Chapter 4: Monetary Policy
Regimes
1. Exchange Rate Targeting Regime
• Under this regime, a central bank maintains the value of its currency
relative to another stable currency or a basket of currencies (e.g., US
Dollar, Euro). The goal is to keep the exchange rate within a fixed or
narrow band. This provides a nominal anchor to stabilize prices and
expectations.
• Key Features:
Domestic currency value is fixed or pegged to a foreign currency.
Central bank uses its foreign reserves to maintain the rate.
Suitable for small open economies with weak monetary credibility.
• Advantages:
Provides a strong commitment to price stability.
Reduces exchange rate uncertainty and encourages trade and investment.
Imports credibility from a stable foreign currency.
• Limitations:
Loss of monetary policy independence.
Vulnerable to speculative attacks and external shocks.
Requires large foreign exchange reserves.
If domestic conditions differ from anchor country, peg may collapse.
• Example:
Hong Kong’s currency board (pegged to USD), early Bangladesh pegging policy,
GCC countries.
2. Money Supply Targeting Regime
• Here, the central bank targets a specific growth rate of money supply
(e.g., M1, M2, M3) consistent with expected GDP growth and desired
inflation. The theoretical base is the Quantity Theory of Money (MV =
PY).
• Advantages:
Transparent and measurable policy.
Helps in controlling inflation through monetary discipline.
Limits discretionary decisions by the central bank.
Cont……………
• Limitations:
Relationship between money growth and inflation became unstable
due to financial innovation.
Difficult to accurately measure “money supply.”
Velocity of money is not constant.
• Examples:
Germany (Bundesbank) in the 1970s–80s, USA (Federal Reserve)
during Volcker period.
3. Inflation Targeting Regime
• Under inflation targeting, the central bank announces an explicit
inflation goal (e.g., 2%) and uses its interest rate policy to keep inflation
near that level. Transparency and accountability are key principles.
• Advantages:
Clear communication and predictability.
Anchors inflation expectations effectively.
Central bank retains control over interest rates.
Cont……….
• Limitations:
Requires strong institutional independence and good forecasting.
May ignore asset bubbles or financial instability.
Ineffective when interest rates are near zero (liquidity trap).
• Examples:
New Zealand (first adopter, 1990), UK, Canada, Thailand.
4. Risk Management Approach
• This flexible approach focuses on managing risks to price and financial
stability, rather than targeting a single variable. Central banks adjust
policy based on a broad assessment of economic and financial
conditions.
• Advantages:
Flexible and forward-looking.
Accounts for asset price bubbles and financial cycles.
• Limitations:
Lack of a clear “anchor” makes communication difficult.
High reliance on forecasts and judgment.
• Examples:
Federal Reserve (U.S.) between mid-1980s to early 2000s (Greenspan
era).
5. Unconventional Monetary Policy
• When interest rates reach near zero and traditional tools fail, central
banks use unconventional tools like quantitative easing (QE), forward
guidance, or negative interest rates.
• Advantages:
Stimulates the economy when conventional tools are exhausted.
Reduces long-term interest rates and improves liquidity.
• Limitations:
Difficult to reverse (exit problem).
May distort financial markets and create moral hazard.
Possible inflationary effects in the long run.
• Examples:
U.S. Federal Reserve, European Central Bank, Bank of Japan after the
2008 crisis
Nominal Policy
Regime Type Advantages Limitations Example
Anchor Instrument
No
Exchange Rate Exchange rate Price stability, Hong Kong,
FX intervention independence,
Targeting (fixed/peg) credibility GCC
speculative risk
Money Supply Money growth Monetary base Transparent, Unstable Germany, USA
Targeting (M2, M3) control disciplined velocity (1980s)
Inflation Credibility, Forecast errors,
Inflation rate Interest rate NZ, UK, Canada
Targeting accountability ZLB problem
Risk
Multiple USA
Management Interest rate Flexibility Unclear anchor
indicators (1980s–2000s)
Approach
Unconventional Expectations, QE, guidance, Works at zero USA, Japan,
Exit challenge
Policy liquidity lending rate ECB