73 ECON3005 Monetary Theory & Policy - UNIT 3
Unit 3
Monetary Policy Strategies
Overview
Previously, we looked at the main entity that conducts monetary policy and in this Unit,
we will discuss how monetary policy is conducted, as we closely examine the various
monetary policy strategies which can be adopted by a Central Bank and which include
Exchange rate targeting, inflation targeting, monetary targeting and the implicit nominal
anchor (that has been used by the USA).
The main feature in conducting monetary policy strategies is the use of a nominal anchor.
We will define what a nominal anchor is and discuss its role in achieving a successful
monetary policy. Nominal anchors can reduce the time-consistency problem, so we will
define this term and show how it is reduced. We will then compare and contrast the
various monetary policy strategies adopted by countries (as stated above). We will first
examine inflation targeting and exchange rate targeting. Then we will look at monetary
targeting and the case of the United States, which uses an implicit nominal anchor. We
will also give the pros and cons for each approach. As such, students should be able to
analyse the monetary policy strategies adopted by various countries, both internationally
and within the CARICOM region.
Lastly, we will discuss cu
ency boards and dollarization as an exchange rate targeting
mechanism. Cu
ency boards and dollarization is a special type of exchange rate targeting
mechanism which you may be familiar with in the Eastern Cari
ean. As such, we will
look at it separately.
Unit 3 Learning Objectives
By the end of this session you will be able to:
1. Clearly define and explain the role of a nominal anchor in ca
ying out monetary
policy in an economy.
2. Explain how the time-consistency problem is reduced via the use of a nominal anchor.
3. Explain what exchange rate targeting, inflation targeting, and monetary targeting are.
4. Discuss the advantages and disadvantages of exchange rate targeting, inflation
targeting, and monetary targeting, providing at least one example of a country that
uses each as a monetary policy strategy.
74 ECON3005 Monetary Theory & Policy - UNIT 3
5. Explain what a monetary policy strategy with an implicit nominal anchor is, and the
advantages and disadvantages of the strategy.
6. Distinguish between cu
ency boards and dollarization as a form of exchange-rate
targeting strategy.
7. Give examples of countries that adopted cu
ency boards and dollarization as a main
monetary policy strategy.
This unit is divided into three sessions as follows:
Session 3.1: The nominal anchor and its role in monetary policy
Session 3.2: The Monetary Policy Strategies: Exchange-Rate Targeting, Monetary
XXXXXXXXXXTargeting, Inflation Targeting, Use of an Implicit Nominal Ancho
Session 3.3: A deeper look at Exchange Rate Targeting: Cu
ency Boards and Dollarization
Unit Readings and Additional Online Resources
Required Readings
Mishkin, F XXXXXXXXXXMonetary Policy, NBER Reporter: Winter 2001/2002. Retrieved from
http:
www.nber.org
eporte
winter02/mishkin.html
Supplementary Readings
Roberts, D XXXXXXXXXXThe Appropriateness Of Intermediate Monetary Targets Adopted By
Cari
ean Economies, United Nations Association of Guyana. Retrieved from
http:
sta.uwi.edu/conferences/09/salises/documents/D%20Roberts.pdf
Additional Online Resources
Session 1:
1. Quantity Theory of Money:
Economics: The Quantity Theory of Money [Video file]. Retrieved from
http:
www.youtube.com/watch?v=Of74AhZlRK8
The Quantity Theory of Money [Video file]. Retrieved from
http:
www.youtube.com/watch?v=S-6SC1o6R8A
Session 2:
1. Information on European Monetary Strategy
European Central Bank’s 2 of 3 Monetary Policy Strategy [Video file]. Retrieved from
http:
www.youtube.com/watch?v=lIXlpsrTjAA
2. Information on Canada Monetary Strategy:
Bank of Canada: Count On Us [Video file]. Retrieved from
http:
www.youtube.com/watch?v=ULqvuY2penk&feature=plcp&context=C4f
http:
www.nber.org
eporte
winter02/mishkin.html
http:
sta.uwi.edu/conferences/09/salises/documents/D%20Roberts.pdf
http:
www.youtube.com/watch?v=Of74AhZlRK8
http:
www.youtube.com/watch?v=S-6SC1o6R8A
http:
www.youtube.com/watch?v=lIXlpsrTjAA
http:
www.youtube.com/watch?v=ULqvuY2penk&feature=plcp&context=C4f
75 ECON3005 Monetary Theory & Policy - UNIT 3
The Nominal Anchor and its Role in Monetary
Policy
Introduction
A monetary policy, that is too rigid or tight, can negatively impact the economy by
sharply reducing aggregate demand, hence reducing economic growth and increasing
unemployment1. On the other hand, an overly expansionary monetary policy, which
increases the money supply in an economy, may cause high inflation, which also has
drastic effects on the economy. Both high inflation and drastically low levels of inflation
(deflation) have negative consequences on the economy. One tool used to used to keep
inflation “in check” at an appropriate level is the nominal anchor. You will later learn that
a nominal anchor is also used in other types of monetary policy strategies. This is why we
have chosen to examine it for the topic of discussion in this first session.
Session 3.1 Objectives
At the end of this session, you will be able to:
1. Explain what a nominal anchor is.
2. Examine the function of the nominal anchor in monetary policy and as a part of other
monetary policy strategies.
3. Define the time-consistency problem.
4. Explain how the nominal anchor reduces the time consistency problem.
Session 3.1
1 A tight monetary policy means a reduction in the money supply to increase interest rates and reduce spending in the
economy. This is used as an attempt to cu
inflation in an economy. Remember, from the last unit, one way of reduc-
ing the money supply is through the sale of government bonds. The central bank can also increase the discount rate.
By reducing the money supply, this leads to an increase in the interest rate which is synonymous to an increase in the
cost of bo
owing; which effectively reduces its attractiveness. As aggregate demand is reduced, growth levels (GDP)
falls. Moreover, as people invest and spend less, and businesses have less demand for its products – they cut back on
production. In some cases, people are laid off in the process – people and resources are unemployed.
76 ECON3005 Monetary Theory & Policy - UNIT 3
The Nominal Ancho
Figure 3.1: Anchor Silhouette Marine Boat Ship Fix Black
Source: pixabay.com (n.d.). Retrieved from http:
pixabay.com/en/anchor-silhouette-marine-
oat-ship-155220/ Creative commons licence Public Domain Clipart.
What comes to mind when you see the picture above? What is it used for? What is its main
purpose?
It is an anchor, particularly a ship’s anchor. It is used to keep a boat or ship stable when it
is out at sea or even on land when resting in the sand. According to the Oxford dictionary
(2013), an anchor is “a heavy object attached to a cable or chain and used to moor a ship
to the sea bottom” (Anchor section, para. 1). In fact, the alternative definition clearly sums
up the objective of an anchor, “a person or thing which provides stability or confidence in
an otherwise uncertain situation” (Anchor section, para. 2) This is the foundation you will
need to understand the first concept in this Unit, the nominal anchor. Nominal Anchor
just as an anchor is a device used to keep a ship stable and prevent it from drifting, a
nominal anchor is used to keep the price level stable and under control.
77 ECON3005 Monetary Theory & Policy - UNIT 3
USEFUL LINKS/RESOURCES
As mentioned in the last unit, price stability is one of the main goals of monetary policy. In
fact, many countries consider it the main objective of monetary policy. A nominal anchor is
a variable used to establish a price level (for example, the inflation rate, an exchange rate,
or the money supply), as a target for achieving a goal, such as price stability. Therefore, the
main intention is for the nominal anchor variable to stay within a na
ow range.
An Example of a Nominal Ancho
If a monetary authority sets a nominal anchor of 10 percent inflation, it then uses its
various tools and strategies to achieve that target.
When a country uses a nominal anchor, the monetary authority (the central bank) is forced
to keep the nominal anchor variable (inflation rate or money supply) within a certain
ange. Therefore, the growth in the money supply and the inflation rate is kept in check.
How does A Nominal Anchor Work?
How can keeping the money supply and inflation
in check, lead to price stability? You should recall
that there is a direct link between the money
supply and the price level.
In the quantity theory of money equation, MV=PY,
where V and Y are assumed to be constant and
fixed. Any change in the money supply, M, will
have a direct and proportional change in the price
level, P. If there is an increase in the money supply,
the price level tends to increase2. Conversely, a
eduction in the money supply leads to a fall in
the price level3. Likewise, when the inflation rate
is kept at a certain level, the authorities are directly trying to keep the price level stable at
a given rate. In both ways, the nominal anchor promotes price stability.
Understanding the Quantity of Money Theory
To help you understand the quantity of money theory even better, please visit the following
videos found at URLs:
• Economics: The Quantity Theory of Money [Video file]. Retrieved from
http:
www.youtube.com/watch?v=Of74AhZlRK8
• The Quantity Theory of Money [Video file]. Retrieved from
http:
www.youtube.com/watch?v=S-6SC1o6R8A
2↑ Money Supply → ↓ Interest rates → ↑ Aggregate Demand → Price level.
3↑ Money Supply → ↑ Interest rates → ↓ Aggregate Demand → ↓ Price level.
http:
www.youtube.com/watch?v=Of74AhZlRK8
http:
www.youtube.com/watch?v=S-6SC1o6R8A
78 ECON3005 Monetary Theory & Policy - UNIT 3
The Nominal Anchor therefore preserves the value of a country’s money because it
keeps the price level from growing or falling too fast. A nominal anchor of some sort is a
necessary element in successful monetary policy strategies.
Time Consistency
A nominal anchor can be used in some of the monetary policy strategies to reduce the time
consistency (sometimes also refe
ed to as time inconsistency) problem.
What is Time Consistency?
Time consistency, or time inconsistency, is defined as a situation in which an agent, planner
or objective maximizer must make a choice about an action or decision in a future plan
which is optimal initially but is no longer optimal at a later date. This change in what is
optimal, occurs despite the fact that nothing new is learned and no physical circumstances
change, except that decisions of the past are locked in place (Swanson, n.d.).
In fact,