The Advantage of Transparent Instruments of Monetary Policy, Issue 8681
National Bureau of Economic Research, 2001 - Monetary policy - 36 pages
Is the exchange rate or the money growth rate the better instrument of monetary policy? A common argument is that the exchange rate has a natural advantage because it is more transparent: it is easier for the public to monitor than the money growth rate. We formalize this argument in a simple model in which the government chooses which instrument it will use to target inflation. We find that when the government cannot commit to its policies, the greater transparency of the exchange rate makes it easier to provide the government with incentives to pursue good policies. Hence, transparency gives the exchange rate a natural advantage over the money growth rate as the monetary policy instrument.
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Alberto Alesina best and worst best equilibrium best money regime best payoff chooses a low choosing an exchange continuation value function current action current period payoff David Laibson denote domestic inflation shocks domestic shocks economy starting exchange rate regime Fiona Scott foreign inflation shocks government and agents government can commit government cannot commit government chooses government's choice government's continuation value government's payoffs Hence high money growth history ht incentive compatible incentive constraint 12 instrument of monetary Lemma low money growth mean inflation rate Michael Woodford monetary policy instrument money growth rate natural advantage NBER Working Papers noisy signal normally distributed Number optimal continuation value perfect equilibrium payoffs problem Proposition realized inflation recursive regime is preferred regime is strictly repeated game second-order condition sets the mean starting in period static Nash outcome strictly higher trigger strategies variance of domestic variance of foreign worst equilibrium payoff worst money regime worst payoff www.nber.org