Today is Christmas Eve and in Denmark that is the most important day of Christmas (just ask my son!) so it is not really time for blogging. So instead I will do a bit of a re-run of a blog post I wrote exactly a year ago. If there is a area where my thinking about monetary policy has developed a lot over the last couple of years it is in regard to my view of exchange rates as a monetary policy instrument. As I explained a year ago:
I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US.
However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.
Furthermore, most central banks in the world today are “interest rates target’ers”. However, with interest rates effectively at zero it is mentally (!) impossible for many central banks to ease monetary policy as they operationally are unwilling to venture into using other monetary policy instruments than the interest rate. Obviously numerous central banks have conducted “quantitative easing”, but it is also clear that many (most) central bankers are extremely uncomfortable using QE to ease monetary policy. Therefore, the exchange rate channel might be a highly useful instrument that might cause less concern for central bankers and it might be easier to understand for central bankers and the public alike.
In my post a year ago I suggested that Irving Fisher’s proposal for a Compensated Dollar Plan might be an inspiration for central bankers in small open economies.
Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.
Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.
There is no doubt in my mind that the compensated dollar plan demonstrates that even though there is a “zero lower bound” for interest rates there is no limits to monetary easing. There might be a zero lower bound, but there is no liquidity trap. However, I have reservations about the compensated dollar standard in its original form. As I explained a year ago:
There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.
From a Market Monetarists perspective I, however, have three reservations about the idea.
First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.
Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.
Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.
These reservations led me to suggest a “updated” version of the compensated dollar pan for small open economies:
My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).
Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).
No more blogging for today – Merry Christmas to all of my readers around the world.
Reykjavik here I come – so let me tell you about Singapore
Sweden, Poland and Australia should have a look at McCallum’s MC rule
Reading recommendation for my friends in Prague
Exchange rate based NGDP targeting for small-open economies
Imagine that a S&P500 future was the Fed’s key policy tool