Monetary policy rules: Exchange Rate and Monetary Policy Rules
The role the exchange rate ought to play in the adoption of an MPR is a common subject of debate. There are two broad discussions in this area. The first relates to whether the instrument of monetary policy should react in a significant way to the exchange rate when setting policy. The second is whether the exchange rate ought to be used as an instrument, or coinstrument, of policy (see Cavoli and Rajan 2007).
The literature on inflation targeting using MPRs makes it clear that the exchange rate should have no part in the implementation of policy and, if using simple MPRs, should not appear at all in the MPR. The reason for this is that a policy trade-off between the exchange rate and domestic objectives may occur it may be difficult to address both objectives with a single policy instrument.Thismaywell appear to be an appropriate strategy for large, relatively closed economies such as the United States, but the debate is more complicated for open, developing economies. The simple reason for this is that the exchange rate may contain information (about global events or capital flows) that is important in the operation of a MPR that is not contained in other variables (such as output and inflation). This is so even if the exchange rate is not itself an objective of monetary policy. Hence, under these conditions, there is a strong argument for the inclusion of the exchange rate in the rule it helps provide all the necessary information for the attainment of domestic policy.
Once the decision ismade to include the exchange rate in the rule, how might one manage the possibility that the exchange rate and inflation may suggest opposing instrument changes?One possibility is to use a partial adjustment. Under this process, the MPR instrument will react to both current and lagged exchange rates. Then, if there is a shock that requires a strong reaction to the current exchange rate but is an inappropriate reaction for inflation, then that reaction can be partially offset next period.
The second issue relates to the possibility of using the exchange rate as an instrument of policy. There are two lines of research here. The first examines a policy rule called a monetary conditions index (MCI). The MCI is an MPR in which the policy instrument is a linear combination of the interest rate and the exchange rate. They are effectively coinstruments of policy. The main premise behind the MCI is that both interest rates and exchange rates indicate monetary conditions and that, for example, a tightening of these conditions can be brought about by an interest rate rise, an increase in the foreign currency value of the domestic currency, or both. As such, it is possible that the variables can move in opposite directions so that monetary conditions are not affected. Therefore, it is the imperative of the policymaker that if a change in one of the variables leads to changes in monetary conditions, the other must be moved to maintain the present policy position and offset monetary changes.
The way that theMCI is typically captured in an MPR is by both the exchange rate and the interest rate appearing on the left side of the rule (see Ball 1999). The economist Laurence Ball (2001), however, believes that this situation is broadly equivalent to an MPR where the interest rate is the main instrument and the exchange rate appears on the righthand side. Under this version of an MPR, the implicit assumption is that the interest rate is the main instrument of policy and is able to be competently controlled by the policymaker. The exchange rate still offers the policymaker information about the relative tightness of policy and can still guide movements in the instrument and therefore the direction of policy.
The secondway that the exchange rate can be used is as a policy instrument in its own right. There is a line of research (particularly in relation to Singapore) where variables such as the nominal bilateral or nominal effective exchange rate (NEER) appear on the left side of anMPR as the sole policy instrument. Underlining this rule is the ability to control the nominal exchange rate (in the conventional manner through foreign reserves). This rule works in precisely the same way as the Taylor-type specification using the nominal interest rate the right-hand side of the rulewould contain expressions for the inflation gap, output gap, possibly lagged exchange rate term, and any other variable deemed to possess information sufficiently important to guide the exchange rate toward the policy objective (Cavoli andRajan 2006). The overall policy objectives need not be any different from the Taylor-type MPRs; the rule simply reflects the opinion of the policymaker that the exchange rate does a better job at reaching the policy target.