1. Open Market Operations
2. Discount Rates
3. Reserve Requirements

Since open market operations is the tool used most, we will cover it. Here’s how it works: When the economy is growing too fast and the Fed is worried about the inflation rate, it will sell government securities from its portfolio to the open market. This decreases bank reserves, which means the money supply decreases. When there are less bank and businesses have to pay the bank more in order to borrow. This discourages consumers and businesses from borrowing. Less borrowing means less spending, which slows the economy and eventually can reduce price pressures.

When the economy is growing too slowly and the inflation rate is low the Fed will buy government securities, such as Treasury bills and notes. This increases bank reserves, which increases the money supply and causes short-term interest rates to decrease. Reduced rates induce consumers and businesses to borrow. Consumers will borrow money for items such as automobiles or home loans. Businesses borrow to build their inventories or finance a new factory. As a result, economic growth will accelerate.

The Fed will also leave rates unchanged if the economy is growing at a moderate pace with low inflation or if they feel the economy will slow down by itself. They will even take a wait-and-see approach with regard to how slowly the economy is growing and the rate of inflation, before determining monetary policy.

The bond market plays close attention to the activities of the Federal Reserve, which is why it’s important for us as well.

The Federal Reserve has three goals:

1. Moderate economic growth (not too fast, not too slow)
2. Low unemployment
3. Low inflation

How does the Fed determine whether they are reaching these goals? They watch the same economic indicators as we do. In other words, they monitor the reports that are released by the Labor Department, the segments of our economy.

For instance, the Gross Domestic Product (GDP) consists of four major components: (1) consumption; (2) investment; (3) government; (4) exports. Most of the key economic indicators fall into one of the above categories. For example:

• Retail sales would fall under consumption.
• Business inventories and housing starts would fall under investment.
• Construction Spending would fall under government.
• Trade would fall under exports.

If the key economic indicators continue to come in strong, the GDP will increase. If the indicators come in weak, it will decrease. In other words, Gross Domestic Product measures economic growth.

It is possible to motivate our analysis in several ways. A number of countries are considering whether to abandon national monetary sovereignty and unilaterally adopt the money of another country, including Mexico and Argentina; Ecuador, Guatemala, and El Salvador are already proceeding with dollarization. In Europe, 12 countries have already abandoned national monetary discretion within the Economic and Monetary Union (EMU). More generally, there has been much discussion of the “disappearing center” of exchange rate regimes; countries are said to have a choice of either freely floating or going to an extreme monetary stance.

A tight monetary regime might be expected to be associated with a smaller fiscal presence because it reflects generally conservative economic policies. It also might induce conservative fiscal policy to harmonize policy, avoid fiscal externalities, and enhance the sustainability of the monetary regime, as is the (partial) intent of the “Growth and Stability Pact” (Eichengreen and Wyplosz, 1998). More generally, if one interprets an extreme monetary regime as a credible commitment device to improve credibility by limiting discretionary economic policy, then one might expect a smaller fiscal presence in extreme monetary regimes. On the other hand, a tight monetary regime makes fiscal policy a more potent tool of policy in a variety of models. For instance, the classic Mundell-Fleming logic dictates that fiscal policy grows in importance when monetary independence is abandoned. The role of fiscal policy might therefore be expected to be large in countries with extreme monetary regimes. The purpose of this paper is to explore if there is in fact any systematic difference between fiscal policy in extreme monetary regimes and fiscal policy in typical countries that retain monetary sovereignty.

In our analysis we consider the issue of endogeneity. Some countries have experienced episodes of hyperinflation associated with loose fiscal policy that have in turn led toward tighter monetary regimes. This is very relevant in practice for currency boards; one thinks of Argentina as the quintessential example. Hence, one might expect to see very loose fiscal policy preceding the adoption of a currency board and much tighter policy after the date of adoption. We argue below that this endogeneity problem is not nearly so relevant for currency unions. Currency unions have not been adopted as a result of episodes of macroeconomic instability, and indeed most of the currency unions in the data remain as such for the whole sample period. Still, our results are best viewed as correlations rather than causal statements, especially in the case of currency boards.

We find that currency boards and multilateral currency unions are characterized by conservative fiscal policies. Their governments are smaller, and on average they have kept a larger budget surplus when compared with either all the other countries in our sample or a restricted sample of countries with fixed exchange rates. Unilateral currency unions, on the other hand, are characterized by governments that spend more, as a percentage of GDP. This result supports the view that the implementation of fiscal policy in currency boards is dominated by the goal of adding credibility to the monetary regime. In multilateral currency unions, the restrictions on fiscal policy might originate in the possible externalities associated with loose national fiscal policies. This type of reasoning has recently led to explicit restrictions on budget deficits in both the EMU and the proposed West African Economic and Monetary Union (WAEMU).

John Taylor’s rule for setting interest rates provides a framework for studying the global monetary policy generated by individual countries pursing their own policy goals. The study reflects the global nature of monetary policy by modeling an aggregate short-term interest rate as a function of measures of worldwide inflation and the GDP gap. Multiple specifications are estimated to correspond to past studies of the U.S. relationships between these variables. The authors find that Taylor rule is a useful tool for characterizing the global monetary environment as his equation provides a good fit to the data in every specification explored by the authors. However, the international response to inflation is slightly less robust despite claims of inflation targeting by the bulk of the larger economies in the sample. (JEL F33)

Introduction

As each country pursues its monetary agenda, what is the nature of the resulting global monetary policy? Applying John Taylor’s rule for setting interest rates helps to answer this critical policy question. The “Taylor Rule” presents the Federal funds rate as a simple linear function of the inflation rate and the GDP gap [Taylor, 1993]. Researchers have taken his simple rule, which prescribes policy, and used multiple regression techniques to estimate what weights the monetary authorities actually use in setting interest rates. They find that the rule’s recommendations have come very close to the actual policies pursued by the Fed in the recent past [Taylor, 1993; Judd and Rudebusch, 1998]. Earlier monetary regimes followed far different paths [Spencer and Huston, 2002].

The formulation of monetary policy has become increasingly complicated. The relaxation of restrictions on the flow of money among countries has made the monetary policies of individual countries more interdependent. Thus, the three variables in Taylor’s Rule are now less under the control of individual countries. For example, when capital flows are unfettered, interest rates around the world tend to move together [van der Ploeg, 1995]. As a result, efforts to unilaterally change U.S. policy rates become more difficult. Inflation, too, can be a shared experience as monetary expansion in one country spills over into other countries [Hamada, 1985]. (1) The GDP gap is also affected by the policies of other countries. For example, U.S. monetary policy clearly affects the GDP gaps of its major trading partners.

The study presented here reflects the global nature of monetary policy by modeling an aggregate short-term interest rate as a function of measures of worldwide inflation and the GDP gap. The results facilitate judgments about the implicit monetary policies of the world. That is, as each country pursues its own monetary agenda, what is the nature of the aggregate monetary policy that is produced? This is a critical question for monetary policy making. Since a country’s actions have spillover effects for other countries, it is not clear that uncoordinated monetary policies produce optimal worldwide results.

Replicating U.S. studies at the international level demonstrates that the Taylor Rule is a useful tool for characterizing the global monetary environment as his equation provides a good fit to the data in those specifications explored by the authors. At the world level, however, the aggregate of central banks reacts less to inflation than does the Federal Reserve. The inflation target may have become more important to central banks, in total, in the 1990s but the evidence is not strong.