Designing Monetary Policy for Developed and Developing Countries

Summary of research findings
This study analyses the policy implications of international financial market frictions for developing countries. It also looks at how developing countries can deal with monetary stabilisation when the public perceives the Central Bank as a weak institution. Focusing on developed countries, it examines wage setting practices and analyses how fiscal stabilisation affects the performance and the optimality of inflation targeting. It considers how how limits to the amount that countries can borrow in the international capital market affect their policy stabilisation problem. The work also pays special attention to the role of central bank communication with the public.

Key Findings

Limits to the amount that countries can borrow in the international capital market affect their policy stabilisation problem.
• Financial crises in emerging market economies in the 1990s have been characterised by an abrupt decline in capital flows and a large decline in output. Recent models have replaced the assumption of perfect financial markets with plausable financial frictions which take the form of collateral credit constraint.
• The ability to borrow from foreigners is limited by the value of the collateral and the occurrence of the crises is an endogenous outcome of the model.
• Optimal stabilisation policy is highly non-linear.
• If the credit constraint is not binding, optimal policy would mimic the one that would arise in an economy without a credit constraint.
• If the credit constraint is binding, policy reacts by relaxing the constraint through an increase in the value of the collateral.
• Financial consideration might be an important determinant of stabilisation policy.

Interaction between fiscal and monetary policy for developed economies

• The more open the economy, the more volatile are taxes and the real exchange rate.
• The timing of policy intervention by Central Banks matters for the behaviour of output and employment.
• For countries that plan to adopt inflation targeting, credibility associated with the inflation target is an important component of the monetary policy framework since it allows a reduction in volatility and persistence of inflation.
• The frictions in the credit market, as in the current sub-prime crisis, might undermine the robustness of inflation targeting.

Communication with the public determines the degree of uncertainty faced by central banks
• The central bank is subject to wide range of uncertainty. One way to cope with it is to make use of information financial markets provide.
• By reducing the uncertainty that financial-market participants face about the future course of monetary policy, the central bank can manage market expectations about future nominal interest rates and inflation.
• The two directions of communication are complementary. When the inflation target is credibly observable by the public, the central bank can extract enough information about the aggregate state of the economy by looking at financial markets. Thus central bank can stabilise inflation around its target value.
One of the contributions of this work is in providing the welfare metric for the determination of optimal policy for the small open economy and for the small open economy subject to constraints as in the Maastricht treaty.

Key publications

Aoki, Kosuke, Benigno, Gianluca and Kiyotaki, Nobuhiro (2009) CEP Discussion Papers, 921. Centre for Economic Performance, London School of Economics and Political Science, London, UK

Aoki, Kosuke and Benigno, Gianluca and Kiyotak, Nobuhiro (2007) London School of Economics and Political Science, London, UK

Benigno, Gianluca and Theonissen, Christoph (2006) Centre for Economic Performance, London School of Economics and Political Science, London, UK


Journals, seminar papers and other publications:
K. Aoki & T. Kimura, “Uncertainty about Perceived Inflation Target and Monetary Policy”, unpublished manuscript

Barnichon, Olivei & Tenreyro, “Time-Dependent Effects of Monetary Policy: Evidence from Japan and Europe”, unpublished manuscript

Benigno & De Paoli, “Optimal Fiscal and Monetary Policy for a Small open Economy”, unpublished manuscript


Contact:
Dr Gianluca Benigno
Department of Economics
London School of Economics
Houghton Street
London
WC2A 2AE

Tel: 020 7955 7807
email:

Duration of Research:
June 2006 - May 2008