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Monetary Policy Rules, Asset Prices, and Exchange Rates

  • Jagjit S. Chadha

    (International Monetary Fund)

  • Lucio Sarno

    (International Monetary Fund)

  • Giorgio Valente

    (International Monetary Fund)

During the 1990s a number of African central banks succeeded in bringing inflation to relatively low levels while maintaining a market-determined exchange rate. These central banks were generally reluctant to fully subordinate exchange rate targets to monetary targets, however, particularly in the face of large external shocks. We focus on the management of highly persistent shocks to aid flows, including PRSP-related increases in net flows, in the presence of currency substitution by the domestic private sector. Such shocks have beneficent long-run effects, but when currency substitution is high they can produce dramatic macroeconomic management problems in the short run. What is the appropriate mix of money and exchange rate targeting in such cases, and the role of temporary sterilization? We analyze these and related issues in an intertemporal optimizing model that allows a portion of aid to be devoted to reducing the government's seigniorage requirement. This creates a strong link between official aid flows and private capital flows, giving rise to tradeoffs reminiscent of the literature on private capital inflows in emerging markets. When the credibility of policymakers' commitment to low inflation is firm, some degree of dirty floating, with little or no sterilization of increases in the monetary base, is the most attractive approach.

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Article provided by Palgrave Macmillan in its journal Staff Papers - International Monetary Fund.

Volume (Year): 51 (2004)
Issue (Month): 3 (November)
Pages: 529-552

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Handle: RePEc:pal:imfstp:v:51:y:2004:i:3:p:529-552
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