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The monetary-policy strategy is the link between the monetary-policy instruments and the monetary-policy objective.
In many countries the objective of monetary policy is to maintain price stability, which is generally taken to mean very low and stable inflation. In pursuance of this objective, many central banks in practice make use of an intermediate target. Examples of intermediate targets are the exchange rate, the monetary development and inflation targets.
Under Denmark's fixed-exchange-rate policy, the intermediate target of monetary policy is the exchange rate vis-à-vis the euro. Danmarks Nationalbank pursues a monetary policy that ensures a stable krone rate vis-à-vis the euro.
Central banks conduct monetary policy using monetary-policy instruments, most often a short-term interest rate. The most important interest rates in Danmarks Nationalbank's monetary-policy instruments are the discount rate, the current-account rate and the lending rate. The latter is equal to the interest rate for certificates of deposit.
Monetary-policy performance is also affected by other factors besides the elements of the monetary-policy strategy. Central banks' independence of the political system in the implementation of monetary policy is considered to play an important role. This creates the best conditions for price stability. Like most other central banks, Danmarks Nationalbank is an independent central bank.
Sustainable fiscal policy and a clear division of labour in economicpolicy enable the central bank to better fulfil its objective. In Denmark, the division of labour is explicitly stated: the monetary policy is aimed at ensuring a stable krone vis-à-vis the euro, while stabilising domestic economic development rests with fiscal policy.
In the last decades, monetary policy has become more transparent. Central banks now issue more information than before regarding their tasks, objectives and decisions. This enables the outside world to gain more insight into monetary-policy decisions.
Credibility is another important factor for a successful monetary policy. Irrespective of whether the objective is to stabilise the exchange rate or to reach e.g. an inflation target, the success of the policy depends on general public confidence that the central bank can and will pursue the chosen strategy.
It is generally accepted that the overall objective of economic policy should be to ensure a high standard of living. A high rate of employment, sustained high economic growth and price stability are often specifically cited as objectives for macroeconomic policy, of which monetary policy and fiscal policy are elements.
In many countries, an independent central bank is responsible for monetary policy. The historical background to the separation of monetary policy from the political system was the limited success with the same institution being responsible for central-government expenditure and for monetary policy. There are numerous examples of how public spending was financed via the central bank's printing of more and more banknotes. In these cases, the consequence of monetary financing was often that money lost its value due to high inflation.
Politicians have sought to maintain citizens' confidence in the issue of money by assigning the responsibility for monetary policy to the central bank. In connection with the delegation of tasks a framework is drawn up for the central bank's functions, often as a central bank act, of which the monetary-policy objective is an important element. The overall objective of monetary policy is defined at the political level, but there is variation in the degree to which the central bank determines the more specific objective, cf. e.g. Cukierman (1998).
As the central bank of Denmark, Danmarks Nationalbank is responsible for monetary policy, including determining the monetary-policy interest rates and designing the monetary-policy instruments. This responsibility is stated formally in the Danmarks Nationalbank Act of 1936. The Act also stipulates that Danmarks Nationalbank shall be the sole issuer of banknotes. According to the Danmarks Nationalbank Act, the objective of Danmarks Nationalbank is "to maintain a safe and secure currency system and to facilitate and regulate the circulation of money and the extension of credit". The Act empowers Danmarks Nationalbank to work to stabilise the purchasing power of the krone. At the same time, Danmarks Nationalbank must contribute to the smooth and stable functioning of the financial system.
A well-functioning financial system facilitates desired transactions. This ensures that the savings and investment financing planned by private individuals and business enterprises can be transacted smoothly without being impeded by shortcomings in the functioning of the financial markets.
The objective of stabilising the purchasing power of the krone is pursued via monetary policy aimed at stabilising the value of the krone vis-à-vis the euro. A credible stability-oriented monetary policy also provides a framework for a stable financial system.
In recent years many central banks have given greater weight to the ob-jective of price stability. According to the provisions forming the framework for the European System of Central Banks (ESCB), the primary objective is to maintain price stability. Without prejudice to price stability, monetary policy may also be arranged to support the general economic policies in the Community.
The objective of the Bank of Japan is to manage the monetary development. Via the pursuit of price stability the purpose is to contribute to sound development in the Japanese economy. The Bank of Japan is also responsible for ensuring the smooth settlement of funds between financial institutions and thereby contributes to maintaining an orderly financial system.
The statutory objective of the US Federal Reserve system is to promote maximum employment, stable prices and moderate long-term interest rates.
According to the most recent Sveriges Riksbank Act, which entered into force in 1999, the objective of monetary policy is to maintain price stability. Furthermore, Sveriges Riksbank shall also promote a safe and efficient payment system.
The objective of the Bank of England is to maintain price stability. Subject to this objective, the Bank of England shall support the government's economic policy, including its objectives for growth and employment.
These examples show that price stability is the primary objective of the central banks in most of the countries. However, they also reveal variation in the degree to which the central bank must plan its policy according to real-economic targets such as growth and high employment. In the Federal Reserve Act, the objective of maximum employment is thus ranked alongside the objective of price stability, while the ESCB statute and the Bank of England Act place the objective of price stability above the real-economic objectives.
There are many arguments in favour of focusing on price stability in the sense of stable, low inflation. The fundamental argument is that there is basically only one monetary-policy instrument available. Monetary policy can therefore be used to pursue one objective only. If monetary policy is used to pursue several objectives, it will not generally be possible to meet these objectives at the same time, so that a weighting of the objectives is required, cf. the classical analyses of Tinbergen (1952) and Theil (1961). Non-compliance with the objectives is naturally a problem in itself, but may also undermine the credibility of monetary policy.
The motivation for price stability as the overall monetary-policy objective is the relationship between money creation and price development, as well as the advantages of low, stable inflation. In the longer term, monetary growth and the rate of price increase (inflation) are closely interdependent, but in the shorter term the relationship is not one-to-one. This relation has given rise to the (monetarist) view that inflation is fundamentally a monetary phenomenon.
The arguments in favour of price stability as an objective are described in further detail in Box 4.1. Firstly, high inflation usually means varying inflation, which impedes forward-looking savings and investment decisions. Another cost of high inflation is that an unexpectedly high rate of inflation may entail redistribution of wealth between debtors and creditors. Furthermore, high inflation makes it more difficult to determine the part of a given price increase that is attributable to increases in the general price level, and the part attributable to the product in question becoming more expensive in relation to other goods. The price mechanism, which is central to the functioning of market economies, is thus working less well than in a situation with low inflation. Finally, high inflation may lead to less appropriate interaction with the taxation system if the tax base is compiled in nominal terms, since the real return after tax will then depend on the inflation rate, cf. Kjeldsen and Pedersen (2002).
Intermediate targets are often applied in the implementation of monetary policy. The explanation is that the overall objective of price stability is not immediately operational due to the indirect relation between the monetary policy pursued and price stability. It may take some time for a monetary-policy measure to impact on price development, or for a trend requiring monetary-policy intervention to impact on the price level. Furthermore, monetary policy alone cannot fulfil the objective, since price development is also influenced by many other factors. For example, an excessively expansionary fiscal policy may create bottlenecks and inflation shocks; inflation may be imported from trading partners in general, or via the development in prices for specific products such as oil; and inflation may acquire its own self-sustaining dynamics due to the labour-market structures.
In practice, the choice of monetary-policy intermediate target applied to meet the objective of price stability will vary. Examples of intermediate targets are the exchange rate (applied in Denmark), a monetary aggregate or a more direct measure of inflation in the medium term.
As the basis for discussion, the intermediate target can be regarded as the link between the instruments applied in monetary policy and the objective(s) that the central bank wishes to achieve. Intermediate targets may so to say lie at various points in the chain between instruments and objectives. Some intermediate targets lie closer to the instruments, whereby it is easier to ensure compliance with the intermediate target by adjusting the instruments. Other intermediate targets lie closer to the final objective, so that compliance with the intermediate target very much contributes to meeting the final objective. In overall terms, exchange-rate targets are normally close to the instruments, while inflation targets are close to the final objective, cf. the illustration below. Monetary aggregates generally lie between the two other types of intermediate target in the chain between instruments and final objectives.
An intermediate target is basically an economic variable with certain special features. It is important to ensure a clear relation between instrument and intermediate target, and that the intermediate target can contribute to meeting the long-term objective. The intermediate target should be operational and preferably simple and easy to understand.
A central function of the intermediate target is to serve as the economy's "nominal anchor". In an economy where money is used as a means of payment, a unit of account and for savings, it is important to have a clear point of reference for the value of money that is also future-oriented. A credible intermediate target is the foundation for the future value of money on which households and business enterprises can base their savings and investment decisions. This anchoring of the inflation expectations also contributes to stabilising the current development in prices and wages. The ability of an intermediate target to function as a nominal anchor critically depends on a close relation between the intermediate target and the long-term objective of price stability.
It is important that the central bank has the opportunity to influence the course of the intermediate target by applying the monetary-policy instruments. The credibility and relevance of an intermediate target will vanish unless the central bank can contribute to ensuring compliance.
The simpler the intermediate target, the more transparent the monetary policy. When the central bank implements monetary policy by pursuing a simple, specific intermediate target the outside world's real understanding of monetary policy is enhanced. The transparency of monetary policy is further enhanced if it is possible for everybody to directly monitor the actual development in the intermediate target, and thereby assess compliance.
Structural factors in the economy may also influence the quality of a given intermediate target for a given country. An obvious example is the economy's openness to the outside world. In a very open economy where imported goods carry great weight in the (consumer) price index, the exchange rate will be relatively important to inflation. Furthermore, the exchange rate will be of significance to profitability and wage trends in exporting enterprises. The openness of the economy can therefore make the exchange rate especially important to the development in prices, and make it more attractive to pursue an exchange-rate target as an intermediate monetary-policy target.
Most countries rarely change their intermediate monetary-policy target. A natural consequence of the central position of the intermediate target in a monetary-policy strategy is that significant adjustment of the intermediate target will imply a shift in strategy, which may have a destabilising effect on the economy. If the intermediate target is to function as a nominal anchor, the outside world must be able to trust the central bank to implement monetary policy with a view to compliance with the intermediate target. The most reliable method to achieve this credibility is to do to what one has promised to do over many years. This naturally requires an unchanged intermediate target. The application of intermediate targets is thus associated with some sluggishness. In practice, intermediate targets have often been adjusted as a result of monetary-policy and/or foreign-exchange-policy crises where the authorities have been obliged to introduce monetary-policy reforms.
It is most often government or parliament that determines the overall objective for the central bank, as described above, while the institution determining the intermediate target varies more in international terms. Monetary aggregates are often determined by the central bank, while inflation or exchange-rate targets may be determined by either the central bank or the government, or both, cf. Mahadeva and Sterne (2000, Chapter 3).
Danmarks Nationalbank's overall objective is to ensure a stable krone, and the intermediate target of monetary policy is to keep the krone stable vis-à-vis the euro.
Chart 4.1 shows the relation between the exchange rate and prices in Denmark and Germany.
In the long term, it does not make much difference whether the monetary-policy strategy is directed at the domestic or international purchasing power of the krone. With a credible intermediate target of a fixed krone rate vis-à-vis a partner with low inflation, domestic inflation will normally also be low.
The relation between prices and exchange rates is not least a result of Denmark being a small, open economy. There is a considerable foreign element in price formation, even though price trends first and foremost depend on the development in domestic costs. Imports thus account for around 40 per cent of final domestic demand. For this reason alone, trends in exchange rates and prices abroad are of great significance to the course of prices in Denmark. Furthermore, changes in import prices may impact on Danish wages and profit margins.
In the longer term, a change in foreign prices and the exchange rate will normally have a full impact on domestic prices. Similarly, a sustained higher inflation rate in Denmark than in other countries will at some point affect the krone rate vis-à-vis other currencies. A cornerstone of the fixed-exchange-rate policy is therefore to ensure that inflation differentials between Denmark and the euro area are limited and temporary.
The krone's domestic and international purchasing power thus cannot be regarded individually. This also means that a devaluation normally has no permanent effects, and in the long term will entail higher prices in Denmark. This undermines the initial improvement in competitiveness after a devaluation, unless there were obvious imbalances from the outset.
The objective of price stability can therefore be fulfilled by pegging the krone to the currency of one or more countries that pursue a low-inflation economic policy. This is the essence of the foreign-exchange-policy strategy since 1982. With a fixed-exchange-rate policy aimed at the euro, fiscal policy must be planned to keep inflation in Denmark on average in line with inflation in the euro area member states.
Box 4.2 outlines the history of Denmark's foreign-exchange policy.
While Danmarks Nationalbank is responsible for monetary policy, as described above, the foreign-exchange policy is determined by the government after consultation with Danmarks Nationalbank. Section 2(3) of the Danish Foreign-Exchange Act thus stipulates that "the guidelines for the foreign-exchange policy to be pursued in the period that the Act is in force shall be determined on the basis of negotiation between Danmarks Nationalbank and the Royal Bank Commissioner". In most other countries too, the foreign-exchange policy is the responsibility of the government, while monetary policy is the responsibility of the central bank. The government and Danmarks Nationalbank are in contact on an ongoing basis in this respect.
The current framework for Denmark's foreign-exchange policy is the agreement on participation in ERM II, the European Exchange-Rate Mechanism, concluded by the government and Danmarks Nationalbank with the euro area member states and the ECB. The day-to-day conduct of the foreign-exchange policy, including intervention in the foreign-exchange market, is the responsibility of Danmarks Nationalbank. ERM II, Danmarks Nationalbank's implementation of the foreign-exchange policy, and the relation between the monetary policy and the foreign-exchange policy are described in further detail in Chapter 1.
The experience of Denmark and a number of other countries that pursue a fixed-exchange-rate policy is that under normal circumstances it is possible to manage the exchange rate via the interest rate (and intervention in the foreign-exchange market) if there is general confidence in the economic policy. It is relatively simple to apply stabilisation of the exchange rate as a fixed rule. In periodsofpronouncedunrestandgreat
uncertainty concerning the krone rate significant interest-rate increases have contributed to cushioning exchange-rate fluctuations, but have rarely prevented fluctuations completely.
The exchange rate as an intermediate target is a firm, unequivocal and simple monetary-policy rule. Compared to e.g. monetary aggregates, the exchange rate can furthermore be observed on an ongoing basis, while the money supply is typically only compiled monthly, and is always subject to a certain lag.
Stable price development is beneficial to economic activity. Likewise a monetary-policy strategy directed at fixed exchange rates has the advantage of reducing exchange-rate fluctuations vis-à-vis the currencies in question. This stimulates external trade and investments, since it reduces exchange-rate uncertainty. Besides being an intermediate target, an exchange-rate target can thus also be of value in itself.
Denmark's monetary and foreign-exchange policies ensure that the exchange-rate fluctuations vis-à-vis the euro are very moderate. The euro area is Denmark's largest trading partner, so that the fixed-exchange-rate policy contributes to minimising the exchange-rate uncertainty related to external trade.
Like Denmark, a number of other European countries have pursued a fixed-exchange-rate policy for a prolonged period. The successful fixed-exchange-rate policies contributed to the decision laid down in the Maastricht Treaty of 1992 to introduce a single currency in Europe. So far (until the beginning of June 2003), 12 euro area member states have replaced their former currencies with the euro. Introduction of the single currency is the ultimate fixed-exchange-rate policy, since it irrevocably fixes the reciprocal values of the legacy currencies.
Direct inflation targets have gained significant ground in recent years. The UK and Sweden, for example, chose intermediate inflation targets shortly after the UK left the ERM and Sweden abandoned its unilateral peg to the ECU during the foreign-exchange crisis in 1992.
The exact target varies from country to country. For example, the Bank of England applies an inflation target of 2.5 per cent, while Sveriges Riksbank's inflation target is 2 per cent +/- 1 per cent. It is sought to achieve the inflation target via ongoing adjustment of the monetary-policy instruments. Excessively high inflation is sought dampened by tightening monetary policy, and excessively low inflation is sought countered by easing monetary policy. In acknowledgement of the lag associated with the impact of monetary policy on price development these countries have usually chosen a medium-term inflation target, e.g. 2 years.
Monetary policy is thus aimed at ensuring a certain level of future inflation. Current inflation, on the other hand, is in principle without special significance in this regime. Deviations between the target and actual inflation will thus occur due to uncertainty concerning the transmission mechanism as well as sudden changes in the economic situation that were not foreseen by the central bank (e.g. changes in oil prices or exchange rates).
Since monetary policy is aimed at future inflation, it cannot also be used to manage the exchange rate. This may cause problems in open economies that are strongly dependent on external trade. It is well-known that floating exchange rates show considerable volatility, and that persistent deviations from equilibrium values may occur.
Monetary policy based on inflation targeting makes great demands of external communication. The reason is that the central bank cannot manage the inflation currently observed, but seeks to manage future inflation, which by its nature cannot be observed. The task faced by the central bank is to explain any deviations between current inflation and the inflation target, and furthermore to explain the monetary-policy decisions, which may sometimes appear to be in conflict with the prevailing economic situation. For example, it requires good communication strategies to explain why a tightening may be called for, even though inflation is close to the target. The communication challenge may increase if there are no signs of inflationary pressure after the tightening, even though this may indeed reflect that the tightening was successful.
Central banks pursuing this strategy therefore devote considerable resources to presenting information about the regime and the monetary-policy decisions. An important element in this communication process is the inflation reports issued at regular intervals (usually quarterly).
In economic theory a distinction is drawn between strict and flexible inflation targeting, cf. e.g. Svensson (1997). While monetary policy under a strict inflation-targeting regime does not consider the development in output and unemployment when determining the monetary-policy stance, the cyclical situation is included in the assessment basis under a flexible inflation-targeting regime. In practice, all central banks with inflation targeting adhere to a flexible regime. The central banks therefore do not seek to eliminate deviations from the inflation target as quickly as possible, but instead to plan monetary policy so as to bring inflation back to compliance with the inflation target within a certain period. The duration of the adjustment period depends on the central bank's weighting of stabilisation of the development in output compared to the development in inflation, and on the current reason for the deviation, cf. Svensson (1999).
Many countries have applied the money supply as an intermediate target for monetary policy. At the end of the 1970s, targets for monetary aggregates were used to combat rising inflation, cf. Bernanke and Mishkin (1992). It subsequently emerged that the money supply was not of sufficient quality as an intermediate target in many of the countries. Targets for monetary aggregates are thus now rarely used as the basis for monetary policy.
Germany is an often-cited example of a sustained money targeting strategy. From 1975 until the commencement of the third stage of EMU, the Bundesbank officially applied a monetary-aggregate target. However, the implementation of the money targeting was flexible, since deviations from the target were not always countered by means of monetary-policy intervention, cf. Bernanke and Mishkin (1997). Until recently, Switzerland too applied a target for a monetary aggregate as an intermediate target in monetary policy. After the decline in this indicator's quality as an intermediate target in the late 1990s Schweizerische Nationalbank at the beginning of 2000 decided to base its monetary-policy decisions on a medium-term inflation forecast.
The European Central Bank arranges its monetary policy to meet the Treaty-bound objective of maintaining price stability in the euro area. In this connection, the ECB has defined price stability as a year-on-year increase in the Harmonised Index of Consumer Prices (HICP) for the euro area of below 2 per cent. Price stability is to be maintained over the medium term. The ECB's Governing Council has announced that in pursuit of price stability it aims to maintain inflation close to 2 per cent, cf. ECB (2003).
The monetary-policy decisions of the Governing Council are based on a comprehensive analysis of the risks to price stability comprising an economic analysis and a monetary analysis, cf. the illustration below.
The purpose of the economic analysis is to determine the factors that present a risk to price stability in the short and medium term. The analysis comprises a wide range of economic and financial variables to assess the shocks that impact the euro area's economy and the future macroeconomic development.
The purpose of the monetary analysis is to assess the inflationary trends in the medium to long term. The analysis takes into account a large number of monetary indicators, including the money supply, its components and counterparts. The monetary analysis serves primarily to crosscheck the results of the economic analysis.
Monetary policy is medium-term oriented, reflecting that it takes time for monetary-policy measures to be transmitted to price developments. The two sets of analyses both contribute information on the medium term, but from different starting points. The economic analysis focuses on the outlook for price stability in the short to medium term, while the monetary analysis concentrates on the outlook for price stability in the medium to long term.
The ECB's monetary-policy strategy corresponds to actual inflation targeting in several respects. The Governing Council's decision to aim at an inflation rate below and close to 2 per cent in the medium term combined with the inflation analysis in the short and medium term are reminiscent of inflation targeting. However, the inflation forecast is not the pivotal point of the ECB's strategy, unlike the practice of the inflation-targeting central banks. The ECB's structuring of the analysis behind the monetary-policy decisions is thus different from the structure applied by central banks with an inflation target as the intermediate target. Overall, the ECB's monetary policy can be viewed as a strategy that combines several elements to fulfil the main objective of price stability, rather than focusing on one intermediate target.
In the USA, the Federal Reserve does not apply intermediate targets in its conduct of monetary policy. Some observers have therefore characterised the US monetary policy as a "just-do-it" policy, cf. Lyngesen (1999). Monetary policy is adjusted on an ongoing basis against the background of the overall objectives, i.e. maximum employment, stable prices and moderate long-term interest rates. In the absence of an explicit intermediate target, the Federal Reserve has sometimes responded to the development in other macroeconomic indicators besides prices. Cases in point are the easing of monetary policy after stock prices plummeted in October 1987, and the relaxations in 1998 after the unrest on the international financial markets.
In recent years the Federal Reserve has applied "pre-emptive strikes" in pursuit of the overall objectives. The rationale behind these measures is that it is easier for the central bank to fulfil the objectives when it responds to a changed outlook for e.g. future inflation, rather than waiting until the increase/decrease in inflation turns up in the actual figures. This procedure is similar to the monetary-policy strategy under an inflation-targeting regime where the central bank will also respond to a changed outlook for inflation.
The monetary-policy instruments are the first link in the chain from monetary-policy measures via intermediate targets to the final objective of monetary policy. The instruments are variables controlled directly by the central bank such as a short-term interest rate or base money. The central monetary-policy decisions relate to the ongoing setting of values for the monetary-policy instruments.
The majority of central banks currently apply a short-term interest rate as their monetary-policy instrument. This is often a rate of interest for one of the facilities made available by the central bank to the banks, but it may also be an (in principle) market-determined interest rate that the central bank seeks to manage via (money-) market operations. In the latter case, the interest rate to be managed is often referred to as an "operational target".
The choice of monetary-policy instruments should be viewed in the light of their function as generator of the monetary-policy transmission mechanism. With an intermediate target that contributes to meeting the overall objective the monetary-policy instruments should be arranged to meet the intermediate target. An optimum instrument shows close and stable correlation with the intermediate target, so that changes in the instrument have direct and predictable consequences for the intermediate target.
Poole (1970) put forward the classical theoretical analysis of the optimum choice of monetary-policy instrument. Poole sets out a simple IS-LM model for whether a central bank seeking to stabilise the development in output should choose an interest rate or a monetary aggregate as its instrument. The main result is that if shocks in the financial markets (e.g. to the demand for money or to the relation between the money base and broader monetary aggregates) prevail, the interest rate is the optimum instrument. If, on the other hand, shocks to overall demand (e.g. to consumption or investment) prevail, a monetary aggregate is the appropriate instrument. If money demand is often affected by shocks, an interest-rate instrument has the advantage of allowing corresponding variation in the money supply. This prevents the shocks from spilling over to interest rates, so that consumption, investment and output remain unaffected. Conversely, the best way to stabilise output in the event of shocks to aggregate demand is to let interest rates carry part of the adjustment.
The original analysis in Poole's article makes no distinction between base money and broader monetary aggregates (see the definitions of various monetary aggregates in Box 4.3). However, in practice it is important to distinguish between the two, since the central bank can control base money, but not the course of the broader monetary aggregates. If the analysis takes this factor into account, it turns out that this increases the relative advantage of using the interest rate as the monetary-policy instrument, cf. e.g. Walsh (1998).
In practice most central banks now apply an interest rate as their monetary-policy instrument. One reason is that it has proved increasingly difficult in many countries to identify a stable relation between money demand and its determinants, partly due to the constant evolution of the financial markets. Another reason is that the central bank, as stated, cannot control the broader monetary aggregates, but only the narrower money base.
The overall framework for monetary policy has changed in several respects over the last decades. This has also impacted on the monetary-policy instruments used by central banks. Supervision of the banks' extension of credit and interest rates as well as other administrative measures was previously a frequently applied monetary-policy instrument. On the surface at least it played an important role in the management of economic development via economic policy.
Today the various quantitative regulations of the financial sector have been more or less abolished, and price formation is subject to market terms. Monetary policy is also implemented on market terms, and credit extension is influenced indirectly via the market's response to adjustments of the official interest rates. In other words, the widespread use of the market mechanism has entailed that monetary policy is conducted via interest rates, and not by direct rationing of credit extension by banks, etc.
The market orientation has also led to depolitisation of monetary policy. Decisions to e.g. adjust interest rates or the structure of the monetary-policy instruments are now of a more technical and less political nature than previous lending restrictions, etc. This has furthermore supported the trend for more independent central banks.
The trend for a more market-oriented monetary policy is mirrored by the liberalisation of capital flows to and from abroad. The abolition of (the possibility of) quantitative regulation in monetary policy is moreover in accordance with the tendency for economic policy to provide a framework, while leaving it to the market forces to apply the framework in practice.
Denmark's monetary-policy instruments and their use are described in detail in Chapter 1. Danmarks Nationalbank's instruments are associated with the facilities made available to the monetary-policy counterparties, i.e. lending against collateral, certificates of deposit and current-account deposits. Denmark's monetary-policy interest rates are Danmarks Nationalbank's lending rate (equal to the rate of interest for certificates of deposit), the current-account rate and the discount rate. Danmarks Nationalbank sets the monetary-policy interest rates in order to keep the krone stable vis-à-vis the euro, i.e. with a view to compliance with the intermediate target for monetary policy. In line with international practice, the primary monetary-policy instruments are short-term interest rates. Since the instruments are rates of interest for the counterparties' deposits with and loans from Danmarks Nationalbank, they are determined by the Board of Governors of Danmarks Nationalbank.
As stated, most central banks apply a short-term interest rate as their monetary-policy instrument. The variations in the different countries' instruments are found at a more detailed level. The specific arrangement of a country's monetary-policy instruments is often the result of tradition, and has no vital significance in practice.
The Eurosystem also applies a short-term interest rate as its key monetary-policy instrument, cf. Section 1.4. The primary facility is the weekly market operations in which the Eurosystem allots liquidity to the counterparties. Since June 2000 this allotment of liquidity has taken place via variable-rate tenders with a minimum bid rate set by the ECB's Governing Council. The minimum bid rate signals the monetary-policy stance.
The Eurosystem also makes available a deposit facility and a marginal lending facility to its counterparties on an overnight basis. The counterparties may use these standing facilities at their own initiative, so that the deposit rate and the marginal lending rate constitute a corridor for the overnight interest rate in the euro money market. In order to further limit the fluctuations in the overnight interest rate the Eurosystem applies a minimum reserve system. Under this system the credit institutions in the euro area must deposit an amount with the Eurosystem equivalent to a certain proportion of their liabilities.
The operational target takes a more central position in the USA's monetary policy than the instruments that are used to achieve it. The Federal Reserve sets a federal funds target rate for the rate of interest for overnight liquidity in the interbank market, and seeks to achieve the target by entering into repurchase agreements in government securities with selected counterparties. The operational target for the federal funds rate is the interest rate signalling US monetary policy. In the USA too, monetary policy is thus centred around a short-term interest rate.
The Federal Reserve requires all credit institutions receiving deposits to hold reserves at the central bank. It also offers a standing lending facility to generally sound counterparties. This facility gives the counterparties access to very short-term (often overnight) loans at a discount rate that exceeds the federal funds target rate.
The Bank of Japan normally has an operational target for the overnight interest rate for liquidity (the call rate), and seeks to achieve this target by buying and selling securities in the market. The Bank of Japan also applies a minimum reserve system requiring all credit institutions receiving deposits to hold reserves at the central bank corresponding to a certain proportion of the deposits. Finally, the Bank of Japan offers a facility whereby the counterparties can obtain very short-term loans from the central bank at a discount rate exceeding the target for the call rate.
The preceding sections have reviewed the key elements of a monetary-policy strategy. A clear monetary-policy strategy specifying objectives, intermediate targets and instruments is a precondition for an effective monetary policy. However, a successful monetary policy also depends on many other factors. Some of these factors are discussed in the following from a predominantly Danish perspective.
During the 1980s and 1990s most countries sharpened the focus on making their central banks independent of the political system. The background was especially the practical experience from the coordination policy of the 1960s and 1970s, although a number of theoretical concerns also played a role. Both practicians and theorists thus agree that a central bank that is not under direct political control provides the best platform for price stability, cf. e.g. Cukierman (1998).
Central-bank independence is a vital element of the EU Treaty's provisions concerning the ECB, i.e. the central bank of the euro area member states, and the national central banks. Independence of the political system is stressed inter alia by the rule that the members of the decision-making bodies of the European System of Central Banks may not seek or take instructions from national governments in the performance of their tasks. The Treaty also stipulates a number of criteria for the appointment of members of the ECB's Executive Board. They are appointed by the heads of state and of government, with focus on their professional expertise.
The current Danmarks Nationalbank Act is from 1936. The Act and the associated by-laws comply with the EU Treaty's requirements concerning the independence of central banks. The Board of Governors undertakes the day-to-day management of Danmarks Nationalbank and determines and adjusts monetary policy on an ongoing basis. Danmarks Nationalbank may thus tighten or relax monetary policy at its discretion, but must inform the government prior to any adjustment of the discount rate. Nevertheless, the decision rests with the Board of Governors of Danmarks Nationalbank, irrespective of the government's position.
The background to Danmarks Nationalbank's independence is primarily historical. Denmark's very considerable military expenditure on several wars in earlier centuries was financed by issuing banknotes. As a result, the value of the banknotes was almost completely eroded. Using current terminology, the central government resorted to monetary financing of its deficits. Against this background Danmarks Nationalbank was already granted independence on its establishment in 1818. It would otherwise have been difficult to gain the population's confidence in the bank's ability to maintain the purchasing power of the currency. Today the EU Treaty contains a prohibition on monetary financing of government deficits, cf. Section 1.5.2.
An independent central bank must have the financial strength to take monetary-policy decisions without consideration of the impact on its financial position. One reason is that the central bank's independence of the political system may be compromised if the central bank's net capital is insufficient, making a capital contribution from the central government necessary.
It is also important for the central bank's independence that no groups in society are given special borrowing privileges. This ensures that monetary policy including monetary-policy interest rates is not undermined by borrowing privileges regarded as prudent at a given time.
Finally, certain differences between monetary policy and other economic policy call for delegation of responsibility for monetary policy to an independent central bank. Firstly, the monetary-policy instruments applied today do not have the same distributional consequences as before, cf. Section 4.3.1. Secondly, it is especially important to ensuring monetary stability that a long-term perspective is applied to monetary-policy planning. As stated, expectations of and confidence in the future monetary policy are prerequisite to the intermediate target of monetary policy functioning as the nominal anchor of the economy.
The central bank's ability to meet the intermediate targets of monetary policy and fulfil the overall objectives depends on the compliance of fiscal policy with certain requirements. Fiscal policy must be sustainable irrespective of the objectives and intermediate targets that are pursued. An unsustainable fiscal policy might dominate monetary policy and become the decisive factor for the development in prices. Ultimately, imbalance between public revenue and expenditure may oblige the central bank to abandon the objective of price stability. An independent central bank and a clear monetary-policy strategy, among other factors, can help ensure that this is avoided.
The interaction between monetary and fiscal policy is of great significance to the effectiveness of the overall economic policy. In practice, the division of work may be more or less explicitly stated. In Denmark's case it is explicitly stated: monetary policy is aimed at keeping the krone stable vis-à-vis the euro, whereas any specific Danish requirement to stabilise the cyclical development is to be accommodated via fiscal policy. In Denmark's experience one must be careful to avoid the stabilisation policy creating its own fluctuations. Furthermore, the norm for central-government borrowing plays an important role in the separation of monetary and fiscal policy, cf. Section 1.5.2.
The division of work relating to Denmark's economic policy was established after the stabilisation in 1982. The late 1970s and early 1980s saw clearly unsatisfactory economic development. In 1982 unemployment had risen to around 10 per cent of the labour force, annual inflation exceeded 10 per cent, and the long-term interest-rate differential between Denmark and Germany was above 10 per cent. At the same time, the government budget deficit was increasing rapidly, and exceeded 8 per cent of GDP in 1982, cf. Chart 4.4.
The stabilisation after the change of government in 1982 comprised a declaration that devaluation would not be an element of economic-policy planning. It subsequently also comprised a tightening of fiscal policy and the abolition of the cost-of-living adjustment. The promise to pursue a fixed-exchange-rate policy was soon put to the test when Sweden Denmark's second-largest trading partner devalued its currency by 16 per cent one month later. Denmark did not devalue. This and the other tightening measures meant that the credibility of Denmark's economic policy was soon enhanced. In the following years the government budget improved, cf. Chart 4.4, and the inflation and interest-rate differentials to Germany fell significantly.
In the euro area the responsibilities are also clearly distributed between the single monetary policy and the fiscal policies of the individual member states. The primary objective of monetary policy is to maintain price stability in the overall euro area, but it is up to the fiscal policy of the individual member state to remedy a member state's deviation from the development in the rest of the euro area, within the framework of the Stability and Growth Pact.
There is now a clear trend for central banks, like other areas of society, to provide more information on their tasks, objectives and decisions. The increase in external communication is via e.g. websites, press conferences, hearings, speeches and reports. The increased information level reflects greater openness regarding monetary policy.
For a central bank the ideal external communication scenario is where the general public and financial-market players have a genuine understanding of monetary policy. Achieving this understanding naturally makes demands of both the central bank and the outside world. By enhancing the transparency of monetary policy the central bank can make it easier for the outside world to understand monetary policy.
However, the means to achieve greater transparency is not necessarily to increase the amount of information from the central bank, since good communication is a complex task. Nevertheless, by publishing consistent and relevant information, the central bank can contribute to the general public's understanding of the monetary-policy decisions.
The significance of the exchange-rate regime is often overlooked in discussions of the transparency of monetary policy. This is unfortunate, since both the requirements of and the opportunities for ensuring transparency depend on whether the central bank manages the exchange rate or not.
Monetary policy is fundamentally more transparent in a fixed-rate regime than in a floating-rate regime, because the general public can observe at all times whether the central bank pursues the promised policy, and since it is technically less complicated for the central bank to manage an exchange-rate target than a future inflation target. Under a fixed-exchange-rate regime the information requirement is therefore lower. In particular, there are fewer factors of relevance to monetary policy. In order to achieve the same degree of transparency, a central bank applying inflation targeting in its monetary policy therefore has to issue more information than a central bank pursuing a fixed-exchange-rate policy.
A central bank applying inflation targeting must conduct a comprehensive analysis of the outlook for inflation as the basis for the monetary-policy decisions. Under a fixed-exchange-rate regime the monetary-policy decisions will usually be based on other analyses that focus especially on the course of the exchange rate as well as supply and demand in the foreign-exchange market in the short and long term. The differing internal analyses that are the basis for monetary-policy decisions will naturally be reflected in the information issued under the two different types of monetary-policy regime.
Openness and transparency also play a role with regard to the outside world's opportunities of holding the central bank accountable for its conduct of monetary policy. As stated above, many countries have delegated the responsibility for monetary policy to an independent central bank mandated to determine monetary policy in compliance with a politically determined objective. Since the central bank's decisions are made independently of the political system, there is a need to be able to assess whether the central bank's actions are in accordance with the given objective. The central bank can facilitate the outside world's opportunities to make this assessment by conducting an open and transparent monetary policy that explains the strategy and the decisions implemented.
Most central-bank acts contain provisions concerning the central bank's accountability for its decisions. Danmarks Nationalbank is statutorily obliged to publish an annual report on its activities in the past year. Moreover, during the year Danmarks Nationalbank reports on the monetary and foreign-exchange policy in the Monetary Review, as well as in speeches and interviews, etc., cf. the overview in Appendix 1.B.
According to the EU Treaty, the European Central Bank shall publish quarterly reports and an annual report. In practice, the ECB has opted to publish a Monthly Bulletin containing the ECB's assessment of the economic situation, as well as the background for the monetary-policy decisions. After the first meeting of the Governing Council each month a press conference is held with the participation of the President and Vice-President of the ECB. At the press conference the monetary-policy decision is presented, as well as the Governing Council's views on the economic situation and the outlook for price stability. Furthermore, each quarter the President of the ECB reports on monetary policy to the Committee on Economic and Monetary Affairs of the European Parliament.
In the USA, the Chairman of the Board of Governors of the Federal Reserve is legally obliged to participate in semi-annual monetary-policy hearings in Congress. In this connection the Federal Reserve Board must present a report to Congress on the conduct of monetary policy, economic developments and prospects for the future.
In the 1970s many countries experienced stagflation, i.e. inflation rose, while the economy stagnated. One of several explanations of high inflation found in the economic literature is that there is a fundamental credibility problem associated with monetary policy. The train of thought can be outlined as follows: a central bank seeking to stimulate output has an incentive to conduct an expansionary monetary policy. This is realised by the private sector, which adjusts its inflation expectations upwards to the exact level where the central bank's incentive to stimulate output via an inflationary monetary policy is eliminated. The result is that the central bank does not succeed in stimulating output, but inflation is nonetheless still higher than desired by both the central bank and the private sector. This is called an "inflation bias" in the literature. If the central bank could, in a credible manner, undertake not to surprise the private sector with an expansionary monetary policy, it would be possible to achieve a lower inflation rate without diminishing the output performance.
For a central bank applying an exchange-rate target, the issue of credibility is not associated directly with the inflationary effects of an expansionary monetary policy. Instead, a credibility problem may arise if the outside world lacks confidence in the central bank's willingness to defend the announced fixed exchange rate, or in the compatibility of other economic policy with the fixed-exchange-rate policy. Lack of confidence in a fixed-exchange-rate regime can have serious consequences if the loss of credibility leads to a speculative attack on the currency.
The central bank's primary instruments to counter a speculative attack are intervention in the foreign-exchange market and adjustment of the monetary-policy interest rates. If the pressure on the currency is attributable to a lack of confidence in the general economic policy, it may also be necessary to adjust e.g. fiscal policy in order to stabilise the foreign-exchange market.
Credibility is thus a precondition for an effective monetary policy, irrespective of the central bank's monetary-policy strategy. However, it normally takes years for a central bank to gain the confidence of the outside world in its commitment to pursue the announced policy. The most certain way for the central bank to build credibility is to show its ability and commitment to pursue the chosen strategy over a sustained period.
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 This chapter considers only selected OECD countries. Mahadeva and Sterne (2000) give a more detailed review of monetary-policy and foreign-exchange-policy strategies. The website of the Bank for International Settlements, www.bis.org, is a good source of information on central banks worldwide, and gives links to the central banks' websites.
 Central-bank independence is discussed in more detail in Section 4.4.1.
 During the first reading of the bill Trade Minister Hauge said as follows concerning the first part of the objective: "A safe and secure currency system means that exchange rates will be kept stable in so far as this is possible for the bank and society" (Rigsdagstidende, Deliberations of the Folketing
 The ESCB consists of the European Central Bank, ECB, and the national central banks of the EU member states.
 Article 105 of the EC Treaty and Article 2 of the Statute for the European System of Central Banks and the European Central Bank. The Treaty and the Statute entered into force on 1 November 1993.
 The Bank of Japan Act, Articles 1 and 2. The Act entered into force on 1 April 1998, and was last amended in 2001.
 US Code, Title 12, Chapter 3, Section 225a. The Act of 23 December 1913.
 The Sveriges Riksbank Act (1988:1385), Chapter 1, Section 2.
 The Bank of England Act 1998, Section 11.
 Walsh (1998, Chapter 1) reviews the basic empirical relations between money supply, prices and output.
 How a monetary-policy measure is transmitted through the economy is often referred to as the monetary-policy "transmission mechanism", cf. Chapter 3.
 The monetary-policy instruments are discussed in Section 4.3.
 See e.g. Clarida, Galí and Gertler (1999) for an analysis of monetary policy in (neo-Keynesian) economic models featuring a relation between current and expected future inflation.
 Unlike the overall objective, the intermediate target is not stipulated in the Danmarks Nationalbank Act. When the Act was proposed again in 1936, Kjærbøl, Minister for Trade, Industry and Shipping, said as follows: "The way in which and the means by which the bank will best be able to ensure the currency system and facilitate the circulation of money and the extension of credit will depend on the circumstances at various times. At this point, it would neither be possible nor appropriate to determine and lay down this in the Act". (Rigsdagstidende, Deliberations of the Folketing (Parliament), 1935-36, col. 2556.)
 In economic theory, purchasing-power parity is often assumed to apply in the long term. Purchasing-power parity means that the price for a domestically manufactured product must correspond to the price in Danish kroner for the same product manufactured abroad. If the purchasing-power parity is a good approximation, an intermediate target of a fixed krone rate entails that domestic inflation will automatically approach inflation in the targeted countries.
In general, product differentiation, transaction costs (including transport costs), various product standards in various countries, and varying trends in productivity and prices for goods and services not traded across national borders (e.g. rent) can mean that purchasing-power parity does not apply fully, even in the long term, or at least that it does not have a full impact on the available price indices.
Sarno and Taylor (2002) give an overview of a number of empirical studies of purchasing-power parity.
 See Christensen and Topp (1997) for a more detailed description of the transition to a fixed-exchange-rate policy in 1982 and Denmark's monetary policy and foreign-exchange policy since then.
 Consolidated Act on Foreign Exchange, etc. (Consolidated Act, No. 279 of 11 April 1988). The Minister for Economic and Business Affairs is the Royal Bank Commissioner.
 Theoretically, a central bank can normally stabilise the exchange rate at a given level via its interest-rate and intervention policy. In practice, however, there will always be a limit to how far a central bank can and will go to defend a given exchange rate, since the required means may be incompatible with the economic-policy objectives concerning growth and employment. For example, an extremely high interest-rate increase (by e.g. 100 or 500 per cent) may be so detrimental to the domestic economy that the increase is not credible. Normally, a fixed-exchange-rate policy therefore requires a generally stability-oriented policy to be conducted so as to prevent monetary policy from becoming too stretched. Even though the economic fundamentals are in place, speculative attacks may not be ruled out if doubt arises e.g. concerning the authorities' objectives or willingness to raise interest rates to the necessary extent.
For a critical discussion of fixed-exchange-rate policy, see e.g. Obstfeld and Rogoff (1995).
 The European currency unit, ECU, was a basket of the member states' currencies. When the euro was introduced as the single currency, it replaced the ECU on a 1:1 basis.
 Current inflation is naturally an important element in the evaluation of the preceding years' monetary policy.
 See von Hagen (1999) for a review of the circumstances in connection with the application of a monetary aggregate target.
 Bernanke and Mishkin furthermore argue that, in practice, Germany's monetary policy was not far from inflation targeting.
 The ECB's monetary policy is described in ECB (2003) and previously in ECB (2001) and Issing et al. (2001).
 Furthermore, the development in the money supply is compared to a reference value for annual growth in M3.
 The money base is defined in Box 4.3.
 If the central bank can control the operational target to a high degree, the distinction between an operational target and an instrument is less important.
 Friedman (1990) gives an overview of the research in monetary-policy instruments and targets.
 The qualitative results presented below are also found in more complete models, cf. Friedman (1990).
 Blenck et al. (2001) presents a review of the instruments, operational targets and procedures applied by the central banks of Japan, the USA and the euro area.
 In March 2001 the Bank of Japan decided to set an operational target for the financial institutions' current-account deposits with the central bank until consumer prices cease to decline. Japan's monetary policy in recent years is reviewed in further detail in Beier (2002).
 The UK is exempt from the provisions concerning the independence of central banks for as long as this member state remains outside the euro area.
 The European Monetary Institute, EMI, the predecessor of the ECB, and the European Commission found in their convergence reports of March 1998 that the Danish central-bank legislation is compatible with the independence requirement laid down in the EU Treaty.
 See Winkler (2000) for an analysis of openness and transparency in monetary policy.
 The relation between exchange-rate regimes and transparency is discussed in Storgaard (2002).
 See e.g. Blinder (1998).
 Section 17 of the Danmarks Nationalbank Act.
 The Statute for the European System of Central Banks and the European Central Bank, Article 15.
 See e.g. ECB (2001) for a more complete review of the ECB's communication activities. Eijffinger and Hoeberichts (2002) compare how the central banks in the euro area, Canada, Japan, the UK and the USA are held accountable for their monetary-policy decisions.
 US Code, Title12, Chapter 3, Section 225b.
 The development in the reporting requirements of the Federal Reserve is described in Pollard (2003).
 See e.g. Barro and Gordon (1983). Barro and Gordon show that in some cases a central bank obliged to stimulate output, and also stabilise the development in both inflation and output, may benefit from applying a fixed rule for monetary policy to avoid credibility problems. The authors assume that it is possible for the central bank to stimulate output in the short term only. In the long term this is a classical model in the sense that monetary policy has no impact on output.
 There is an extensive literature on speculative attacks. Drazen (2000) is a recent contribution that takes into account the central bank's ability to adjust the monetary-policy interest rates to defend the currency. Sarno and Taylor (2001) describe the literature on intervention in the foreign-exchange market.
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