Monetary and Exchange Rate Policies

D. Begg, L. Halpern, C. Wyplosz (Forum Report of the Economic Policy Initiative (EPI)), (Centre for Economic Policy Research (CEPR), 1999) 108pp, £25, ISBN 1898128419

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David Begg is a lecturer at Birkbeck College, London and a member of the CEPR.

Laszlo Halpern is a lecturer at the Institute of Economics, the Hungarian Academy of Sciences, Budapest and a member of CEPR.

Charles Wyplosz is a professor of international economics at the Graduate Institute of International studies in Geneva and a member of CEPR. He is a frequent consultant to the IMF and World Bank and Director of the International Center for Monetary and Banking Studies.

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The Economic Policy Initiative is a body designed to strengthen public policy in transition economies and assist their accession to the EU. This, the last report from the EPI, comes from a series of discussions held at the end of 1998 and deals with the public policies of the transition economies as they look forward to joining the EU over the next decade.

Ten years into transition and the exchange rate question is still at the forefront of policy makers' minds. Initially, exchange rate policy was largely dominated by the trade-off between disinflation and external competitiveness. With few exceptions (Russia and Romania) inflation is no longer dominating the policy agenda, thanks mainly to international pressure. Those that have achieved the best growth since 1989 have settled for an inflation rate in the 10-15% range. But, even with this problem out of the way, two others have arisen - the appropriate exchange rate and the exchange rate regime.

The report deals with these in turn. Approximating the appropriate exchange rate has remained difficult as transition economies have yet to go through a full business cycle. This eliminates any hope of computing the determinants of a sustainable current account. In addition, some of them have started to undergo capital inflows of a clearly unsustainable nature. Instead, Wyplosz and Halpern have proposed a formal comparison of prices across countries that share similar characteristics. They find that the estimated equilibrium dollar wage rises during the transition period in all countries bar Bulgaria, Hungary, Russia and the Ukraine, perhaps reflecting the slide in public spending. Also the study finds that by 1996 the exchange rates of Hungary, Poland, Romania and Slovenia were overvalued. Although the authors admit these estimates are open to error they should be better than assessments of the evolution of the current account or informal international comparisons.

Next, the study deals with appropriate exchange regimes, with its gaze firmly set on joining the EU. It re-casts the choice of a regime within the framework of monetary policy: objectives, targets and instruments. The authors claim that rigid monetary targets cannot be upheld when the determinants of money demand are changing. In addition, exchange rate policy cannot be considered independently of fiscal policy. Inflation targets are unattractive until price liberalization and structural adjustments are completed. This has important implications for accession to the EMU. Limiting the exchange rate flexibility may show commitment to EMU standards but early on it may be costly to accessing countries. In the end the authors sensibly conclude that structural adjustment and fiscal responsibility are the keys to operating a rigid monetary policy.

Lastly, the report focuses on the link between fiscal policy and the success of the monetary policy. They use Canzoneri's distinction between a 'fiscal dominance' and a 'monetary dominance' regime. In the former monetary policy will solve fiscal unsustainability, while in the latter a central bank will never be coerced into bailing out an undisciplined government. Thus fiscal stabilization is the transfer from fiscal to monetary dominance. Likewise for a narrow band and parity crawl to be successful, monetary policy must be able to defend the parity. Shocks to solvency must be dealt with by fiscal policy alone.

The report is an important addition to the growing number of books about transition economies and throws new light on their different monetary, fiscal and exchange rate policies.