Central banks and monetary policy effectiveness in inflation control

Central Banks

What criteria are, and have been, used to determine monetary policy. Examine the evidence for and against the view that central banks can control inflation. Should central bank's target zero inflation?

What criteria are, and have been, used to determine monetary policy. Examine the evidence for and against the view that central banks can control inflation. Should central bank's target zero inflation?

Central Banks and Inflation

The Ideal Indicator

An Open Mind

The Consumption Function

Historical and Future Analysis

of the Criteria for Determination

of Monetary Policy

Optimum Currency Area Theory

The Microeconomic Benefits

Reduced Costs of Foreign Exchange Dealings

Chapter Five

Findings and Conclusions

Signature/Approval Page

An Economics Dissertation

Central Banks, Monetary Policy and Zero Inflation

Department

Dr. *** *********, Major Professor

Dr. *** ******, Committee Member

Chapter One

Introduction

With fundamental banking problems throughout the world, as revealed by 1997-99 crises, and with the European Union a reality, we ask questions that are no longer just hypothetical. For example: How does one go about structuring and provisioning a new central bank on the basis of analysis, the comparisons of central banks, the facts, the experiments, and the phases of post-World War II developments? Without ignoring the policy matters we associate with the economic analysis, we shall in this thesis, discuss summary statements of interest-rate/fiscal-policy and money-stock regimes and reconsider some hypotheses and institutional concerns. The European Monetary Union (EMU) was an enormous achievement. An overview of it and the related central bank operations go along a twofold route: one, to a sketch of a model central bank for countries emerging with open market economies; and, two, to reflect on central banking and monetary control with respect to the turn-of-the-century Asian economies.

The main central banks introduced in the evolution of central banking are the pre-Blair Bank of England, the post-1930s Federal Reserve, and the pre-EMU Bundesbank. The first is the oldest of the three, as we have said. However, open market operations of a special sort came about at the Federal Reserve Bank of New York and were later written into the Federal Reserve Act. They arise because of key features, namely: the trading desk at the New York Fed may enter the New York market primarily to influence reserves without the requirement that a targeted interest rate is set; and, in the presence of shifts to liquidity, the operations do not require that borrowers take the initiative to expand the money and credit aggregates. The operation may be directed toward inflation-rate targeting and/or controlling money and credit aggregates, even if imprecisely, and irrespective of any interest rate, except as a surrogate for monetary policy (Posen, 2005. pp 254).

The special nature of these New York operations is highlighted by a situation where the short- or long-term bond rate may be quite low -- as in the United States during the 1937-38 recession and in Japan during the 1997-98 Asian crises. In these cases, firms and households do not on the average take the initiative to borrow and accelerate spending. As pointed out by Obstfeld & Rogoff (2006), by contrast, the special open market operations may expand the money stock directly at first and then indirectly by satisfying first the liquidity preference of banks and then that of households. Although these matters require emphasis and go back in the Federal Reserve's history, and although the European Union's European Central Bank (ECB) enters near the century's turn, the pre-EMU Bundesbank is the most recent of the prominent central banks of the twentieth century. Its legacy appears in the new century's European Monetary Union. Early in the move toward a central bank for the EMS member countries, British Labor Party politician Roy Jenkins, German Chancellor Helmut Schmidt, and French President Valery d'Esting were the main players. However, as an early Friedman monetarist, Britain's Margaret Thatcher reacted negatively to the EMS developments. She raised issues over sovereignty and the exchange-rate mechanism, which linked to central bank involvement with fiscal policy prior to Tony Blair's 1997 success with the British Labor Party (Faust, 2006 268-9).

As an early leader in the redirection of the 1970s policies bearing on inflation and efforts at controlling prices by price-control, direct means, Thatcher is a major political figure in the "big U-Turn" (Gerling, et al. 2003). I see this in connection with new ideas contained in the Friedman system of analysis and economic problems such as Thatcher confronted. Also, a focus on the pre-EMU Bundesbank's noninflationary demeanor, its orientation as a central bank, and the notion of ideas impacting policy, draw consideration to Germany, the pervasiveness of changes in the 1980s, and the ideas concerning economic analysis, policy implementation, traditions, and practices. These and other matters of importance to economic analysis accompany the separation-of-effects problem (Sibert, 2003 pp 662) and the symbolic equation. Juxtaposing alternatives found in economic analysis, for the most part, leads to conflicts with what we encounter in the European Community (EC) experience with economic integration. In extending the monetary analysis we ask further why so much attention was given to "one money" or a German/French-led currency block to begin with. The answer centers on transaction costs and exchange-rate uncertainties. Most notably, the substitution of a single currency with a zero inflation rate for multiple currencies with diverse inflation rates and disparate central banking arrangements offered the following prospects (Dixit & Luisa 1999). First, the substitution reduced the direct cost of exchanging one money for another in order to make across the-border purchases. Second, the one money with the attained zero inflation goal reduced the uncertainty associated with holding a given stock of money balances and undertaking long- and short-term contracts concerning the repayment of debt and future deliveries of goods and payments denominated in a currency of uncertain future value. Third, closely allied with reduced uncertainty were reduced costs of getting information about future prospects and legal statuses governing contracts in one vs. another unit of account.

Tying a block of currencies to a single "hard" currency, via an exchange rate mechanism, was a step toward reducing uncertainties and information costs, but this action did not go quite all the way to reducing uncertainty through the acceptance of one monetary medium. Reduced uncertainty over transactions costs and future purchasing power are thought to encourage trade and the indirect exchange of goods through the acceptance of money. However, and more important, the market mechanism with a satisfactory money umbrella disburses power and enhances voluntary association in market, as discussed by Kydland, et al. (1977). The acceptance of the monetary arrangement itself goes back to the definition of money, the speculative shifts in the demand for money, business conditions generally, and the interplay of money as a liquid asset and the real goods markets where we find less liquid assets. Although the following parts of our thesis paper has a special focus (the central banks, the EMS), awareness about money, central banks, and Europe's new place in the global community should be raised by the existence of the European Union. The money and central banking lessons should not be lost on countries seeking to undertake transformations to market economies that call for viable monetary systems.

Central Banks and Inflation

In much of the period 1867-1975, for which Faust analyzed data (Faust, 2006), the world was on a gold or gold-exchange standard. In fact, for most of the nineteenth century and until the early 1930s, with World War I and its immediate aftermath aside, the neighborhood in and about London was on a gold or gold-exchange standard that gains its significance in relation to the gold-flows mechanism. Under the classical form of the gold standard three rules held: (1) there is free coinage of gold; (2) the price of gold is fixed by law in terms of a country's monetary unit (e.g., the dollar in the United States and the pound in the United Kingdom), and hence there are fixed relations between the units of account (e.g., $/£ const.) for the most part; and (3) paper currency, coins, and bank deposits are freely convertible into gold under a gold-exchange standard. It comes about where some currency, such as the British pound in its day, is accepted by other central banks as a key currency and hence as good as gold.

Quite briefly, under the gold standard, countries trade goods and services and compete for sales in domestic and foreign markets where attention is focused on prices. The matter is viewable as if the respective countries have averages for their prices (or price indexes). As one country's relative position is favored for trade purposes [say, -? (P U.S. / P UK ) for a favored U.S. position], that country exports more and enjoy an inflow of monetary reserves (the symbol G. In the bank reserve equation), as a rule. There is a balancing out of reserves as the countries compete in terms of trade in goods and services. The main point, however, is that the competition regulates price averages and disperses power that may otherwise reside in the hands of state planners, price controllers, and government bureaus. Under the arrangement, moreover, a country with efficient production and a favored competitive position (including as enhanced by new capital goods) is rewarded with rising income and reduced unemployment. No grand scheme of state or international planning and direct control is required. Exchange rates are for the most part fixed under the classical gold-flows mechanisms (say, $/£ const. within fixed limits), as stated, and adjustments to trade imbalances take place through price-level changes (e.g., PU.S. versus P. UK ) or product prices (and the special part of product prices called wages) (Bullard & Christopher 2004 101). Faced with unemployment, a country's position can be improved by enhancing productivity and having prices on its real goods and services and wages adjust downward relative to those of other countries.

Another way to achieve adjustments in trade positions (or more generally balance of international payments positions) is to have exchange rate changes rather than price changes. Whatever the case-exclusive of full floating that the world does not come to -- some elements of economic efficiency and wage and price discipline (via relative prices, as under the gold-flows mechanism) enter from an international point-of-view. This mechanism of monetary flows and price-level discipline, as it were, impacts on the domestic monetary mechanism (the G. term in the bank reserve equation). Complexities aside, in principle the idea is that of a stock of reserves being identical to factors such as international monetary reserves, and credit extended by the central bank (with discount windows and open market operations as the principal sources).

These reserves, in turn, support liabilities of banking institutions (mainly, since the National Banking Act in the United States, deposit liabilities). These liabilities are in the form of bookkeeping entries. They are a part of the money supply, and paper and other currency can be freely exchanged for the deposit liabilities. Here is the idea of a money supply (the currency and deposit liabilities) that can vary in its measures, depending on the assets included from the point-of-view of the economic "agent" (Briault, et al. 1997 301). Since reserves can be controlled, allowing for various factors, they have a link with the money supply, which in turn can be controlled, after allowances for shifts in the liquidity preference necessities for reserves, because of the banks themselves, and other factors such as changes in the ratio of the currency held by the public to deposit liabilities.

The bookkeeping entries on the liabilities side are a part of the money supply, as stated, and they may come about as bank credit expands in response to increases in bank reserves (mostly via open market operations, or historically gold inflows). The expansion of the money supply comes about via banks extending credit (loans), or purchasing securities. Both actions give rise to banks increasing deposit liabilities, as personal and business accounts are credited, coincidental with the depositing of checks or the crediting of accounts. The banking institutions that are in turn dependent on the central bank have balance sheets that can be thought of as an aggregate balance for all of the banking, money-creating institutions comprising the national economy. On the asset side are mainly the reserves (R o ) and bank loans and investments (called "bank credit") (McCallum, 1999 210), and on the liabilities side are mainly a component of the money supply. There are what can be called credit and money multipliers, to refer to the inverse of the fractional relations (i.e., the inverse of R. o to bank credit, and Ro to the deposit liabilities, respectively). These concepts are synonymous with the idea of a fractional reserve banking system.

This is the fractional reserve system with reference to a simplified and consolidated balance sheet for the non-central bank part of the U.S. banking system. Under such a system, reserves (R o ) are some fraction of deposit liabilities (say, one-fifth of check transferable deposits) and a slightly smaller fraction of bank credit (say, one-fourth B. c ). The deposit liabilities are identifiable in the United States as a main component of the money supply since the National Banking Act of 1863, and they are readily substitutable for currency considered as paper notes and coins (Obstfeld & Kenneth 2006). Confronted with an increase in reserves, under the properly functioning fractional reserve system, banks have every inducement to expand bank credit in that it is the major source of income to the banks. The increase in reserves may come about in the United States because of deposits of currency (or gold coins at an earlier date) and/or because of the deposits of checks drawn on the Federal Reserve and used in the purchase of commercial paper and/or government securities by the Federal Reserve.

As bank credit is extended via an increase in loans (or purchases of securities), the recipient of the credit rarely wants the credits to his or her deposit account to hold. A deposit is soon transferred and the bank loan remains on the books. Questions remain about how fast the deposit liabilities get moved around and turned over (the matter of the income-velocity ratio Y/M). These are discussed on various occasions. Further, the process of reserve, bank credit, and deposit creation may go fast, slow, or in reverse. The process of expansion may start in a financial center (say, New York, to continue with open market operations of a special sort) and spread throughout the banking system. There are two reinforcing mechanisms -- those within the banking system and those within the larger financial system. Within the banking system, the reserves may get passed around through trading among banks in reserves (called in the United States trading in federal funds) and through other means, including the sale of securities, mortgages, or loans to other banks. In the larger financial system, a deposit balance for a New York securities dealer (the dealer who sold securities to the New York Fed), may get passed to the hinterland as the dealer replaces the inventory by the purchase of more securities from a firm in the hinterland. Financial markets adjust quite rapidly, even internationally (Walsh, 2005 159). The point, nevertheless, is that important control is exerted through the fraction of reserves supplied by the central bank. This control may be for good, or for evil. It exists, whatever the latter complexities. The general thrust of operations under the historical gold-type mechanism leads to a conclusion: namely, efforts via effective international competition to export goods (as symbolized by -? PU.S. / P UK ) and to obtain gold (or monetary reserves) under fractional reserve banking arrangements raise nominal and/or real income within the time frame of the inflow, and possibly with some lag afterward.

Starting the sequence of events with a more favorable stance with respect to U.S. via-a-vis U.K. prices (-?P U.S. / P UK ) would result in a more favorable balance of trade in the United States. The United States could face greater monetary growth without adverse balance-of-payments consequences. The money growth or inflow of monetary reserves (?R U.S. ) could support the expansion of bank credit and the money stock (?M) and also contribute to the prospect of increased spending and increased income received (?

). There would always be the threatening prospect of relatively higher U.S. prices (?P U.S. / P UK ) (Lohmann, 2004 284). Quite clearly, causation is from money to income (? ). And indeed this process may continue in a money and markets oriented economy. However -- and perhaps not surprisingly for one who reads the lines in the financial press and between them -- all of this balance-of-payments balancing out is not what we encounter in the global economy we come to in the 1990s and upon entry to the twenty-first century. In this new, emerging open-economy world, traditions and practices (including saving to income ratios) vary as we emphasize.

Indeed, there may be a permanent (or quasi-permanent) balance of sorts, exclusive of above and below the line balance in the U.S. balance of international payments. In it Japan appears as a major capital-funds exporting economy in the world and, reversing a century of economic thought, the largest, most developed economy in the world attracts inflows of capital funds (Kydland & Edward, 2004 481). Again reversing the tradition in economic theory, these inflows of capital funds to the United States may come about even with prevailing low interest rates via-a-vis selected Asian economies, Russia, Brazil, and emerging market economies on the average.

Chapter Two

Literature Review

We have drawn distinctions between an essentially i-regime and an M-regime/inflation-rate targeting approach at the national level with roots in Keynes's work and Friedman's respectively. In this interest-rate orientation, as set on a course by Keynes, however, "the interest rate" is the long-term rate (iL), although short-rate control arrangements enter into the Keynes/Keynesian investment and liquidity preference blocks. As pointed out in the i-regime context, these control arrangements are such that direct control by the central bank over the short rate is expected to impact change in the same direction to the long-term rate (iL.). There are no New York-revenge and Bundesbank effects (Lucas, 2003 330), no psychological time enters to confront possible interest-rate effects, and no bond traders enter to process information and thereby set a long-bond rate. In the presence of these foregoing conflicts, a matter of expediency on the part of operating officials appears with respect to the envisioned arrangements because of central bank traditions and practices. They are such that attention drifted to control over the short rates because the central banks were thought to control such rates and because institutional complexities made the attainment of money aggregates difficult. I came to do two things against such a background -- to question why the institutions were not changed to accommodate control of money aggregates, and to see a combination of the pre-EMU Bundesbank and the post U-Turn Federal Reserve as a preferred model for a central bank in a markets oriented world.

In contrast to this questioning, however, a variant of the i-regime orientation gets attention. It appears in a Federal Reserve publication by Vickers, (1998) and in lesser measure in comments by Alan Greenspan, and it appeared in the failure of the Federal Reserve to come within the target range for dollars M2 in 1992. So we turn to the Weiner analysis, assess it from a Friedman system perspective, note comments by Hoskin (1991) and turn to the discussion of "the interest rate" as a surrogate for monetary policy.

The Ideal Indicator

The ideal indicator would consist of the change in money growth (± ) and the income velocity of money (Y/M), along the lines already introduced. Along these, the change in growth provides the direction of policy and the velocity ratio indicates the amount of work the change performs. Taking the product of money growth and velocity, and multiplying by 100 to get growth in percentage terms, monetary accommodation and discipline appear as:

(Y/M) x 100 > 0 (accommodation) -?

(Y/M) x 100 < 0 (discipline)

The idea of accommodation is that the monetary authority accommodates other things, such as government financing of deficits and wage increases that appear as higher priced goods and services and that on the average exceed the growth in productivity. Discipline, of course, is just the reverse of accommodation. In that case, authority is moving to deny government any special accommodation and to reduce inflation inducing price changes, and so on. Monetary neutrality with respect to prices, wages, and production and the real goods economy is attained when the indicator approximates a zero value for a sustained period. However, these are data and policy/control impediments to attaining such refinements in the imperfect world, even for the United States. As to the relevant data series, there are small, detailed impacts on them that get magnified as errors when the series are refined to obtain measures for acceleration and deceleration (Svensson, 2003). As for the velocity ratio, the income component is available only on a quarterly basis and usually with some error of estimation, all when central bankers want the most immediately available information. Also, accounting difficulties as regards the currency (coins-and-notes) component of the money supply arise for the United States when we inquire about changes in the ownership of the currency, whether by parties in the United States or abroad. At different times, a part of U.S. currency may appear as circulating currency in Mexico, Poland, Russia, Cuba, Argentina, and elsewhere. So, taking the United States as an example, we turn to a surrogate for monetary policy -- whether it is inflationary or deflationary. (McCallum, 1999 209).

An Open Mind

Weiner pleads for an open mind about the matters at hand. He says "there is no inherent reason why a central bank need target the money stock." Even though I believe that history and a host of facts enter, as opposed to "no inherent reason," we proceed with Weiner's exposition. He says:

It could be the case that another intermediate target, say, a medium-term interest rate, is deemed to be more closely related to the ultimate goal variables. If so, monetary control can be de-emphasized or even abandoned, in which case reserve requirements again become irrelevant as a vehicle for directly controlling the money stock. (Prescott & Robert, 2000).

In the argument advanced by Weiner, the distinction is made between an "interest rate operating procedure" and the "reserve operating procedure." Weiner embraces these distinctions as Friedman intended when he said, "Direct control of the monetary base is an alternative to fiscal policy and interest rates as a means of controlling monetary growth." Although not touching on fiscal policy at all, Weiner says (Bullard & Christopher, 2004 pp 95) along the lines of H. CB (Walsh, 2005) "institutional structure within a country . . . may still have an important role to play" (meaning in the public choice between the interest rate and reserve requirements operating procedures). Weiner's case for a short-rate orientation proceeds with time series for "effective" reserve ratios and the money multipliers that go with them in fractional reserve banking systems (Svensson, 2003). U.S., Canadian, and German series appear. They show downward trends for the effective reserve ratios from the early 1970s to 1992 and upward trends in the corresponding money multipliers. In any event, Weiner goes back to what I see as earlier stages of the Keynesian orientation (Faust, 2006) to come up with ordinary supply and demand functions for the money stock, with the view of also dealing with the unlikely prospects of actually identifying the respective functions. For the monetary approach I associate with Friedman, this problem of the identification of supply and demand relations is dealt with by viewing money demand in terms of velocity, by treating households as determining the real money stock (Kreps & Robert, 2002) and by having the central bank determine the nominal money stock (Gerling, et al. 2003). The behavior of the households and velocity, on the one hand, and that of the central bank, on the other, is thought to be different, hence identification. 3

Weiner offers a money/interest-rate (M-i) plane with M. On the horizontal axis and with I (short-term) on the vertical axis. A downward-sloping demand curve and an upward-sloping supply curve are imposed on the plane. They intersect at the "effective money supply" line (Ms, effective). The intersection is a solution (equilibrium, or balance) point [point A (M*, i*)]. Growth conditions such as I stress throughout are possible in that the static money supply and demand curves (Ms and Md) may move about and outward as growth occurs. The idea, under the conditions of change, is that point A moves along the path for the effective money supply (Ms effective ). A money supply line with lower reserve requirements appears (Ms, Irr ). It intersects at point A, and rotates downward as reserve requirements are lowered. The downward rotation also reflects the potentially greater impact of short-term interest rate changes on the quality of money (the M-axis), but that variable is insignificant to the analysis. It just comes about and appears as the effective money supply. It comes about apart from being targeted directly.

The money stock comes about when the specific short-term market rate (i*) is set by the central bank. While overlooking the phenomenon called "the chasing of interest rates," Waller says (2003) the central bank focuses on achieving this special market interest rate (i*) rather than providing reserves and relying on the link between reserves and the money supply. The implication is that the market interest rate known as the "federal funds rate" may be used to target a real rate of interest (and hence a zero inflation rate goal). Waller says "a crucial implication is that the level of reserve requirements is now irrelevant, i.e., requirements no longer play a direct role in monetary control." In taking up a changing role for reserve requirements, he says ( 2003, 412): "Reserve requirements are no longer seen as a vehicle to directly control the money stock but rather as a vehicle to facilitate control over short-term interest rates." Going further, he says "depending on a country's institutional framework, there may be scope for reducing or even eliminating reserve requirements."

Of course, changes in reserve requirements per se are no unusual thing, nor need they be seen as a means of controlling reserves (or "base money" defined as reserves plus currency and coins in circulation). In the context of the bank reserve equation, the Federal Reserve may readily intervene with open market operations to counter the reserve requirement change and continue to control the growth of reserves (or "base money") irrespective of the legally required level for reserves. From a money aggregates control perspective according to Faust (2006), nothing really changes but possibly the "effective" money and bank-credit multipliers.

Chapter Three

Findings and Discussions

The classical, gold-standard arrangement was rather impersonal in its operation. It worked according to certain rules, and dispersed the power that might otherwise reside in a government-managed economic system. As Keynes indicated, its function was surrounded by mystery, respect, and certain amounts of awe and reverence. However, as Keynes reviewed the matters of the 1920s, he saw that the managed financial system had crept in. To be sure, some phases of it that bear on the present analyses, its conclusions, and extensions of national policies to an open-economy setting have been reviewed here. At the domestic level, there are the i-orientation and its fiscal policy accoutrements, which I associated with In M = a 0, + a 1, ln I + a 2, ln Y (Symbolic of Keynesian and Bank of England views of controlling money balances, the last equation can be rewritten ln M = a 0 + a 1, ln I + a 2 ln Y (2) ), monetary accommodation, the causation issue, Lord Kaldor, and all (Buiter & Anne, 2001 183). Moreover, these topics were extended to others: namely, to notions about controlling prices directly enter via theories of imperfect and oligopolistic market structures, where inflation may arise (Cukierman & Allan 2007-1099); to the uses of force that arise that may extend to making the world fit the models (Cukierman & Allan 2007-1123); and to income redistribution via income policies and the uses of the tax and transfer powers of the state.

Figure 1.3

Juxtaposed to this, on the domestic level, was the M-orientation, which limited the government's function in fiscal, price-control, and market matters. It does several things: it suggests different utility and consumption functions (Barro & David 2003 589); introduces the prospects of freedom and voluntary association in markets as an economic goal (Barro & David 2003 591); and pictures monetary neutrality (?0) as the attainment of the zero inflation goal. "The optimal inflation rate has a large variance around its trend (about 20%) because it is desirable for the government to use its fixed nominal debt, in conjunction with variable inflation, to generate changes in the real burden of its debt over the business cycle" (Hoskins, 1991 2).

Figure 1.4

Now, in the open economy context, the conflicts, issues, and choices take on international extensions. What appears domestically as the "freedom issue" becomes the sovereignty issue. The interest-rate orientation and its fiscal policy accouterment still exist, and notions about a super national central bank and different exchange rate mechanisms enter the picture. Quite basically of course, countries' prices (as in a price index) are extended internationally by means of exchange rates. They are stated in terms of the unit of account for one currency in relation to another (e.g., the dollar price of the pound, $/£, the Deutsche mark, $/DM, the yen, $/¥), and so on (Briault et al. 1997 309). Exchange rates appear at times as fixed and at other times as variable, along the lines set forth in dealing with control arrangements and their ideological extensions. To the extent that domestic central banks bear crucial responsibility for price levels, and to the extent that currencies are freely traded in the foreign exchange markets, speculation in currencies reduces mainly to speculation over the prospects for monetary policy in the respective national states. So anticipations about the future enter with respect to central bank policies, domestic price levels, and exchange rates. As illustrated, these last two sets of prices bear on a country's prospects for importing and exporting goods and services as well as capital.

The existing paradigm of the theory of monetary policy has the central bank's credibility at its centre. The central result, in a world of rational expectations and no information asymmetries, is that discretionary monetary policy has an inflationary bias. That bias can only be eliminated, with a consequent gain in social welfare, if the central bank is pre-committed by strictly tying monetary expansion to a rule. The inflationary bias of discretionary policy exists because central bank announcements are not credible. Here lack of credibility is identical with dynamic inconsistency. If the central bank announces a zero inflation policy, the public, with perfect information including information about the bank's objective function, rationally expects the bank to adopt a different, surprise, policy to expand employment once inflation expectations have been formed, and therefore determines its actions on those fully informed expectations. Dynamic inconsistency means that the bank's announced policy is not credible (Rogoff, 1985; Posen, 2005; Barro & David 1983; Cukierman & Allan 2007).

Extensions to the model, permitting asymmetric information, uncertainty in the minds of the public, and sophisticated strategies in the central bank / public game lead to related results, but rather than credibility being simply present or absent, it is a function of reputation, influenced by central bank actions and a variety of institutional arrangements (Barro and Gordon 1983). The world has been experiencing a wave of institutional reforms in central banking. They include moves towards central bank independence, the appointment of central bank governors with 'conservative' reputations (in terms of the weight given to unemployment and price stability in their objective function), and contractual or constitutional rules regulating relations between government and the central bank. The theoretical rationale for each is located in such models of credibility-increasing institutional arrangements. Therefore the underlying concept of credibility deserves scrutiny, starting with the question 'who has to have confidence in the credibility of monetary policy?'.

The agents around which the model revolves are workers and employers and their critical actions occur in negotiating wages in the labor market. Specifically, they negotiate the nominal wages that will obtain over a period in an attempt to attain an optimum real wage over that period; thus, their negotiations reflect expected inflation over the period and, hence, the credibility of central bank policy announcements. Central bank credibility, therefore, is credibility in the eyes of labor market actors. If the bank lacks credibility, nominal wage settlements will rise faster than otherwise and, given technology and the degree of monopoly, that rate of wage inflation will be reflected in a higher rate of price inflation.

The models' focus on credibility in the labor market can also be seen in their assumption about the central bank's objective function, or loss function. Its two variables are inflation and unemployment, the determination of which is located in the labor market. With given inflation expectations in the labor market, a short-run Phillips curve would exist, apparently offering a trade-off between inflation and unemployment (Dixit & Luisa, 1999). If the central bank announces a policy ('zero inflation') it would not be credible to workers and employers because they know that dynamic inconsistency exists. That is, if the expectation of zero inflation were held, after announcing its zero-inflation policy the bank would then seek to maximize its objective function (minimize loss) by reneging on its announcement. It would try to reduce unemployment below its 'natural rate', and raise inflation, moving along that short-run Phillips curve to the point where it is tangential to an indifference curve of the objective function. Knowing that the bank has that incentive for dynamic inconsistency, nominal wage negotiators in fact generate a higher inflation rate. Thus, the driving force for the inflationary bias of discretionary monetary policy is lack of central bank credibility in the eyes of labor market actors.

Historical and Future Analysis of the Criteria for Determination of Monetary Policy

The Mechanics and Institutions of a Common Currency

The process of establishing a North American Monetary Union involves the following steps. On January 1, 20 xx, the public in Canada, Mexico, and the United States will surrender their current banknotes and coins in return for new ones, which might be called ameros (Svensson, 2003). At the same time, all prices in the three countries are converted to ameros. The North American Central Bank will be created and will determine monetary policy for the continent. The three member states are represented on the executive board and staff in proportions that reflect their economic importance. One crucial issue is the rate at which the national currencies are exchanged for ameros (Drazen, 2000). To minimize the cost of conversion, one U.S. dollar will be equal to one amero. The exchange of the Canadian and Mexican currencies for ameros will take place at a rate that leaves unchanged the international competitiveness of these countries. To minimize opposition to the monetary union by nationalists, one side of notes and coins circulating in each country will show appropriate national symbols, the other will exhibit abstract designs and writing that identifies them as amero notes or coins. To keep the circulation of national currencies dominant in each country, commercial banks will return foreign amero notes to their home country in exchange for their own country's notes. The currency circulating in each country can be produced locally so that each country can continue to earn the seigniorage profits from that activity and the mints remain in place (Svensson, 2003). The introduction of the amero at the appropriate rates of exchange leaves unchanged the real income and wealth of individuals in all three countries. Incomes, prices of goods, services, and assets all change in the same proportion. The process of creating a common currency involves only what in practice are accounting changes. The public in all countries is likely to get quickly used to the new unit of account. So what are the benefits from monetary union? The following analysis discusses a number of different sources of welfare gains, the assessment of which is facilitated by a brief review of OCA theory.

Optimum Currency Area Theory

After 1945 the international monetary system relied on a system of fixed exchange rates. This system was introduced to prevent the competitive devaluations that had aggravated the depression of the 1930s. However, during the 1960s this fixed exchange rate system came under criticism based in Keynesian economic theory (Gerling, et al. 2003). This theory suggested that countries could lower unemployment permanently by expansionary monetary and fiscal policies at the expense of only relatively small and constant inflation. The fixed exchange rate system was seen as the main obstacle to the pursuit of such policies, and the move to flexible exchange rates gained great momentum. During this period academics and politicians also gave much attention to Milton Friedman (1953) arguing the merit of freely floating exchange rates. His arguments were powerful and influential because he equated the exchange rate to the price of foreign exchange. He then developed the universally accepted idea that price flexibility assures the efficient allocation of resources and thus leads to the maximization of income. The confluence of Keynesian and Friedman's criticism of fixed rates ultimately resulted in the abandonment of fixed exchange rates (McCallum, 1999).

However, important for the present purposes of analysis is the fact that during this period of growing support for exchange rate flexibility, Robert Mundell (1961) published a seminal article in which he introduced the world to the concept of what he called optimum currency areas. He questioned the merit of Friedman's generalized recommendation for freely floating rates by asking the following question. If flexible exchange rates are such a good system, why is their introduction limited to existing nation-states? Why don't regions within countries adopt them? Mundell's answer is that the exchange rate is different from any other price, much the way money is not just a commodity. He argued that large currency areas tend to have more stable prices and economies than small areas simply because within a larger region random shocks tend to average out more than they do in a smaller one. As a result, a country that joins a larger currency area enjoys important microeconomic benefits. In addition, it no longer has to pay the risk premium existing in capital markets of countries with unstable exchange rates. The usefulness of money is increased. The costs of currency trading and measures to deal with exchange rate uncertainty are diminished. All of these benefits translate into higher productivity and living standards through both the more efficient allocation of resources and stimuli to economic growth (Drazen, 2000).

Mundell concluded therefore that the adoption of freely floating rates or the permanent linking of its currency to another requires each country to consider a trade-off between microeconomic benefits and the losses in macroeconomic flexibility, which is at the heart of the case for flexible exchange rates made by Keynesians. Keynesians dominated the economics literature on optimum currency areas that developed in response to Mundell's original article. The focus of their articles was the specification of economic conditions that determined the costs associated with countries' losses due to their reduced ability to deal with economic shocks through monetary, fiscal, and exchange rate policies. Mundell's call for an examination of the microeconomic costs of flexible rates went largely unheeded (Svensson, 2003). The Delors Commission Report redirected the focus from Keynesian macro to Mundellian micro effects by estimating the size of the microeconomic benefits of fixing exchange rates permanently through the creation of a monetary union in Europe (Drazen, 2000). However, while the new emphasis on the micro- and macroeconomic costs and benefits is a step forward, no economist until now has spelled out one of the main conclusions I reach hereafter: flexible exchange may well not have brought macroeconomic benefits but mostly costs.

The Microeconomic Benefits

The benefits from monetary union consist of gains from lower costs of exchange dealings, reduced risk premiums on financial assets (Gerling, et al. 2003), increased labor market discipline, fewer monetary and fiscal policy adventures, and having a direct influence on the formulation of monetary policy in the union.

Reduced Costs of Foreign Exchange Dealings

All trade in goods, services, and securities among the countries of North America requires one party in the transaction to buy or sell foreign exchange. In addition, financial derivatives like forward and future contracts are used to reduce the exchange risk associated with this trade. Speculation takes place in currency contracts. Exchange rate developments need to be forecast. International travelers require foreign currencies to pay for transactions abroad. All of these currency-related activities absorb labor and capital in banks and other firms. It is difficult to estimate the savings from the elimination of the need to engage in such activities in North America. The gross values of trade, capital flows and travel -- for which good data are available -- are an imperfect measure of the potential savings. Thus, much of the recorded trade takes place between divisions of the same firm and does not require foreign exchange transactions. Recorded net changes in the holdings of foreign securities are accompanied by much intraperiod buying and selling, and the time cost and hassle facing international travelers are not recorded anywhere. The Delors Commission Report (Gerling, et al. 2003) assessed the merit of forming the EMU by commissioning special surveys of banks and other private agents. It concluded that savings might be as large as one half of a percent of national income of the average European country. Other, more recent estimates suggest that the foreign exchange departments of European banks will shrink by two-thirds. Without special surveys it is impossible to come up with an equivalent estimate of savings for Canada, Mexico, and the United States. However, given that Canada is one of the most open economies in the world and the bulk of its trade is with the United States, potential savings may be as large as the 0.5% estimated for the average European country. It might well be in the same range for Mexico.

Chapter Five

Findings and Conclusions

Since that basic model became established, the theory of central banking has developed within a political economy framework. In it, a key additional player is the elected political authority ('government'), for, as Waller, (2000) put it, and such models address 'the continual tensions between the Federal Reserve and the U.S. Congress as well as the ... worldwide moves toward redesigning central banking institutions'. Walsh, (2005) for example, examine a variety of institutional arrangements as outcomes of the desire to solve a political principal-agent problem. The public (principal) finds that the central bank (agent) operates sub-optimally because its ties to the government, whose objectives are reelection, affect its credibility. The effects of a variety of institutional arrangements are examined, with independence or performance contracts having the best effect. Similarly, Lucas, (2003) examine optimal institutional arrangements in the form of the length of term of the central banker's appointment and the principle of appointing a conservative central banker, showing that long terms of appointment may be too costly if society's preferences shift permanently. However, the political economy models of optimal institutional design, with inflation and unemployment in the objective or social welfare function, are also driven by labor market reactions and credibility perceived in the labor market.

Cukierman & Allan (2007) develop a political economy framework as a positive theory orientated towards explaining the existence of inflationary monetary policy, and goes beyond a simple inflation-unemployment objective function. Recognizing that actual central banks both historically and today have a number of roles, his model includes revenue raising for the state (seigniorage), stabilization of the banking system and financial markets, and balance of-payments objectives, as well as domestic macroeconomic responsibilities (inflation-unemployment) among them. Thus, monetary expansion and inflation might arise either from the standard inflationary bias and credibility problems, or from attempts to optimize the state's revenue from seigniorage, or from short-term interest rate smoothing in pursuit of financial stabilization, or for balance-of-payments reasons. As we suggest in the following section, that perspective increases the model's applicability to existing central banks, but misses important aspects.

A more thoroughgoing attempt to go beyond the labor market orientation of central bank models, is Backus & John's construction of a model (Backus & John 1985) in which the structural characteristics of the labor market are integrated with other structural features of the economy to explain the determinants of monetary policy. In that case the underlying research program is, unusually, a puzzle over the absence of expansionary monetary policy (Backus & John 1985). In his 1994 model, which is seminal within the structural economics paradigm, Epstein demonstrates how the interaction between four structural features can determine monetary policy: in addition to the structure of the labor market they are the relation between the central bank and the state, the connection between the industrial and financial sectors, and the economy's position in the world economy.

The basic model of central banking, which revolves around monetary policy's credibility in the labor market has an unduly restrictive focus. In reality, whatever the relevance of monetary policy for labor market outcomes, monetary policy is conditioned by central bank credibility in other markets. In particular, money market rates, bond yields, equity returns and foreign exchange rates are highly sensitive to the credibility of the central bank. Consequently, the design of central banking arrangements, such as independence, or the installation of a 'conservative' central banker, is driven to a large extent by the need to win credibility in financial and foreign exchange markets. Similarly, the actions of central banks are frequently designed to strengthen the bank's reputation in those markets. Arguably, credibility and reputation in those markets has been the dominant force in modern central banking. But the basic model, with its restricted concept of credibility, is unable to engage with that reality, and the political economy models such as Cukierman's and Epstein's which do introduce the central bank's concern for financial markets do not include a developed concept of central bank credibility in those markets. Any attempt to introduce into our models the central bank's relationship to financial and foreign exchange markets immediately exposes another limitation of the existing models, for they define central banks in terms of their national boundaries while in reality financial markets are increasingly global. That discrepancy is a serious problem for the applicability of central banking models, and requires some consideration at this stage.

The difference between a model defined in terms of national boundaries and a globalized world is not the same as the distinction between a closed and an open economy. Models such as Cukierman's, which includes a 'balance of-payments motive' for monetary policy, and Backus & John are both open economy models, but they remain 'national economy' models. Open economy models treat international finance as flows between nation states; residents of the country or another country move their own or their principals' funds between financial markets located in the country and financial markets elsewhere. And those choices of residents are reflected in balance-of-payments accounts. The notion that financial markets are globalized is rather different. It implies that financial markets have no national identity, and the flows between them are similarly without citizenship (Buiter & Anne 2001). The interest rates on a particular country's paper, or the country's exchange rate, may be determined in offshore markets located anywhere in the world and, according to the concept of globalization, the physical location of those markets in a particular country does not detract from their global character; the Eurodollar markets in London in the 1970s, for example, were quite independent from conditions in the UK economy, having a global role that was an early form of today's globalization (Blinder, 1997). Similarly, in a globalized economy, important financial flows as well as financial markets lack national identities. They consist of global funds, such as hedge funds, rather than portfolios easily identified with residents of particular countries.

It would be wrong to claim that the world economy is fully characterized by globalization (Briault, et al. 1997 299) and the concept itself is open to criticism, but it describes a rising trend along which financial markets and flows are arguably more advanced than others. To that extent models of central banking would be strengthened if, instead of being constructed in terms of national boundaries, they were able to recognize central banks' roles in those markets. Having had a key role in the creation of more global markets -- especially through liberalization of foreign exchange and financial markets and the shift from extensive control over bank assets to capital adequacy controls -- a driving force behind central bank design and monetary policy is the high priority to be given to credibility in respect of those markets. Placing matters in that context highlights a further weakness in the existing models of central bank design. All consider purely domestic devices for increasing the credibility of monetary policy, but in reality the world of global markets both requires and delivers new forms of international devices to bolster credibility. Weak central banks have their policy's credibility in global markets strengthened by publicly subordinating it to a program agreed with the International Monetary Fund, or by linking their currency to a strong central bank's through a variety of currency board type arrangements. And even well-established central banks may seek to strengthen their policy's credibility in global markets by adhering to an exchange rate bloc or currency union.