Issues in Finance and Monetary Policy

Money and financial issues have been studied for several centuries and have played a central role in general discussions about the functioning of economies. Nevertheless, there exists among economists, and will probably continue to exist, a fierce debate over monetary relationships. Monetarists placed money as a central determinant of economic activity, at least in the short run, while Keynesians had already rejected the classical neutrality axiom of money in both the short and long run. Today, new Keynesians reject the classical dichotomy that has been revived in, for example, real business cycle theory.

The entrepreneurial system that most people call capitalism, though imperfect, is the best system humans have yet devised for promoting economic growth, development and prosperity. In fact, classical economic theory in its nineteenth- and early twentieth-century version and its modern Walras-Arrow-Debreu interpretation that is the foundation of twenty-first century mainstream economic theory can ‘demonstrate’ that free market capitalism is the most efficient engine possible for propelling our society towards an economic Utopia here on earth. In such a system, a free market coordinates the decisions of self-interested agents without any need for government interference.

Inflation targeting (IT) as a policy framework, designed to tame inflation, has been with us since the early 1990s. Recent work makes the point that a significant number of countries adopted this strategy, and the number is growing. For example, Sterne (2002) suggests that 54 countries pursued one form or another of IT by 1998, compared with only six in 1990. A more recent study (IMF, 2005) suggests that 21 countries (8 developed and 13 emerging) are now clear inflation targeters, pursuing a fully-fledged IT strategy (FFIT). Indeed, a number of other countries are seriously considering the adoption of this strategy. Many studies have attempted to examine empirically the degree and extent of the impact of IT on inflation in various countries. We review this literature in what follows and conclude that the available empirical evidence produces mixed results.

The revolution of central banking from a position of secrecy to one of transparency has been widely observed (Goodfriend, 1986). This trend is considered as being desirable by proponents of what may be termed the ‘credibility strategy’ (see, for example, Kydland and Prescott, 1977; Svensson, 1997). In the credibility strategy, transparency is seen as the most efficient solution to the major problem facing the effective implementation of monetary policy, namely, time inconsistency (Geraats, 2001). As a key feature of inflation, transparency in inflation targeting has come to be seen as increasingly important with the implementation of this monetary policy regime.

In Keynes’s General Theory, the ‘monetary authorities’ are considered to act as a deus ex machina: they should resolve all the problems regarding the creation and control of money. The banking system and financial institutions are analysed solely in terms of central bank activities.¹ The supply of money is fixed exogenously by the central bank. An endogenous theory of the demand for money co-exists with an endogenous theory of the interest rate (liquidity preference).²

This chapter utilizes the Markov regime-switching modelling framework to study the credibility of monetary policy, with respect to the objective of price stability, in some member countries of the EMS throughout its life (i.e., 1979–98). Eight countries are examined for this purpose: Austria, Belgium, Finland, France, Italy, the Netherlands, Portugal and Spain. In addition, Germany is used as a benchmark case.¹ A number of other studies have investigated the issue of credibility during the EMS period (see for example, Dahlquist and Gray, 2000; Arestis and Mouratidis, 2004a). One of the main conclusions of this body of literature is that monetary policy may go through different stages of credibility through time, in such a way that it is perceived to be credible in some circumstances and may lack credibility on other occasions. It is, thus, appropriate to use the Markov regime-switching modelling framework to study this phenomenon. Moreover, some of these studies allow the probability of switching between regimes to be a function of macroeconomic variables (see Engels and Hakkio, 1996; Gray, 1996; Dahlquist and Gray, 2000; Sarantis and Piard, 2000). In particular, most of these studies attempt to explain the currency crises of 1992 and 1993 using as information variables in the transition probabilities a number of alternatives: the exchange rate within a band (i.e., a target zone model framework), real exchange rates, budget deficits, interest rate differentials, and other variables. None of these studies includes in the transition probability the two main variables that determine the loss function of monetary authorities, namely domestic output-gap variability and inflation variability (the exception is Arestis and Mouratidis, 2004a).²

The academic debate on the merits of hedging has identified five main theoretical rationales for corporate hedging:

The processes of financial liberalization and international integration have contributed to significant changes in the banking sectors of many developing countries. In Latin America, banking sectors have experienced an accelerated process of consolidation. Enhanced consolidation has been accompanied by a significant increase in the degree of market concentration in the banking industry. A direct effect of such measures has been the inflow of foreign capital which, although necessary for recapitalizing the financial system, increases the market concentration of the sector. A number of current concerns about the implications of market concentration on competitiveness in the banking industry and its possible impact in the economy exist. The banking sector seems to be highly concentrated in many countries in Latin America and therefore studying the sector and identifying the impact of the enhanced degree of concentration and its potential collusion effects seems an appropriate task. For example, some of the collusion effects that may have been driven by a highly concentrated banking sector may include high commercial lending rates, credit rationing and low deposit rates.

The financial sector plays an important role in the context of economic development. However, the role that financial institutions played in developed countries was very different from the one they play in developing countries. In developed countries financial institutions largely emerged within the process of industrialization. The process of industrialization increased the demand for finance, and many entrepreneurs recognized that there was an opportunity to make a profit from the intermediation between savers and investors or between lenders and borrowers, and this led to the growth of varieties of financial institutions. Thus there was a mutual feedback between the two, arising from mutual benefit.¹ In developing countries the process of industrialization was not a natural process of transition from a backward state to an advanced industrial state; instead it relied on the respective governments’ deliberate attempts to reach such a state. Thus there is very little scope, if any, to make profit from engaging in financial intermediation. Yet the financial institutions had a very important role to play in fostering the process of industrialization via the coordination between savers and investors.