Monetary Policy and Exchange Rates

Abstract

Given that the monetary authorities are confident of the basic structure of the above model, know the signs but not the exact magnitudes of the parameters, and have no clear grasp over the dynamics, what is the best way for them to conduct monetary policy? Broadly viewed, the objectives of monetary policy are three in number. First, monetary growth must be such as to make the domestic price level grow at a stable rate over the long run – for developed economies that need not use an inflation tax to finance public expenditure, this inflation rate would normally be on the positive side of, but very close to, zero. Second, the stock of liquidity should, ideally, be varied around its long–term growth path in a manner that will prevent deviations of output and employment from their full–employment levels. Third, although central banks should be independent of political control, they nevertheless have to maintain public credibility – this means that they cannot appear to be creating, or allowing, unstable conditions in domestic foreign exchange and capital markets. Historically, the danger has been that this third objective might dominate the other two.