Monetary Policy in a Very Open Economy: Some Major Analytical Issues

• Published date: 01 February 2014
• Author: Bennett T. McCallum
• Date: 01 February 2014
• DOI: http://doi.org/10.1111/1468-0106.12051

MONETARY POLICY IN A VERY OPEN ECONOMY:

SOME MAJOR ANALYTICAL ISSUES

BENNETT T. MCCALLUM*Carnegie Mellon University and National Bureau

of Economic Research

Abstract. This paper develops three considerations relevant to the possibility of modif‌ication of the

Hong Kong currency board system for conducting monetary/exchange-rate policy. The f‌irst con-

cerns the system employed by Singapore, an economy similar in several ways to Hong Kong’s,

whereby the exchange rate is adjusted periodically in activist response to inf‌lation and output

developments. The second concerns a generalization, one that calls for adjustments of a weighted

average of exchange rate and interest rate instruments, so designed to be effective whether the

economy is, or is not, in a liquidity-trap situation. Finally, the third topic concerns political-

economy aspects of policy, which tend to incline against the use of the activist systems.

1. INTRODUCTION

Since the adoption in October 1983 of its famous currency board arrangement,

with the Hong Kong dollar (HKD) linked to the US dollar (USD) at a rate of

7.8 HKD per USD, Hong Kong has experienced excellent economic growth

with a notable absence of serious monetary/exchange-rate problems. With the

recent relaxation of the relationship of the Chinese renminbi (RMB) to the

USD, however, and the growing importance of the RMB in international rela-

tions, consideration of the possibility of modif‌ication of the Hong Kong (HK)

currency-board system has increased.1The purpose of this paper is to present

some analysis that is highly relevant to this consideration, primarily by review-

ing two previous writings of my own on related matters. Specif‌ically, Sections 2

and 3 draw quite heavily on McCallum (2007) and (2005). The f‌irst of these

concerns the monetary/exchange-rate system employed by Singapore, another

economic area that is in several respects similar to Hong Kong, while the second

discusses a type of monetary policy rule that amounts to a generalization of the

Singapore system. Third, I will introduce some political-economy considera-

tions, ones that have been nicely developed in a paper by George Selgin (2010),

that work in the opposite direction from the activist-oriented thrust of the f‌irst

two topics.

*Address for Correspondence: Tepper School, Carnegie Mellon University, Pittsburgh, PA, 15213,

USA. E-mail: bmccallum@cmu.edu.

This paper was prepared for the Workshop on Linked Exchange Rates, Hong Kong Economic

Association, 1 June 2012, in Hong Kong. I am indebted to David Cook and to an anonymous referee

for helpful suggestions.

1For a relevant and recent quantitative study, see Lim and McNelis (2012).

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Pacif‌ic Economic Review, 19: 1 (2014) pp. 27–60

doi: 10.1111/1468-0106.12051

© 2014 Wiley Publishing Asia Pty Ltd

2. THE MONETARY REGIME OF SINGAPORE

2.1. Characterization

Let us begin with an informal description of the Singapore system, before

turning to a presentation utilizing an analytical model. A useful quote from a

1-page summary by the Monetary Authority of Singapore (MAS) is as follows:

Since 1981, monetary policy in Singapore has been centered on the management of the

exchange rate. The primary objective has been to promote price stability as a sound

basis for sustainable economic growth. The exchange rate represents an ideal inter-

mediate target of monetary policy in the context of the small and open Singapore

economy. . . . First, the Singapore dollar is managed against a basket of currencies of

our major trading partners and competitors. . . . Second, MAS operates a managed

f‌loat regime. . . . The trade-weighted exchange rate is allowed to f‌luctuate within a

policy band, the level and direction of which is announced semi-annually to the

market. . . . Third, the exchange rate policy band is periodically reviewed to ensure

that it remains consistent with the underlying fundamentals of the economy (MAS,

undated).

A careful reading of the foregoing, plus additional descriptions by MAS

off‌icials, reveals a crucial aspect of this procedure. It is that the band, within

which the Singapore dollar (SD) effective exchange rate is kept, is not at all

constant through time. Instead, the band may move upward or downward

automatically as time passes (to allow for expected ongoing appreciation or

depreciation) and, more importantly, both the level and slope of the band, and

even its width, may be discretely adjusted each decision period.2Crucially, these

adjustments are made in a manner that is designed to keep inf‌lation low; that is,

to promote price stability. Some adjustments of the band may, in addition, be

made in response to prevailing (or forecasted) behaviour of real variables such

as aggregate output or employment. Thus, the type of exchange rate manage-

ment employed by the MAS is very different from a traditional f‌ixed exchange

rate. In fact, it would appear that the MAS has operated with policy objectives

quite similar to those of the (pre-2008) Federal Reserve or the European Central

Bank or the Bank of England, that is, to maintain low inf‌lation as a priority,

with some attention also paid to output and/or employment considerations.

Indeed, the MAS system might even be regarded as basically a variant of

inf‌lation targeting, not a f‌ixed exchange-rate system!

To continue in this vein, the MAS procedures seem very much like those of

inf‌lation-targeting central banks except that its policy management involves

periodic adjustments in the exchange rate, rather than a short-term nominal

interest rate.3The reason for this difference in policy behaviour is, moreover,

2The MAS often refers to the ‘BBC’ aspects of its procedure, these letters referring to ‘band, basket

and crawl’. That terminology, which draws upon Williamson (1999, 2001), will be discussed further

in Subsection 2.2.

3The MAS system does, as will be seen below, include practices that do not ref‌lect policy trans-

parency of the type or degree usually attributed to inf‌lation-targeting central banks.

B. T. McCALLUM

28

© 2014 Wiley Publishing Asia Pty Ltd

quite straightforward and simple: the Singapore economy is much more open to

foreign trade than those of, for example, the United States, Japan, the euro area

or the UK. Instead of an export/GDP ratio of approximately 0.15 (or around

0.25 for the UK), for Singapore the value is currently approximately 1.4–1.5.

Thus, the exchange-rate channel of monetary policy transmission is much more

important, relative to the familiar interest-rate channel, than in larger economies

that are less open to international trade. Accordingly, use of the exchange rate,

rather than a short-term interest rate, as the principal instrument/indicator

variable for monetary policy, may provide a relatively more effective way of

managing aggregate demand.4This policy comparison will be analytically illus-

trated below.

The foregoing suggestion that the MAS policy framework is basically one in

which inf‌lation is the main target variable, with the exchange rate being used

primarily as an instrument or indicator for specifying policy changes that are

designed to keep inf‌lation close to target, is supported by the behaviour of the

exchange rate over the years 1981–2005. The period discussed here begins with

1981 because that is the year in which the current MAS policy regime was put in

place, according to MAS (undated, 2001). The statistics indicate that, over the

span from 1981 to the middle of 1997, the SD appreciated in value by approxi-

mately 45% relative to the policy basket, despite a large drop in 1985–1987. This

appreciation was needed to prevent inf‌lation because: (i) foreign inf‌lation was

proceeding at a rate higher than the Singapore target; and (ii) because rapid

productivity growth in Singapore was bringing about an ongoing appreciation

in real terms, due perhaps to the Balassa–Samuelson effect. After a fall during

the Asian f‌inancial crisis of 1997–1998, the value of the S$ levelled off and has

not changed much since. Even so, the value of the S$ remained approximately

35% higher in 2005 than in 1981 in terms of the (trade-weighted) basket.

More formal evidence in this regard requires a more analytical description of

policy behaviour. The most common formulaic representation of monetary

policy procedures for more typical economies is provided by some variant of the

‘Taylor rule’, introduced by John Taylor (1993), which relates periodic adjust-

ments in a money-market interest rate made in response to existing (or pre-

dicted) inf‌lation and output-gap measures. A standard formulation is

Rr p p yy

ttt ttt

=+ + −

()

+−

()

+≥ΔΔ

μπμ ημμ

12 12

0*,,

(1)

where Rtis the interest rate, Δptis the current inf‌lation rate, π* is the target

inf‌lation rate (at which the central bank wishes to keep inf‌lation on average),

and yy

tt

−is the output gap; that is, the percent (or fraction) by which real

output exceeds the ‘natural rate’ of output that represents an eff‌icient

4One should not infer, however, that adjustments in the exchange rate are necessarily implemented

by open market purchases in the foreign exchange market. Except when interest rates are at (or near)

zero, such adjustments could alternatively be implemented by purchases in the domestic money

market. Throughout, I presume that purchases or sales in the foreign exchange market are not

sterilized. If a policy action concerning the exchange rate is undertaken for the purpose of affecting

aggregate demand, it makes no sense at all to use sterilized interventions.

MONETARY POLICY IN A VERY OPEN ECONOMY

29

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