Monetary Policy and

Central Banking
Topic:
The economic issues behind the
conduct of monetary policy
 Economic issues behind the conduct of
monetary policy
• In the past decade, significant changes in the design and conduct
of monetary policy have occurred around the world. Many
developed and developing countries have adopted inflation-
targeting regimes, and 11 European countries formed the
European Monetary Union in 1999. These events and the need for
providing guidelines for appropriate institutional design have
been a crucial impetus in the current interest in monetary policy
issues in academic research and policymaking circles.
 Economic issues behind the conduct of
monetary policy
1. Exchange Rate
Exchange rates play a significant role in monetary transmission mechanism
and at the same time, it can have a large impact on inflation rates. Although
the BSP has adopted the inflation targeting approach, it may be tempted to
inexplicitly target exchange rate to achieve its low inflation target.
The issue here is the extent of the exchange rate pass-through or ERPT
to domestic prices since higher ERPT would require the BSP to shift its
attention to exchange rate movements to stabilize prices.
 Economic issues behind the conduct of
monetary policy
2. Role of Monetary Aggregates
Since the shift to inflation targeting, BSP has already abandoned
monetary aggregates because its information content has apparently
declined in the recent years. Moreover, it is also assumed that a shift
of approach was necessary because money aggregates are normally
not good indicators of future economic policy requirements due to
unreliability of measurement.
 Economic issues behind the conduct of
monetary policy
3. Measurement of Inflation
Since inflation targeting leads to lower and stable inflation rates, more
improvement should then be given to the measurement of the consumer
price index since few percentage points have greater repercussions when
rates are low. Errors in CPI (Consumer Price Index) measurement could
lead to ineffective and unsuitable monetary policy response by the
BSP which definitely result to detrimental effects to the economy
 Economic issues behind the conduct of
monetary policy
4. Another issue arising from monetary policies is the liquidity trap.
This happens when inflation rate declines too much leading to a
threat of deflation.
Liquidity trap is defined as a situation in which there are zero
nominal interest rates, persistent deflation and deflation expectations. In
the event this occurs, bonds and money earn the same real rate of
return thus making people indifferent to holding bonds or excess money.
 Economic issues behind the conduct of
monetary policy
5. Budget Deficit and External Debts
Given high budget deficits, the government is concerned about two closely
related issues: it does not want to pay very high interest on its borrowings
and it does not want to crowd out the market. Ideally, the government
could raise tax revenues to avoid borrowing huge sums from the market.
However, the government opted to borrow from the international capital
market and though rates are low, these have shorter maturity and country's
outstanding external debt has continued to move towards a less ideal position.
 Economic issues behind the conduct of
monetary policy
6. Fiscal Dominance
According to the fiscal theory of the price level, it is not the non-interest
bearing money but the total nominal liabilities including interest bearing
notes and future fiscal surpluses that matter for price-level determination. In
the absence of fiscal discipline, an independent central bank such as the BSP
cannot guarantee a stable nominal anchor. In other words, for the BSP to
successfully focus on price stability, there must be a credible commitment on
the part of the National Government to reduce total fiscal deficits by a
meaningful amount.
END OF REPORT

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