experience with fixed exchange rates under the Bretton Woods system, in which the adjustment process to external imbalances was too slow in many countries and in which the central banks were eventually unable and unwilling to defend the fixed rates, most economists in the late 1960s and the 1970s advocated flexible exchange rates. The decision to let the Bretton Woods system collapse and to implement a flexible exchange rate regime between major international currencies reflected the firm belief in the superiority of flexible exchange rates at the time. However, with the strong rise in the value of the U.S. dollar in the early 1980s and its subsequent decline, doubts arose about the advantages of flexible rates. As a result, the 1980s were characterized by a growing disenchantment with flexible exchange rates, which led to an increasing support for limitations on the flexibility of exchange rates.
Michael Frenkel

Comment

Abstract
All exchange rate systems ever implemented are imperfect. Fixed exchange rate systems typically lead to delayed adjustments while flexible systems can produce highly volatile and misaligned exchange rates. Therefore, both systems might cause economic losses. Numerous economists have tried to measure these effects and to make suggestions for more stable and more efficient systems.
Manfred Willms

Approaching European Monetary Union: On Conversion Rates

The Indeterminacy of the Euro Conversion Rates. Why It Matters and How It Can Be Solved

Abstract
On January 1, 1999 the conversion rates of the euro into the national currencies of the EMU-countries will be fixed irrevocably. Two conditions have been attached to this conversion process. First, the Maastricht Treaty stipulates that the adoption of the irrevocably fixed conversion rates should not modify the external value of the ecu. Second, at the Madrid Summit Meeting of December 1995 it was decided that at conversion time one euro should be equal to one ecu. These two conditions severely constrain the choices about how to set these conversion rates for stage three. In a nutshell, the constraint is that the euro conversion rates used on January 1, 1999 will have to be the market rates of the ecu observed at the end of the previous day. In addition, it will not be possible to announce in advance the euro conversion rates that will be applied on January 1, 1999. The reason is that the ecu rates of the participating currencies will continue to fluctuate until the last day because the ecu contains non-participating currencies (e.g. the pound sterling). This will create problems. In particular, if the authorities rely on the market to decide about these conversion rates an indeterminacy problem will arise (see Begg, et al. (1997) and De Grauwe & Spaventa (1997)). This can be described as follows. The ecu rate of say the DM before conversion time will be determined by the expectations the market has about the future euro conversion rate of the DM. The latter, however, will be equal to the last day’s ecu rate of the DM.
Paul De Grauwe

Comment

Abstract
At their Mondorf (Luxembourg)-meeting on 14 September 1997, the EU ministers of finance and heads of central banks agreed upon fixing bilateral exchange rates of their currencies in May 1998, that is to say, in advance of stage three of European Monetary Union (EMU). In a recent strand of papers, De Grauwe and coauthors turn their focus on problems of different proposals of how to set these conversion rates for the third stage of EMU. Different proposals take EMS central rates, market rates at the date of announcement or on the last day of stage two, an average of past or past and future market rates (which is frequently called the Lamfalussy rule though the latter mentioned it only a few times) and forward rates as their basis. By his current paper, De Grauwe convincingly contributes to a significant reduction in this large number of possible options how to set the irrevocable conversion rates of the currencies of the EMU member states.1 Moreover, he is absolutely right in paying special attention to credibility-enhancing announcement solutions, as setting the final conversion factors no sooner than the last trading moments in 1998 will probably lead to serious problems after EMU will have been started. Since he deserves great merits for both jobs, critical comments should only concern some minor points. These points are actually intended to be possible suggestions for further discussions.
Ansgar Belke

Monetary and Exchange Rate Policy in Developing and Transition Countries: Selected Issues

Frontmatter

Some Explanation on Recent Currency Crises

Issues in Monetary and Exchange Rate Policy of Developing Countries

Abstract
The aim of this paper is to discuss issues that relate to the recent exchange rate and capital market crises in developing countries. The body of existing literature on the basics of money and exchange rate reform in developing countries — and increasingly transformation economies as well — is extremely large. I believe, however, that by now it is possible to find a certain number of essentials, i.e. elements that are conditions of sine qua non character for monetary and exchange rate reform in those countries. About the essentials there is either a wide-spread consensus or the differences in opinion have already been comprehensively identified.2 Little value would be added if one was to try to list these essentials again. I consider it a much more rewarding task to analyze those developments that despite extensive existing research „routinely“ surprise national as well as international policymakers, in spite of the dramatic experience with Mexico in 1994/95. As a matter of fact, these developments have shakened a group of newly industrializing countries in East and Southeast Asia which were treated before as the most challenging competitors for the OECD group. By now, it is less than clear what their growth prospects in the future really are.
Friedrich L. Sell

Monetary System Design: On Currency Boards

Towards a General Theory of a Currency Board System

Abstract
There is no such thing as a general theory of the currency board (CB). Hitherto, there is no generally accepted definition of a currency board. Additionally the term is increasingly being used in political discussions, and thereby it is becoming increasingly meaningless.
Wilfried Fuhrmann

Comment

Abstract
Since its implementation in Argentina and Estonia, the currency board idea celebrates a revival which comes quite as a surprise. With the exceptions of Hongkong and Singapore, all currency boards in former colonies were substituted by central banks when colonial times ended (see Schwartz (1993)). Hence, the abolition of currency boards in the past marked the beginning of an institutional reform. It is highly interesting that the recent introduction of currency boards were exactly motivated by full-scale institutional reforms starting either from scratch (transformation countries: Estonia) or chaos (developing countries: Argentina). Have the former colonies made a mistake when abolishing currency boards? What is the role of a currency board in institutional reforms? Fuhrmann touched this issues in his introduction but rather as a motivation for his interesting approach to formalize the currency board idea in terms of exchange rate policy.
Rainer Schweickert

Conclusion and Supplements

Conclusion and Supplements

Abstract
In this concluding chapter I will be showing in Section 1 overviews of the comments or supplementary papers and of the general discussions on the symposium. In Section 2 I will underline again some key issues which were encountered in a whole series of articles and supplementary comments as well as in the subsequent discussions.
Helmut Wagner

Backmatter

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