Working Paper: CEPR ID: DP7001
Authors: Avia Spivak; Nathan Sussman
Abstract: Financial globalization has seen the emergence of a new monetary standard based on inflation targeting. At the same time the most financially advanced economies moved away from exchange rate targeting which also characterized the previous era of globalization - the era of the Classical Gold Standard. Does the new financial environment of free capital flows constrain the independence of central banks to conduct monetary policy? We argue, and show empirically, that credible inflation targeting allows central banks to conduct an independent monetary policy as manifested in their ability to deviate from the world (Fed) interest rate. This new regime, with exchange rate flexibility, generates sufficient short term volatility that prevents short term arbitrage against central banks that deviate from the Fed rate. In contrast, during the Gold Standard only limited deviation was possible within the 'gold points'. On the other hand, the credibility of inflation targeting regime is as good as gold in anchoring inflation expectations for the long run as manifested in strong co-movement and similar levels of long term borrowing rates- just as was the case during the gold standard. We conclude that inflation targeting allows more flexibility than the Gold Standard to conduct monetary policy in the short run and has similar benefits for long term stability. We suggest that it is the new golden rule.
Keywords: credibility; exchange rate variability; gold standard; inflation targeting
JEL Codes: E31; E4; E42; E43; E44; E55; E58; F3; F33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Credible inflation targeting (E52) | Independence in monetary policy (E58) |
| Independence in monetary policy (E58) | Deviation from Federal Reserve's interest rate (E43) |
| Inflation targeting (E31) | Long-term stability in borrowing rates (E43) |
| Inflation targeting (E31) | Flexibility in short-term monetary policy (E52) |
| Volatility of exchange rates (F31) | Flexibility for central banks (E58) |
| Inflation targeting (E31) | Anticyclical policies (E63) |
| Inflation targeting (E31) | Reaction function of central banks (E52) |
| Central banks' reaction function (E52) | Band of interest rates around Fed rate (E43) |
| Inflation targeting (E31) | Influence of global financial markets (F65) |