Has Monetary Policy Been So Bad That It Is Better to Get Rid of It? The Case of Mexico

MANY LATIN AMERICAN COUNTRIES are considering adopting the U.S. dollar as legal currency, and some, like Ecuador, have taken concrete steps in that direction. Proponents of dollarization generally hold the view that domestic monetary policy has been the primary cause for the economic instability experienced by these countries in the past three decades. Yet, at least for Mexico, very few empirical studies have tried to identify the role of monetary policy.

The existing empirical literature on Mexican monetary policy consists mainly of single equation estimations (see Calvo and Mendoza 1996 and Kamin and Rogers 1996), or of reduced-form vector autoregressions (see Copelman and Werner 1995 and Hernandez 1999).(1) The first class of models is silent on the impact of monetary policy on the rest of the economy. The second class of models, by definition, cannot identify monetary policy. In addition, all previous literature has either ignored the issue of changes in regime, or has confined itself to the study of monetary policy within regimes. This despite the fact that some of Mexico’s major crises occurred during the passage from one regime to another. A proper evaluation of the impact of monetary policy on the Mexican economy requires that these critical transition periods are considered.

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Monetary Policy and Interest Rates

Among other things that influence interest rates, monetary policy is also one of them. Democratic governments use two policy tools to help their economies thrive. There is the fiscal policy and monetary policy.

First, let us discuss the difference of fiscal policy to monetary policy. Fiscal policy pertains to the power of the government with congresses or parliament’s consent to increase or decrease tax rates. To increase tax rates, would mean to take away the disposable income of civilians. Think of it this way, the economy is a wheel. The movement of money makes the wheel turn. When people spend less money, the economy turns slowly. So the government increases taxation. The extra money the government collects is then spent on projects that will pour money back into companies for government mandated projects. These companies in turn will give them back to the people by employing more employees or by paying their existing ones with more. Such spending is also known as “pump-priming” activities.

Another instrument of fiscal policy would be for the government to borrow money for its expenditures. They do this so as not to over tax their citizens and provoke protest actions against their management. However, borrowing is not always an option. Lenders do not easily part with their funds. The general economic environment is placed into consideration.

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The real effects of monetary policy in the European Union: what are the differences?

The advent of European Economic and Monetary Union (EMU) scheduled for the beginning of 1999 has sparked off a debate about the best way of conducting monetary policy in the euro area. One dimension of this discussion concerns the preferred framework for conducting monetary policy-that is, about whether the European Central Bank (ECB) ought to target inflation, monetary aggregates, or the exchange rate. A second is about differences in the effects of changes in monetary policy on activity in different EU countries, related to differences in the transmission mechanism.

Opinions have tended to be divided on the question of the preferred monetary policy framework for the euro area, although recently, there appears to be a consensus emerging in favor of informal inflation targeting, accompanied by monitoring of monetary aggregates and other indicators. In any event, policy discussions have in general tended to focus less on questions relating to the real effects of monetary policy in the EU than on the issue of the appropriate framework for conducting monetary policy in the euro area. This may be partly due to the fact that many of the issues pertaining to identification of the monetary transmission mechanism tend to be econometric rather than economic. Nevertheless, a proper understanding of possible differences in the effects of changes in monetary policy on activity among the EU countries is crucial for an appreciation of the difficulties that may arise from the implementation of a unified monetary policy throughout the euro area. And this issue is the main focus of the paper.

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