The choice of monetary policy and its relevance for economic performance: empirical evidence from a global perspective.

AuthorDoroftei, Irina Madalina
PositionReport

Introduction

One would think that in our modern society in which central banks are taken for granted as institutions operating the monetary policy of a country (and capable of generating miracles during financial crises) economists have reached a consensus on several issues. What is certain is that today central banking means that a governmental authority (somewhat independent of the political influences of the government, but sometimes part of the government and Ministry of Finance) is in charge of discretionary monetary management, creating and controlling (or at least trying to control) the money supply in a certain country/region, holding monopoly over such activity, managing the country's international reserves, and regulating the banking system. This implies a couple of functions such as lender of last resort for the banking system, the bankers' bank and the imposition of certain requirements on the system. After many severe financial crises, central banks have assumed not only the purpose of achieving price stability, but also that of achieving financial stability. Yet, other fundamental enquiries deserve our attention. For example, what is money and how does it influence the overall economy? What impact on the economy does monetary policy have and how should central banks exercise it? Does money have a role in the conduct of monetary policy? Surprisingly, there is considerable disagreement over the answers to the questions above, from both academic and professional point of views.

The 20th century debate focuses on the neutrality of money: does increasing the money stock impact real variables such as real interest rates, employment or output? Nowadays, most economists (including monetarists and Keynesians, but not real-business cycle proponents who assume neutrality) agree that there is a short-term effect of monetary changes over output, but that in the long run, money is neutral (Brunner and Meltzer, 1993). Still, Austrian economist Mises (1912) demonstrated that money will have an impact on relative prices and incomes in the end, changing even the structure of production in the economy. The so-called modern literature begins with Tobin's 1965 article "Money and economic growth", published in Econometrica. In a fiat money system, Tobin's portfolio shift would mean that if non-interest-bearing money is considered to be an asset, then people can be induced to "shift" their savings in more productive forms--i.e. real capital. The result of his "descriptive" model is that faster money growth (and, thus, faster inflation) will increase the capital stock and output per person (Orphanides and Solow, 1990), though not the rate of real growth, as noted by the two authors. The debate is not over yet: many empirical studies have tried tackling the neutrality issue with inconclusive results, assessing whether monetary policy influences macroeconomic performance.

The 19th century debate introduced the idea of one monetary authority "producing" money, thus institutionalizing the concept of central bank, while Walter Bagehot (1826-1877) described the 'lender of last resort' role that the Bank of England should have--i.e. helping banks in distress, lending them liquidity in order to avoid disaster in the whole banking system--institutionalizing the prototype of the modern central bank. The free-banking option was left out of the equation for good. Thus, today, monetary policy represents the sum of actions and activities undertaken by a central bank--using instruments such as interest rates, reserves, base money creation etc.--with the purpose of achieving its objectives (for example, maintaining price stability). The statutory objectives are usually set through different Acts governing the central bank (Treaty on the Functioning of the European Union, Article 127 (1) in the case of the European Central Bank (ECB), the Federal Reserve Act established by the Congress in the USA etc.). Sometimes these objectives are vaguely mentioned, or cover a wide range of issues, which leaves to the central bankers to decide on the priorities of the moment (Eijffinger and de Haan, 1996). But the focus shifted in time from maintaining specie convertibility towards stabilizing the economy--real output and prices (Bordo, 2008).

Basically, a central bank may have as objective of monetary policy one or several (simultaneously) objectives from the following list (some can be conflicting among them): achieving price stability, maximum employment, economic growth, interest-rate stability, stability of financial markets, stability in foreign exchange markets, stability of its monetary unit etc. The central bank reaches the objectives through a monetary policy strategy--which can be inflation targeting, interest rate targeting, monetary aggregates targeting, output gap targeting or exchange rate targeting. Generally speaking, the aim of targeting is to achieve the monetary policy objective by focusing on the deviations of the target (be it inflation, interest rate, money growth etc.) from a pre-announced target and trying to bring the target as closely to the pre-announced one by using its policy instruments (interest rates, reserve requirements, money printing etc.). The conduct of monetary policy evolved from money aggregates targeting to interest rates targeting, to the now widely used in developed countries inflation targeting (Goodhart, 1992). Price level targeting may seem to be the next step. The changes in the priorities of central banks occurred as a result of trials and errors--when monetary targeting didn't give the expected results the central bank moved to another strategy and so on. The central bankers would change objectives and strategies when finding it appropriate, depending on the circumstance of the time--at least those having discretionary power.

Given the various objectives and strategies a central bank can use in the conduct of monetary policy, two issues arise. We intend to tackle them in our article. Firstly, our purpose is to assess whether there are differences in economic performance among countries with different monetary policy objectives and strategies Secondly, we are interested in whether monetary policy has an impact over the national economy or not. The next section reviews the academic literature approaching the subject. Section 3 and section 4 explain the research methodology and the data sample used. Section 5 assesses the results of the discriminant analysis framework we employed and, finally, section 6 concludes and illustrates the most important findings of our research.

The Role of Monetary Policy for Economic Growth

By investigating monetary policy frameworks around the world, we reached the conclusion that it is not easy to establish the monetary strategy one country uses. Not every central bank has a clear-cut targeting strategy and many use a mix of objectives and targets. A problem of methodology arises as not all central banks use the same meaning of monetary stability and price stability, for example. Moreover, central banks use different forms of direct inflation targeting--the prevailing monetary strategy in the world--, having in common the numerical target and the time horizon as elements announced officially in the policy framework (ECB, 2011). Some central banks conduct discretionary policy or do not define their monetary policy strategy explicitly. Others, such as the Federal Reserve System define it as eclectic, combining various macroeconomic targets, objectives and monetary instruments. The European Central Bank itself uses a two-pillar approach, based on economic and monetary analysis in order to assess the risks to price stability. The ECB's approach is similar to inflation targeting, but is not defined as such--the European monetary strategy differs especially by taking into account a diversified range of analytical methodologies in order to analyze the available economic data (ECB, 2011).

When researching on the influence of monetary policy on economic performance we try to evaluate whether the choice of monetary objectives and monetary strategies has an impact on several macroeconomic variables. The task is a difficult one, as the trend in central banking has been to adopt a price stability objective and an inflation-targeting regime. Still, there remain a consistent number of central banks who operate different strategies, in order for us to be able to make an approximate assessment. Also, the case of managed floating as monetary strategy operating with interest rates and exchange rates targets has been made. Under the International Monetary Fund's supervision, many states adopted officially a flexible exchange rate and renounced to exchange rate targeting. But an enquiry of 44 countries during 1975-2000 showed that 77% of the free-floating regimes were actually under an exchange rate targeting regime (Bofinger and Wollmershauser, 2003).

During the 80s and 90s many academic studies found that inflation rate (as a proxy for monetary policy) and output growth are negatively correlated on the long run (Haslag, 1995; Chari, Jones and Manuelli, 1995). Nevertheless, some evidence exists that inflation stimulates on the short run the output growth (Gomes, 2006), without taking into account the negative implications over the long run. Reed and Ghossoub (2012) evaluate the effects of monetary policy depending on countries' economic development level. They consider the Tobin effect and reach the conclusion that developed countries provide an environment where inflation is conducive to capital accumulation, as opposed to developing countries, positioned in lower stages of economic development, where inflation harms capital formation. Miao and Xie (2007) consider the 'money illusion' (confusion between nominal and real magnitudes) and agents' aversion to risk in their assessment of monetary policy and economic growth. Accordingly, inflation and economic growth are...

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