The Unending Search for Monetary Salvation

This paper discusses some recently popular strategies for improving the performance of monetary policy, including increasing the independence of the central bank, setting explicit inflation targets, and fixing the exchange rate. With respect to central bank independence, the most important conclusion is that a central bank should have instrument independence (the freedom to set its instruments as it chooses) but not goal independence (the freedom to set its ultimate objectives); this arrangement makes the central bank accountable, which is necessary both for the central banker to have proper incentives and for democratic oversight. The need for accountability is also a reason to set explicit inflation targets; inflation targeting does not necessarily imply greater output variability, if the target inflation rate is adjusted for supply shocks. Fixing the exchange rate—even temporarily—may help reduce inflation and inflationary expectations, particularly in an economy starting from a situation of low central bank credibility.