Conference on Challenges to Central Banking from Globalized Financial Systems

AuthorAndrea Schaechter/Mark Stone/Marco Arnone
Pages10-11

Page 10

Choosing the right exchange rate regime is a traditional dilemma central banks face. Richard Webb (Central Reserve Bank of Peru) observed that there are additional complications, though, when a country has a partially dollarized economy. For Peru, the limited use of U.S. dollars for transactions and wages (currency substitution or real dollarization) coupled with the vulnerability of Peru's open economy to external shocks suggested that a floating exchange rate would be appropriate. But with a large share of private sector liabilities denominated in U.S. dollars (financial dollarization), a large depreciation could translate into financial instability, and that implies a fixed exchange rate is best. In Peru's case, monetary policy options are further constrained by a lack of domestic-currency-denominated financial instruments. Webb noted that Peru has been able to adopt a floating exchange rate and an explicit inflation targeting framework because its low degree of real dollarization-and thus low "pass-through" from exchange rate movements to domestic prices-allows an independent monetary policy. Alain Ize (IMF) remarked that dollarization can build in a vicious circle from currency instability to financial instability to excessive foreign exchange intervention, which can lead to more dollarization. For dollarization to be "cured," a gradual commitment to the currency in the form of an inflation target and better prudential regulation are needed.

The challenges for monetary policy from globalized financial markets may enhance the advantages of monetary unions, but this option comes with its own set of practical difficulties, according to Gert Jan Hogeweg (European Central Bank). He laid out a list of preconditions for the success of a monetary union such as the creation of common market, harmonized legal systems, areawide large value payment systems and security settlement systems, economic convergence, fiscal consolidation, and the creation of an independent central bank with a clear monetary policy framework. In particular, the importance of the latter two conditions for the success of a monetary union was also highlighted by K. Dwight Venner (Eastern Caribbean Central Bank).

There are special challenges, too, for countries that want to use an inflation target as an anchor for monetary policy but cannot fully commit to a full-fledged inflation targeting regime. Mark Stone (IMF), in his presentation, termed this policy option...

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