Working Paper

The advantage of transparent instruments of monetary policy

Abstract: A classic question in international economics is whether it is better to use the exchange rate or the money growth rate as the instrument of monetary policy. A common argument is that the exchange rate has a natural advantage since exchange rates provide signals of policymakers? actions that are easier to monitor than those provided by money growth rates. We formalize this argument in a simple model in which the government chooses which instrument it will use to target inflation. In it, the exchange rate is more transparent than the money growth rate in that the exchange rate is easier for the public to monitor. We find that the greater transparency of the exchange rate regime makes it easier to provide the central bank with incentives to pursue good policies and hence gives this regime a natural advantage over the money regime.

Keywords: Monetary policy - Mathematical models; Foreign exchange rates; Inflation (Finance) - Mathematical models;

Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Working Papers

Publication Date: 2001

Number: 614