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Complete Issue FEDERAL RESERVE BANK OF ST. LOUIS R EVIEW NOVEMBER/DECEMBER 2001 VOLUME 83, NUMBER 6 Inflation Targets and Inflation Targeting Laurence H. Meyer Equity Financing of the Entrepreneurial Firm Frank A. Schmid Dollarization as a Monetary Arrangement for Emerging Market Economies Gaetano Antinolfi and Todd Keister Persistence, Excess Volatility, and Volatility Clusters in Inflation Michael T. Owyang R EVIEW Director of Research Robert H. Rasche Associate Director of Research Cletus C. Coughlin Review Editor William T. Gavin Banking R. Alton Gilbert Frank A. Schmid David C. Wheelock International Christopher J. Neely Michael R. Pakko Patricia S. Pollard Macroeconomics Richard G. Anderson James B. Bullard Michael J. Dueker Hui Guo Kevin L. Kliesen Michael T. Owyang Daniel L. Thornton Regional Rubén Hernández-Murillo Howard J. Wall Adam M. Zaretsky Managing Editor George E. Fortier Assistant Editor Lydia H. Johnson Graphic Designer Donna M. Stiller Review is published six times per year by the Research Division of the Federal Reserve Bank of St. Louis. Single-copy subscriptions are available free of charge. Send requests to: Federal Reserve Bank of St. Louis, Public Affairs Department, P.O. Box 442, St. Louis, Missouri 63166-0442, or call (314) 444-8808 or 8809. The views expressed are those of the individual authors and do not necessarily reflect official positions of the Federal Reserve Bank of St. Louis, the Federal Reserve System, or the Board of Governors. © 2001, The Federal Reserve Bank of St. Louis. Articles may be reprinted, reproduced, published, distributed, displayed, and transmitted in their entirety if this copyright notice is included. Please send a copy of any reprinted, published, or displayed materials to George Fortier, Research Division, Federal Reserve Bank of St. Louis, P.O. Box 442, St. Louis, Missouri 63166-0442; [email protected]. Please note: Abstracts, synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis. Please contact the Research Division at the above address to request permission. FEDERAL RESERVE BANK OF ST.LOUIS offerings against the background of asymmetric Contents information between the entrepreneur and the (outside) investor. The analysis shows that venture capital financing (i) is superior to initial Volume 83, Number 6 public offerings when the entrepreneur has low initial wealth relative to the size of the 1 Inflation Targets and Inflation Targeting project and (ii) is equivalent otherwise. This result highlights the importance of private Laurence H. Meyer equity in financing entrepreneurial enterprises. The Gramm-Leach-Bliley Act of 1999 allows The Federal Reserve currently has a dual man- banks to expand the scope of their activities date: promote price stability and full employ- in this arena. The act allows financial holding ment. In a speech presented at the University of companies to provide equity financing to non- California at San Diego Economic Roundtable, financial enterprises for up to ten years. In Laurence Meyer explores two policy options particular, the act defines a framework in which that would change the current framework. financial holding companies can sponsor pri- Meyer discusses whether the United States vate equity funds that may provide venture should (i) move to an inflation-targeting regime capital to entrepreneurial start-ups. (placing primary emphasis on price stability) or (ii) set an explicit numerical target for inflation 29 Dollarization as a Monetary Arrangement within the context of the current dual mandate. for Emerging Market Economies For background, he describes an inflation- targeting regime, reviews various mandates Gaetano Antinolfi and Todd Keister around the world, and discusses common elements and differences among the regimes. Official dollarization refers to the adoption of He then explores each option. Because the first the U.S. dollar as legal tender in place of the option may reduce the flexibility of monetary national currency. Some Latin American coun- policy too stringently, it is determined to be tries have recently dollarized, and others have undesirable. The second option would, in the seriously considered dollarization. This article author’s opinion, give added precision to an discusses the reasons behind the surge of inter- already mandated objective because it would est in dollarization and provides a review of improve transparency and accountability of the new academic literature on the topic. It the Fed, anchor inflation expectations and discusses in detail some of the factors that are increase the Fed’s credibility, and institutional- commonly considered to be the important ize good monetary policy. The steps necessary costs and benefits of dollarizing. The paper to implement the preferred option are outlined. also provides an analysis of the existing liability dollarization in several countries and its rela- 15 Equity Financing of the Entrepreneurial tion with official dollarization. Finally, it briefly Firm looks at dollarization from the perspective of the United States. Frank A. Schmid 41 Persistence, Excess Volatility, and Volatility Equity financing of the entrepreneurial firm Clusters in Inflation has achieved a rapid increase over the past decade. Venture capital funds, which finance Michael T. Owyang privately held start-ups, raised a record $92.3 billion in 2000. This is a 30-fold increase This paper presents a single, integrated model relative to 1990. At Nasdaq, initial public offer- to explain the persistence and volatility charac- ings raised an all-time high of $53.6 billion in teristics of the U.S. inflation time series. Policy- 2000, which is 24 times as much as in 1990. maker learning about a Markov-switching This article studies venture equity financing natural rate of unemployment in a neoclassical and equity financing through initial public Phillips curve model with time-varying prefer- NOVEMBER/DECEMBER 2001 i R EVIEW ences produces inflation persistence, volatility clustering, and mean/variance correlation. The interaction between the policymaker’s prefer- ences and the Phillips curve generates the first and last results. Policymaker learning produces clusters of volatility as the monetary authority resets the learning algorithm whenever a shock to the Phillips curve occurs. Simulations using parameters estimated via Gibbs sampling con- firms the theory. 53 Working Paper Series 59 Review Index 2001 ii NOVEMBER/DECEMBER 2001 FEDERAL RESERVE BANK OF ST.LOUIS do not favor, is moving to an inflation-targeting Inflation Targets and regime—that is, also substituting a hierarchical mandate for our current dual mandate. The purpose Inflation Targeting of this lecture is therefore to explain the benefits of an explicit inflation target in the context of the Laurence H. Meyer Federal Reserve’s dual mandate and to set out the operational steps for implementing such a target. here is widespread agreement that price Before proceeding, let me note that the views stability (in practice, low and stable inflation) that I am presenting here are my own. I am not should be an objective of monetary policy. speaking for the Board of Governors or the Federal T Open Market Committee (FOMC). This agreement is reflected both in the mandates set for monetary policy by governments and in the THE EVOLUTION OF MONETARY practice of central banks. Several other important POLICY MANDATES questions about the objectives for monetary policy are less settled: Should there be other objectives? A good starting point is a survey of mandates If there are multiple objectives, should one of the around the world. I will begin by discussing the objectives take priority? And how explicit should evolution of the mandate in the United States, the objectives be? including the precise language related to the dual Central banks typically operate under one of two mandate, the way in which the price stability objec- types of mandate. A hierarchical mandate makes tive has been interpreted, and proposed legislation price stability the primary objective for monetary that would have amended the mandate. Then I policy and subordinates other potential objectives. sketch an inflation-targeting regime and discuss A dual mandate recognizes two objectives—price some common elements and differences among stability and full employment—and puts them on the inflation-targeting regimes of developed econ- an equal footing. Either regime could make the price omies around the world. stability objective more precise by setting an explicit numerical target for inflation. The Evolution of Policy Objectives in Thus we can describe a typical central bank’s the United States mandate and objectives in terms of two sets of In the United States, it took quite some time for alternatives: between a hierarchical or a dual man- the Congress to establish a precise set of objectives date, on the one hand, and an implicit or explicit for monetary policy. In fact, remarkably little about inflation objective, on the other hand. During the policy objectives was included in the original Federal 1990s, a number of central banks adopted a frame- Reserve Act in 1913. The only policy objectives of work that is called inflation targeting, combining the Fed, as identified in that statute, were “to furnish a hierarchical mandate and an explicit inflation an elastic currency [and] to afford means of redis- objective. The United States, in contrast, combines counting commercial paper.” The absence of any a dual mandate
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