Reading 16. Monetary and Fiscal Policy
Learning Outcome Statements
j. describe qualities of effective central banks;
l. contrast the use of inflation, interest rate, and exchange rate targeting by central banks;
CFA Curriculum, 2020, Volume 2
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Subject 5. Monetary Targeting Rules
Price stability is the primary goal of inflation-targeting monetary policy strategy. Inflation is usually defined as a range of permissible values (e.g., 1%-3%) rather than as a point value (e.g., 2.4%). The definition of inflation also varies from country to country.
There are three key concepts:
Central bank independence. Central bank independence exists on two dimensions. Goal independence is the freedom that the central bank has to select the objectives of monetary policy, whether they are low inflation, the target rate of unemployment, the level of GDP, etc. Instrument independence is the freedom that the central bank has to pick appropriate policies to produce a certain outcome in the economy. Most inflation-targeting countries only lay out the goals and not the operating procedures; the central bank does have operational independence.
Credibility. Central bankers who are unable to credibly convince the public that they are serious about fighting inflation will be faced with a high inflation rate as a result.
Transparency. It is well known that credibility requires transparency. The benefits of transparency are obvious: it improves the efficiency of monetary policy, allows for a more effective management of expectations, and promotes the discussion and evaluation of monetary policy.
Exchange Rate Targeting
Many countries have viewed pegging their nominal exchange rate to a stable, low-inflation foreign currency as a means of achieving domestic price stability. In a sense, countries that target their exchange rates against an anchor currency attempt to "borrow" the foreign country's monetary policy credibility. However, this monetary policy deprives the central bank of its ability to respond to idiosyncratic domestic shocks. Such countries can become prone to speculation against their currencies.
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Can you explain further the difference between operational independence and target independence.
Setting the objectif of inflation is what ?
Setting the policy rate is what ?
mhorovitz: I guess when you say target independence, you mean goal independence in this reading?
From my understanding, goal independence just means that the central bank has independence in determining the appropriate inflation rate, interest rates, and horizon over which target is to be achieved.
Operational independence means that they can choose whatever method necessary to achieve those targets.
For some countries where central banks are closely tied to politics, they usually only have operational independence as the target rates are normally set by the government.