THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 575

CHAPTER 20

The International Financial System

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market constrains central bankers from pursuing overly expansionary monetary
policy and constrains politicians from putting pressure on the central bank to
engage in overly expansionary monetary policy, fear of exchange-rate depreciations can make overly expansionary monetary policy, and the time-inconsistency
problem, less likely.
The need for signals from the foreign exchange market may be even more acute
for emerging-market countries, because the balance sheets and actions of their central banks are not as transparent as they are in industrialized countries. Targeting the
exchange rate can make it even harder to ascertain a central bank s policy actions.
The public is less able to keep watch on the central bank and the politicians pressuring it, which makes it easier for monetary policy to become too expansionary.

When Is
Exchange-Rate
Targeting
Desirable for
Industrialized
Countries?

Given the above disadvantages with exchange-rate targeting, when might it be an
appropriate strategy?
In industrialized countries, the biggest cost to exchange-rate targeting is the loss
of an independent monetary policy to deal with domestic considerations. If an independent, domestic monetary policy can be conducted responsibly, this can be a serious cost indeed, as the comparison between the post-1992 experiences of France
and the United Kingdom indicates. However, not all industrialized countries have
found that they are capable of conducting their own monetary policy successfully,
either because the central bank is not independent or because political pressures on
the central bank lead to an inflationary bias in monetary policy. In these cases, giving up independent control of domestic monetary policy may not be a great loss,
while the gain of having monetary policy determined by a better-performing central

bank in the anchor country can be substantial.
Italy provides an example: It was not a coincidence that the Italian public had
the most favourable attitude of all those in Europe toward the European Monetary
Union. The past record of Italian monetary policy was not good, and the Italian
public recognized that having monetary policy controlled by more responsible
outsiders had benefits that far outweighed the costs of losing the ability to focus
monetary policy on domestic considerations.
A second reason why industrialized countries might find targeting exchange
rates useful is that it encourages integration of the domestic economy with its
neighbours. Clearly, this was the rationale for long-standing pegging of the
exchange rate to the deutsche mark by countries such as Austria and the
Netherlands, and the more recent exchange-rate pegs that preceded the European
Monetary Union.
To sum up, exchange-rate targeting for industrialized countries is probably not
the best monetary policy strategy to control the overall economy unless (1) domestic monetary and political institutions are not conducive to good monetary policymaking or (2) there are other important benefits of an exchange-rate target that
have nothing to do with monetary policy.

When Is
Exchange-Rate
Targeting
Desirable for
EmergingMarket
Countries?

In countries in which political and monetary institutions are particularly weak and
which therefore have been experiencing continued bouts of hyperinflation, a characterization that applies to many emerging-market (including transition) countries,
exchange-rate targeting may be the only way to break inflationary psychology and
stabilize the economy. In this situation, exchange-rate targeting is the stabilization
policy of last resort. However, if the exchange-rate targeting regimes in emergingmarket countries are not always transparent, they are more likely to break down,
often resulting in disastrous financial crises.