Importance of institutional design for monetary policy

Mervyn King gave a speech in 2004 on importance of institutions of monetary policy.

I argue that it is useful to think about the optimal design of monetary institutions using the insights  from the theory of incomplete contracts. The core of the monetary policy  problem is the uncertainty about future social decisions resulting from the successors to any given monetary policy strategy. The impossibility stems from the observation that collective decisions cannot be enforced so that it is impossible to commit to future collective decisions. The undesirability reflects the fact that we cannot articulate all possible future states of the world.

Monetary institutions expand the possibility frontier of the technology of collective decisions by raising the costs of making inefficient deviations from pre-announced paths. I illustrate the importance of institutional design for the operation of monetary policy by reference to three case studies: the collapse of exchange rate regimes in Brazil and the United Kingdom; currency arrangements in Iraq and their reform after the 2003 war; and the relationship between central banks and governments when the zero constraint on nominal interest rates is binding.

Very interesting case studies. Especially of currency arrangements in Iraq. There were 2 currencies in Iraq in 1991 – one known as Swiss Dinar in North Iraq and Saddam Dinar in South Iraq. Saddam Dinar was backed by government but not Swiss and still remained a currency! How the two move because of changes in political regime is fascinating stuff.

However, for current times the 3rd case study is more appropriate. King says:

The interplay between monetary policy and debt management may not matter too much when short-term interest rates are positive because the central bank can control the level of interest rates, even if debt management affects the optimal level of rates. But when rates are at their zero bound then the central bank no longer has instrument independence. Indeed, because its actions can be offset by appropriate sales or purchases in the government debt market, it loses goal independence too. It becomes crucial that fiscal and monetary authorities cooperate.

Interesting again. I never thought it this way. In ZIRP, central bank loses both instrument independence (as rates are zero) and goal independence (what goals as finance ministry/treasury  rules!).  Read the case study of Japan in this context.

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One Response to “Importance of institutional design for monetary policy”

  1. Adam Montana Says:

    Interesting article, do you have a link or a reference for the Japan case study? I’d be interested in reading it.

    (Side note:

    More on the dinar at http://www.dinarspeculation.com.)

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