Actual monetary policy independence in a small open economy: the Polish perspective

Łukasz Goczek,Dagmara Mycielska

doi:10.1007/s00181-017-1370-y

Abstract

The aim of this article is to examine the actual degree of monetary policy independence in a small open economy with floating exchange rate that is integrated with the world economy. It is frequently argued that for such a country the primary cost of participation in a currency area is the loss of monetary policy independence. The article raises the question if the proposition of monetary independence provided by floating exchange rate applies to a small open economy, operating within highly liberalised capital flows and highly integrated financial markets. We examine the actual degree of monetary policy independence in Poland using a vector error correction mechanism model and the data for the years 2001–2014. We obtain evidence pointing to the lack of such independence, and we show that this result is robust to extensive changes in specification, including impulse saturation.

Highlights

The assumption of monetary policy independence in an open economy with floating exchange rates lies at the heart of most analyses concerning the effects of the European Monetary Union (EMU)
This depreciation is costly both in terms of balance sheet effects and inflation. These factors should be incorporated into the small open economy’s central bank loss function, which would give the monetary authority of the small open economy an incentive to use the interest rate to carry out the adjustment instead of allowing its currency to depreciate
The authors do not discuss the diagnostic problems, which we found to be relevant for weekly frequency of interest rates in the case of Poland

Summary

Introduction

The assumption of monetary policy independence in an open economy with floating exchange rates lies at the heart of most analyses concerning the effects of the European Monetary Union (EMU). Monetary policy independence is understood as the ability of the central bank to set interest rates independently of international rates (Aizenman et al 2013) This can be questioned especially in terms of small open economies with highly integrated financial markets. This depreciation is costly both in terms of balance sheet effects and inflation These factors should be incorporated into the small open economy’s central bank loss function, which would give the monetary authority of the small open economy an incentive to use the interest rate to carry out the adjustment instead of allowing its currency to depreciate. A monetary authority in the small open economy may not enjoy monetary independence even under a more flexible exchange rate regime because it lacks credibility

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Conclusion