Monetary Policy Under an Exchange Rate Anchor

Abstract

This paper argues that there is scope for monetary policy under an exchange rate anchor, and discusses the related monetary policy design and implementation. It shows that the exchange rate can be used as the main monetary policy instrument while the policy rate can target the exchange rate. An exchange rate anchor is compatible with an inflation objective, provided fiscal dominance is not an issue, monetary conditions are supportive of the peg, and the level of international reserves is adequate. The paper argues that, while an exchange rate anchor is more prone to policy inconsistencies, there is ample scope for strengthening monetary policy design and implementation under soft pegs. In that context, the principles of dichotomy and interest rate parity are critical.

Evaluating Monetary Policy Effectiveness in North Macedonia: Evidence from a Bayesian Favar Framework

“…Against this backdrop, the current version of the FAVAR framework might be extended by the ECB key interest rate and the overall size of FX flows-related to current and capital account transactions, since the latter is the driver for arbitrage between the money and FX markets, in turn shaping the nature of monetary transmission (El Hamiani Khatat et al 2020). By adding the FX flow to the framework, but also by adding certain global variables, such as the prices of food and energy commodities, the framework would become economically more consistent and flexible.…”

“…FX flow is certainly part of the monetary policy reaction function in countries with a fixed exchange rate. The ability of the central bank to calibrate the interest rate to domestic conditions may be challenging, especially when FX reserves are low, and the economy is exposed to sizeable terms-of-trade shocks (El Hamiani Khatat et al 2020).…”

“…Monetary policy implementation under an exchange rate peg as a commitment mechanism to achieve price stability is, nonetheless, more complex than a simple reaction in conformity with a certain monetary policy rule: the authorities need to not only manage the interest rate differential and close the inflation gap with the anchor country. They also must take into account the level of international reserves that are considered supportive of the credibility of the peg exchange rate arrangement (El Hamiani Khatat et al 2020). The exchange rate targeting countries may face some operational and policy challenges, including the necessity for supportive fiscal policy, and a strengthened and coherent monetary policy framework (see, for instance, Mance et al 2015) for an indepth discussion on this particular aspect for the case of Croatia), the optimal choice of monetary policy reaction function, development, and implementation of sound strategies on managing interest rate and exchange rate and selection of liquidity management framework (El Hamiani Khatat et al 2020).…”

Monetary policy and inflation targeting under global uncertainty: a SVAR approach for Tunisia

“…However, monetary targeting has had only limited success because the demand for money is often unstable, due to innovations in financial markets (Arbouch, 2022). Exchange rate targeting does not bring satisfying results in terms of price stability, especially with the current account deficit and increase in international reserves (El Hamiani Khatat et al, 2020).…”

“…Thus, rethinking of monetary Monetary policy and inflation targeting policy framework in Tunisia is still appealing. Inflation targeting, particularly, should be the perfect future destination for Tunisian monetary policy (El Hamiani Khatat et al, 2020). Without an evaluation of the effects of a policy, it is difficult to decide what it should be.…”