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Monetary Policy: From Theory to Practices

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 Monetary Policy:
From Theory to Practices

by

Thierry Warin

June 2005

MIDDLEBURY COLLEGE ECONOMICS DISCUSSION PAPER NO. 05-08

DEPARTMENT OF ECONOMICS
MIDDLEBURY COLLEGE
MIDDLEBURY, VERMONT 05753

http://www.middlebury.edu/~econ
Monetary Policy: From Theory
to Practices+

*
Thierry Warin
Department of Economics, Middlebury College
Minda de Gunzburg CES, Harvard University

Abstract. The paper proposes an overview of the literature on

monetary policy. It shows the influence of the debates in the
theoretical literature on the actual implementation of policies, as
well as the counter effect. The European Economic and Monetary
Union (EMU) is largely studied as an example of this counter effect
with regard to the study of the credibility concept in an open
economy setting.

JEL Classification: E50, E52, E58

+
A largely revised version of this paper is forthcoming in International
Encyclopedia of Public Policy, edited by Phil O'Hara, (Routledge: London
and New York).
*
Thierry Warin, visiting scholar, Minda de Gunzburg Center for European
Studies, Harvard University. Assistant Professor, Department of Economics,
Middlebury College, Vermont (USA).
Warin: Monetary Policy: From Theory to Practices 2

1. Introduction

For many centuries, monetary policy was seen as a twofold process:

deciding about the money supply, and deciding to print paper
money to create credit. While now thought of as part of monetary
authority, interest rates were not coordinated with the other forms of
monetary policy. Monetary policy was generally in the hands of the
executive body, which benefited from seigniorage, or the power to
print money.

Created in 1694, the Bank of England acquired the responsibility to

print notes and back them with gold. With this, the idea of monetary
policy began. The aim of monetary policy was to sustain the value
of the currency, and print notes. In the late 18th and 19th centuries,
the establishment of central banks in industrializing nations was
mostly coupled with the wish to preserve the nation's peg to the
gold standard. Central banks began setting the interest rates that
they charged to both their own borrowers, and other banks that
required liquidity.

During the 1870-1920 period, the industrialized nations set up

central banks, with one of the last being the American Federal
Reserve in 1913. The central bank was beginning to take on a new
role as the “lender of last resort.” This supplementary responsibility
led to the nationalization of central banks; the Bank of England, for
example, was nationalized on March 1, 1946. Although the notion
of interest rate was already debated between the Mercantilists and
the Physiocrats in the 18th century, it was also increasingly
understood that interest rates had an effect on the real economy. It
also became clear that there was a business cycle, and economic
theory began emphasizing the relationship between interest rates
and this cycle. Macroeconomics was born with Keynes’s General
Theory (Keynes 1936).

In the 1980s, many economists began to believe that making a

nation’s central bank independent was the best way to ensure a most
favourable monetary policy. This would prevent the plain
Warin: Monetary Policy: From Theory to Practices 3

manipulation of the tools of monetary policies to effect political

goals.

In the 1990s, central banks began adopting formal inflation targets.

A central bank may, for example, have an inflation target of 2% for
a given year. The goal was to make the outcomes, if not the process,
of monetary policy more transparent. The Bank of England
illustrates both of these trends. It became independent of
government through the Bank of England Act 1998 and adopted an
inflation target of 2.5%.

2. Definitions

Monetary policy is the process of overseeing a nation's money

supply to complete specific objectives such as restraining inflation,
or achieving full employment. Monetary policy can involve setting
interest rates, margin requirements, capitalization standards for
banks, and acting as the lender of last resort.

The primary tool of monetary policy is open market operations.

This entails overseeing the quantity of money in circulation through
the buying and selling of a variety of credit instruments, foreign
currencies, or commodities. Among such credit instruments, one
finds public bonds. In order to prevent distortion in its
independence, article 21 of the European Central Bank (ECB)’s
statutes forbids the Bank from buying public bonds. This makes the
ECB very unique among monetary institutions across the world. All
of these purchases or sales result in more or less base curr ency
entering or leaving market circulation. Usually the short-term goal
of open market operations is to reach a specific short-term interest
rate target. However, monetary policy might entail the targeting of a
specific exchange rate relative to some fore ign currency, or else
relative to gold instead of targeting interest rates.

For example, the Federal Reserve targets the Fed Funds rate, the
rate at which member banks lend to one another overnight. In
Europe, the ECB targets the Main Refinancing Operations Rate,
also known as Repo.
Warin: Monetary Policy: From Theory to Practices 4

A policy maker may choose either to apply open market operations

to reach certain targets (inflation targeting), or to have intermediary
objectives (monetary aggregates) with no consideration ex ante of
the outcome in terms of inflation. Let’s have first a look at inflation
targeting. Inflation is approximated by the rate of change in the
Consumer Price Index (CPI). It requires that a basket of consumer
prices be monitored, and from these prices a CPI defined. For
example, the target might be to keep the CPI index between 2% and
3% per year through periodic changes of the interest rate. The
interest rate is targeted for a specific period using open market
operations. In general, the period will vary between months and
years. As a rule, a committee reviews this interest rate target on a
monthly or quarterly basis. There has been considerable attention
paid to simple interest rate rules for monetary policy. These rules
offer a hypothetical path for the policy instrument — short-term
interest rates. The Taylor rule is a well known example of a
monetary policy rule, with the path for the short-term interest rate
depending on deviations of inflation from target, and output from
trend (Taylor 1993). Changes to the interest rate target are made in
response to a variety of market indicators in an attempt to forecast
economic trends, and keep the market on track towards achieving
the defined inflation target. This monetary policy approach was
initially pioneered in New Zealand. It is currently used in Australia,
New Zealand, Sweden, South Africa and the United Kingdom.
Differing slightly from inflation targeting is price level targeting.
The dissimilarity is that CPI growth in one year is offset in
subsequent years, such that the aggregate price level does not move
over time. Price level targeting was used in the 1930’s by Sweden,
and seems to have helped the Swedish economy during the Great
Depression.

Second, let’s have a look at monetary aggregates. In the 1980’s,

while countries faced a double -digit inflation rate, several countries
used an approach based on constant growth in the money supply.
This approach was refined to include different definitions of money
and credit (M0, M1, etc). In the US, this approach was discontinued
with the selection of Alan Greenspan as Fed Chairman. Called
monetarism, this approach focuses on monetary quantities, whilst
Warin: Monetary Policy: From Theory to Practices 5

most monetary policy focuses on a price signal of one form or

another.

Another monetary policy is to enter into a monetary regime in order

to import the credibility from another central bank. Base money is
bought and sold by the central bank on a daily basis to target the
determined exchange rate. For instance, this type of policy is used
by China. The Chinese Yuan is managed such that its exchange rate
with the United States dollar is fixed: 1 US$=8.2765 Yuan.

A currency board illustrates a slightly different version of the

former policy. In order for a currency board to be established, a
country must decide to relinquish its monetary policy to another
country. This decision is often made after a country’s unsuccessful
struggle against inflation. The currency board will no longer issue
fiat money, but instead, will only issue one unit of local currency
for each unit of foreign currency it has in its reserve. The growth of
the domestic money supply can now be coupled with the
supplementary deposits of the banks at the central bank; these
deposits equal the additional hard currency reserves in the hands of
the central bank. In such a system, questions of currency stability no
longer apply. The drawback is that the country no longer has the
ability to set monetary policy according to other domestic
considerations. Hong Kong and Bulgaria operate a currency board.
Argentina discarded this policy in January 2002 after a severe
recession. This illustrates the fact that currency boards are not
irrevocable, and hence, may be abandoned in the face of speculative
attacks by foreign exchange traders.

A gold standard is a special case of a currency board where the

value of the national currency is linked to the value of gold instead
of a foreign currency. The gold standard is a system in which the
price of the national currency, as measured in units of gold, is kept
constant by the daily buying and selling of the base currency. This
process is called open market operations. The gold sta ndard might
be regarded as a special case of the “Fixed Exchange Rate” policy,
and the gold price might be regarded as a special type of
“Commodity Price Index.” A form of gold standard was used
widely across the world prior to 1971: the Bretton Woods system.
Warin: Monetary Policy: From Theory to Practices 6

3. Practices since the end of Second World War

At the Bretton Woods conference in 1944, 44 allied countries

created a new international financial system in which the U.S. dollar
became the anchor: each member country fixed its currency to the
U.S. dollar, and the U.S. dollar officially fixed to gold at 35 dollars
per ounce. When foreign countries had a trade surplus, they could,
theoretically, have used the excess dollars and asked the U.S. to
exchange them for gold. With a fixed parity between dollar and
gold, this would have restricted dollar creation.

In the late 1960s and early 1970s, as the Vietnam War accelerated
inflation, the United States was running not just a balance of
payments deficit, but also a trade deficit (for the first time in the
twentieth century). The crucial turning point was 1970, which saw
U.S. gold coverage deteriorate from 55% to 22%. In the first six
months of 1971, $22 billion in assets fled the United States. On
August 15, 1971, Nixon decided to “close the gold window,”
making the dollar inconvertible to gold directly, except on the open
market.

The blow of August 15 was followed by efforts under U.S.

leadership to develop a new international monetary system.
Throughout the fall of 1971, there was a series of multilateral and
bilateral negotiations within the Group of Ten seeking to develop a
new system.

Gold became a floating asset: in 1971, it reached $44.20 per ounce,

and in 1972, it climbed as high as $70.30 per ounce and continued
climbing. By 1972, currencies began abandoning even this devalued
peg against the dollar. In February of 1973, the Bretton Woods
system collapsed after a last devaluation of the dollar to $44 per
ounce.

Since then, the international monetary system has consisted in a

multitude of different currency arrangements ranging from currency
unions and currency blocs, to floating exchange rates, with many
other schemes in between, such as unilateral fixed parities, managed
floating or currency boards, and currency baskets.
Warin: Monetary Policy: From Theory to Practices 7

As early as 1970, the members of the European Economic

Community decided to prepare for the establishment of a common
currency. The Exchange Rate Mechanism (ERM) crisis in the early
1990s severely threatened the Economic and Monetary Union
(EMU) project.

On December 30, 1998, eleven members of the European Union

locked their currency exchanges at irrevocably fixed rates. This was
the establishment of the EMU with the inception of the euro on
January 4, 1999. 1

Currently, twelve European countries take part in the European

Monetary Union. Goodhart (1989) notes that “monetary policy
operations of the Central Banks” can be viewed as “quantity, or rate
setting actions.” Generally, central banks have viewed short-term
interest rates as their preferred policy instrument. Occasionally a
central bank, (such as the German Bundesbank starting in the
1970s), has focused on monetary aggregates, a practice that still
survives in the European Central Bank’s much-debated “second
pillar” of monetary policy. In the process of disinflation beginning
in the late 1970s, other central banks, such as the Federal Reserve
and the Bank of England, briefly paid attention to quantity targets.

4. Monetary policy in the economic literature

Rules or discretion? This question is at the heart of the modern

theory of central banks and monetary policy. This debate, which
took its real dimension after the publicatio n of the General Theory
by John Maynard Keynes in 1936, has evolved over time.
Responses to Keynes gave birth to new questions, and the tools
developed to solve them brought forth new research directions.

Taking as a starting point the work by Argy (1988) and Fischer

(1990) , this section gives a brief overview of the theoretical
literature on the “rules versus discretion” debate considering also

1
The financial markets were closed from December 31, 1998 to January 3, 1999
for the switchover.
Warin: Monetary Policy: From Theory to Practices 8

historical and analytical points of view. Creating, on purpose, an

anachronism, the premises and evolution of the debate are
represented as a simple model in order to create a homogenisation
of the literature. The reasoning behind this approach is threefold: to
clarify the dissensions between the various schools of thought; to
facilitate the description of the common points; and to give the
debate some congruence with the current literature. Finding its
geographical origin in the country to first use central banks – the
United Kingdom – the debate “rules versus discretion” dates from
the dissensions between the Currency School, and the Banking
School that preceded Peel’s Act of 1844. Head of the Currency
School, though, he deceased in 1823, Ricardo could not attend its
rise in the 1830s. This school did not conceive the bank deposits as
money. Ricardo defended the idea that the quantity in circulation
would fluctuate, as it would if the currency were gold. This implied
that the balance of payments would determine the changes in the
quantity of currency. The Currency School was in favour of control
over monetary growth rather than leaving this decision in the hands
of the authorities of Bank of England. Imagining that central
bankers, framed by clear and transparent statutes, would set up its
program, the Currency School approaches recent discussions on
independence of the central banks.

The Banking School was opposed to the idea that bank deposits
constituted the only currency. Based on t he fact that the evolution of
the stock of money depended on the movements in the reserves of
the Bank of England, on the one hand, and whether these
movements were permanent or transitory, on the other, its authors
criticized the rule of the gold standard. Naturally, the Banking
School defended the idea of discretionary authorities. However, it
proposed an abstract rule for the operations of the Bank of England:
the “Real Bills doctrine.” Credit was to be emitted only at a
discount on those invoices whose object was to finance real goods
in the course of production and distribution. In this case, monetary
creation could never be excessive, i.e. inflationary, since these
doctrines claimed to bind monetary creation to the real production
(Sijben 1990) . The Act of 1844 ended up separating the Bank from
England into two entities, an “Issue Department” and a “Banking
Department,” the latter functioning as a commercial bank.
Reflecting the ideas of the Currency School, the “Issue Department”
Warin: Monetary Policy: From Theory to Practices 9

was to convert banknotes of England into gold or coins according to

a precise rule of convertibility: there was to be a fiduciary issue of
18 million pounds, and above that, at the margin, there was to be
100 % gold reserve for notes.

The debate between the Currency School and the Banking School
turned to the advantage of the former, and the monetary policy of
the Bank of England was supposed to follow a simple rule: the offer
of currency varied according to the gold reserves of the central
authorities. Although the gold standard is often quoted as an
illustration of a monetary rule, the functioning of the system
implied a high degree of discretion on behalf of the British
monetary authorities. During the period between 1844 and 1914, the
Bank of England actively adjusted the discount rate to answer for
changes in the gold stock. For example, in the case of a deficit in
the current balance, the Bank of England increased the discount rate
in order to protect gold convertibility and the gold reserves by
reducing the outflows of capital and the domestic demand (Schaling
1995). De facto, discretion overrode the rule.

In 1926-1927, the Congress and the Federal Reserve System (Fed)

were opposed on the action to be taken regarding monetary policy.
Congressman Strong wanted to force the Fed to follow a monetary
rule, whose objective was price stability. Based on the “Real Bills
doctrine,” Miller, administrator of the Fed, privileged monetary
discretion (Sijben 1990). The Fed won the debate. The Twenties
were years when the American monetary policy was very strongly
discretionary. With that, two explanations: the transformation of the
Fed as a true central ba nk by the Federal Reserve Act of 1913 and
the suspension of the gold standard during the First World War.
Nevertheless, the act of 1913 made price stability the main goal of
the Fed, without specifying the means of the central Bank to reach
this end. At the time of its creation, the Fed was supposed to exist
within a system of gold standard. But, World War I finally ended.
During the war, the movements of the discount rates were neither
limited by the Federal Act Reserve, nor by the need for facing
external pressure in order to protect the American gold reserves.
Warin: Monetary Policy: From Theory to Practices 10

4a. The Chicago plan

After the Great depression of 1929 (Wheelock 1992) , a group of

economists in Chicago proposed a system in which each bank
would hold 100 % of reserves on easily verifiable deposits. A whole
set of specific arguments was developed in favour of the rule- like
principle of monetary policy in the United States. Entitled the
“Chicago Plan,” this proposal for a monetary reform had as
partisans: Simons (1936) , Fisher (1945), and Friedman (1959).
Taking as a starting point the work of Simons, Fisher proposed
alternative rules such as a rule of stabilization of prices, or a rule of
constant money supply.

In the first case, the political authorities can have a range of

instruments, like the discount rate, the coefficient of reserve and
operations of open market, which they use in a discretionary way.
As Sijben (1990) indicates, in this mode, the authorities are
forcedby the final goals of the monetary policy: the inflation target.

In the last case, the monetary authority could be obliged to respect a

growth rate of the money supply, for example X% per annum. This
approach to the rule is constrained by the instruments of monetary
policy, i.e. intermediate objectives (Poole and Rosenthal 1986).
Taking again the typology of Fischer (1994), under the mode of the
authority, the central bank has an independence of objective,
whereas under the mode of the rule, it does not have independence
in the choice of the instruments.

The ideas of Simons, and more generally of the Chicago School,

would be taken up and adapted a few years later by Milton
Friedman at the time of a new era for the macro-economy that
which started with Keynesianism and continued with monetarism.

4b. Keynesianism

Born in the Great Depression of the late 1920’s and the beginning
of the Second World War, the Keynesian revolution moved aside
the question of the choice of the monetary modes to address a new
problem: what economic policy should be to set up in order to
reach full employment (Lerner 1944)? Centering the debate on a
Warin: Monetary Policy: From Theory to Practices 11

more specific question, the Keynesians postulated discretion,

insofar as their analyses required interventions with economic
instruments. In 1936, J. M. Keynes pleaded in favour of
discretionary policies, because of the multiplier effect on economic
growth.

Logic was deterministic: the political authorities led the monetary

and fiscal policies by knowing the structure of the model perfectly.
Based upon information in sufficient quantities, and an ideal model
comprising multiple targets and instruments, the political authorities
were able to choose a “good” policy-mix.

According to Argy (1988), the analytical base of the Keynesian’s

policies of stabilization which followed the war, can be summarized
by the three following proposals:
1. The money wages of full employment were rigid,
2. The private sector was very unstable because of strong
investments, or weak investments,
3. A negative shock of demand could lower employment.

With rigid money wages, there was no automatic mechanism for

adjustment. In the event of negative shock of demand, the political
authorities could increase the price level, to reduce the real wages,
and consequently, to restore the full employment. The choice
between the monetary policy and the budgetary policy depended
upon the structural coefficients of the Keynesian model.

4c. Phillips’s developments

In the original Keynesian model, the money wages are rigid, and are
unable to explain inflation. This gap was filled by Phillips (1958),
who highlighted a nonlinear relationship between the level of
unemployment and growth rate of the money wages in the United
Kingdom during the period 1861 - 1957. The “Phillips curve”
suggests the possibility of arbitration between the inflation of the
wages and the rate of unemployment. This arbitration rests at the
origin of the modern prolongation of the “rules versus discretion”
debate. Phillips suggested that inflation resulting from an
expansionist monetary policy could have positive impacts on
employment, emphasizing the necessity to have discretionary
Warin: Monetary Policy: From Theory to Practices 12

policies. Friedman, however, (1959) countered this proposal and

favoured the growth rate rule of money stock. The adoption of a
monetary rule would allow for price stability while avoiding
fluctuations created by discretionary policies. This debate was
reborn with the appearance of new analysis tools; game theory bent
the debate over “rules versus discretion” towards a debate over
“credibility versus flexibility.”

Phillips was not the first to have highlighted such a relationship

between inflation and the rate of unemployment. Humphrey (1985)
associates the following authors to the “prehistory” of the Phillips
curve: Hume (1955), Thornton (1939), and Tinbergen (1951).
Samuelson and Solow (1960) replicated the Phillips curve to fit the
United States. But, it was Lipsey (1960) who would give theoretical
foundations to this empirical relations hip; at the time, he
reformulated it as being a process of dynamic adjustment of the
labour market.

4d. Friedman’s refinements

Well before Friedman, many critics questioned the Phillips curve.

More precisely, the theoretical foundations brought by Lipsey
(1960) gave rise to many of these discussions. Holmes and Smyth
(1970) explain why there are no reasons to suppose that there is a
direct relationship between the surplus demand for work, and the
rate of unemployment. But the strongest attacks were those of
Friedman (1968) and Phelps (1968) in connection with the
monetary illusion.
Poorly specified according to Friedman, the Phillips curve was to be
formulated by considering the growth rate of real wages rather than
nominal wages. In practice, trade unions negotiate wages in
monetary terms on the basis of the forecast rate of inflation.
Friedman specified the Phillips curve in terms of the anticipated real
wages, called henceforth the “expectations-augmented Phillips
curve.”

Phelps (1967) launched a second phase of the modern debate

following this work showing the concept of natural rate of
unemployment. A natural rate of unemployment corresponds to the
balance between the job market and full employment production.
Warin: Monetary Policy: From Theory to Practices 13

When the economy does not face a supply or demand shock, the
balance holds. In case of a monetary shock, a long-term deviation
from this natural rate of unemployment is impossible.

4e. The modern reading of the debate

The bases of the New Classical School can be found in the works of
Lucas (1972) , Sargent (1973) , and Sargent and Wallace (1975) . The
object of this new argument is twofold: at the same time, it is a
question of reconsidering the Phillips curve in the light of the
assumption of rational anticipations; and a question regarding the
insistence upon the monetary origin of inflation (Fourçans 1975).
Consequently, unemployment deviates from its natural rate only if
there are random deviations of the offer of currency compared to its
systematic component.

The natural rate of unemployment theory was, nevertheless, not

enough to shake the Keynesian edifice, as it did not exclude the
relative efficacy of monetary policy in the short-run. Since Lucas
(1972) , the “New Classical School” defends the idea that systemic
governmental action cannot produce long-lasting effects on output
and employment by manipulating aggregate demand. Discretionary
monetary policy would, accordingly, be ineffective due to the
rational formation of expectations by economic agents. The “rules
versus discretion” debate was tipped towards the rule more than the
discretion.
With the “time inconsistency” concept, the 2004 Nobel prizes
Kydland and Prescott (1977) created a turning point. There exists a
temptation for a central bank not to respect ex post its own ex ante
monetary objectives. The assumption that agents have rational
expectations of this temptation creates an inflationary bias. Thus,
the possibility that monetary authorities will not respect their own
commitments reduces the confidence that economic agents have in
these individuals.

Why would a government in charge of the monetary policy fool

agents’ expectations? The answer is twofold. Firstly, it can change
its policy because of external events, (e.g. an asymmetric economic
shock that hits the country). Secondly answer is the one studied by
several analysts known as the political business cycle, a finding of
Warin: Monetary Policy: From Theory to Practices 14

Nordhaus (1975). When important elections are approaching, the

government may want to falsify agents’ expectations in order to
give a short run impulse to the economic activity and benefit from
the fruits of the welfare improvement that follows.

This lack of confidence and its repercussion on inflation through the

inflationary bias has authorized the creation of a new concept:
“credibility.” Several authors, since Barro and Gordon (1983),
wonder about the options available to improve the credibility of a
central bank, while keeping open the potential to stabilize the
economy. Barro and Gordon (1983) proved that the inflationary bias
could be reduced if the central bank improved its credibility. They
were the first authors to explain that the degree of confidence in the
central bank is relevant for economic agents when they form their
expectations on future inflation. However, their study did not
propose a practical way of improving the credibility of the monetary
authority.

Rogoff (1985) proposes the appointment of a “conservative central

banker” to increase credibility. It is question of selecting a
candidate whose risk aversion is well known by every agent. Such a
central banker must be more risk averse to inflation than the
average economic agent. This model is the one that created the
momentum for the modern theory of central banks. In parallel to
this criterion of risk aversion, which is delicate to implement, the
literature developed some new institutional extensions.

Lohmann (1992) discusses the possibility to reintroduce Milton

Friedman’s proposal of the “k% rule.” That is to say the possibility
of forcing the central bank to commit itself to a monetary rule.
Because all agents know the rule, it allows them to integrate the
inflation forecast into their salary contracts. Hence, the option to use
the monetary policy to stabilize the economy is non-existent.

Neumann (1991) recalls the advantages of monetary management

by an independent central bank. On the one hand, the inflationist
bias would almost disappear, and on the other, the central bank
would keep an option to stabilize the economy in the case of an
economic shock via a well-suited monetary policy
Warin: Monetary Policy: From Theory to Practices 15

However, some authors discuss the advantages of an independent

central bank. Independence separates the monetary power from the
political power, and the central banker is the only authority in terms
of monetary decisions. Fratianni and Huang (1995), as well as
Waller (1995), applied the agency theory to the relationship
between a central banker and economic agents. The manager of a
central bank is in charge of monetary production, when the agents
are in a position vis-à-vis the central bank that looks like
stockholders of the central bank. Agents are interested in the fact
that the central bank produces the best currency possible, i.e.
properly adjusted to the money demand, without the breaching of
the initial commitment. The central banker’s goal is to augment
his/her personal utility function. There may be an incompatibility
between the objective of the best currency possible and the personal
utility function of the manager. Indeed, the latter may want to
augment the central bank’s return by offering more money than the
economy demands, causing a depreciation of the value of the
money in the economy at large. In order to prevent this outcome, a
control procedure must be implemented forcing the central banker
to renounce to his/her commitments in terms of the stability of the
value of the money. Here too, the rule dominates discretion.

Facing some authors’ scepticism on “independence” as a means

without any objective, Walsh (1995) studies the possibility of
performance contracts. New Zealand could be used as an
illustration. What do performance contracts consist of? It is
basically an incentive given by the government to the central banker
to abide by his/her policy announcements to increase credibility In
other words, if the incentive is a salary premium, the central banker
will received this benefit if he/she succeeded at the end of the
period in achieving the goals stated at the beginning of the period.

In a parallel to this literature aimed at finding concrete solutions to

the credibility problem, options have since been developed by Barro
and Gordon (1983), Backus and Driffill (1985) , and Canzoneri
(1985) who brought an explanation of the lack of credibility using
game theory refinements. The “rules versus discretion” debate has
become a “credibility versus flexibility” debate. Canzoneri
introduces the concept of private information in the game between
agents and the central bank; the latter has information that agents do
Warin: Monetary Policy: From Theory to Practices 16

not have. Canzoneri explains that when agents play a cooperation

strategy, in other words not including an inflationist bias in their
expectations, the central bank has a real interest in not playing a
cooperation strategy, but cheating. He demonstrates that the
equilibrium between both players is when they play a non-
cooperative strategy. He justifies the fact that the inflationist bias
always exists except if one finds a way to force the central bank to
remain in the cooperative equilibrium. He explains the idea that the
inflationist bias stemming from temporal inconsistency is the
outcome of non-cooperative strategies from players.

In retrospect, whatever the methodology used to study the

inflationist bias is (Barro and Gordon, Backus and Driffill,
Canzoneri or Fratianni and Waller) solutions seemed to tend
towards a rule of monetary production rather than discretionary
intervention of the central bank. However, for some authors,
monetary authorities must continue to play a key role, not only in
the respect of the rule, but also in the absorption of exogenous
shocks by an adequate monetary policy. For instance, at the
international level, the monetary policy must remain discretionary;
if one wants to avoid destabilizing economic policies, one must link
the national monetary policy to a stable international monetary
system through a fixed but adjustable exchange rate mechanism.
Thus, when there is no shock, the country will import the low
inflation from the international system, but in case of an economic
shock, one would keep all latitude to absorb it via expansionary
monetary policy.

The study of exchange rate mechanisms has closely accompanied

the literature about optimal currency areas (Mundell 1961). The
exchange regime’s integration in the economic analysis seems
obvious due to its close relationship with the practice of monetary
policies. A fixed exchange rate mechanism disciplines the central
bank through integrating it in an international monetary system, yet
allows it to act independently in the very short-run, if necessary.

If one compares both approaches, credibility enhancing and fixed

exchange rate systems, the former does not consider the open
economy model, while the latter is built upon it.
Warin: Monetary Policy: From Theory to Practices 17

The next question is to know whether it is possible, and desirable, to

look at the credibility concept while introducing the open economy
assumption. The international pressure on the national monetary
policy must be included in the study of the credibility of a central
bank. First, it is question of confronting a central bank to another
bank to measure the impact of a lack of credibility on the exchange
rates. Then, it is necessary to consider the exchange rates by
themselves. Indeed, it seems impossible to constrain the question of
monetary policy to a closed-economy model, and moreover the
study of optimum currency areas (Mundell 1961). Policymakers in
open economies face a macroeconomic trilemma (Obstfeld,
Shambaugh and Taylor 2004):
1. To stabilize the exchange rate;
2. To enjoy free international capital mobility;
3. To engage in a monetary policy oriented toward domestic
goals.

While the second item is a given, and the third is the goal, the first
item is the adjustment variable: in case of an inappropriate
monetary policy, the exchange rate will adjust to the new economic
conditions. One can imagine a large risk premium due to the lack of
credibility of one currency on the world market.

Some authors have started to work in this direction. In the field of

European monetary integration, De Grauwe (1992) used a
methodology close to Barro and Gordon (1983) to measure the
differences in terms of credibility between two countries of the
European Union. Martin (1996) includes the exchange rates in a
model built upon the assumptions drawn from Barro and Gordon
(1983) in order to respond to a precise question: the relevance of the
excluded countries from the euro zone.

In the consideration of the open economy assumption, it seems

interesting to try to ascertain what changes in the strategies of
players, and to measure the impact on exchange rates. From there, it
would be possible to determine the criteria according to which an
exchange rate regime is more credible than another. To this end, the
work by Herrendorf (1999) opens a path. This author develops a
reputatio n model with information asymmetries in an open
economy setting and opposes flexible exchange rates with the
Warin: Monetary Policy: From Theory to Practices 18

argument that asymmetry generates instability. With the birth of the

Economic and Monetary Union, as well as with the discussions
around new moneta ry unions, these questions are very relevant.

In both a fixed and flexible exchange rate mechanism, the

inflationist bias is prevalent. The realization conditions, and the
conditions for the success of a monetary union, have to be analyzed
using the inflationist bias concept. If a country is part of a fixed
exchange rate mechanism, its credibility is not reliant upon its
decisions. If it is part of a flexible exchange rate mechanism,
integration into a fixed exchange rate zone is a means to improved
credib ility (Herrendorf 1999, Melitz 1988).

The stakes are high, as the European Economic and Monetary

Union has become an example for Mercosur, Northern Africa, and
Northern America.
Warin: Monetary Policy: From Theory to Practices 19

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