10095 Public Disclosure Authorized Monetary Policy Instrulments for Developing Public Disclosure Authorized CCountries ¢. ~~~0 edited by Public Disclosure Authorized Gerard Caprio, Jr. Patrick Honohan AWorld BankSymposiwn- Public Disclosure Authorized A WorldBan Sympsiu lZ i - ; Monetary Policy Instruments for DevelopingCountries editedby Gerard Caprio, Jr. Patrick Honohan A World Bank Symposium The WorldBank Washington,D.C. © 1991 The International Bank for Reconstruction and Development / THE WORLDBANK 1818 H Street, N.W., Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing October 1991 The findings, interpretations, and conclusions expressed in this study are entirely those of the authors and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they rep- resent. Because of the informality of this series and to make the publication available with the least possible delay, the manuscript has not been edited as fully as would be the case with a more formal document, and the World Bank accepts no responsibility for errors. The material in this publication is copyrighted. Requests for permission to reproduce por- tions of it should be sent to Director, Publications Department, at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial pur- poses, without asking a fee. Permission to photocopy portions for classroom use is not re- quired, although notification of such use having been made will be appreciated. The complete backlist of publications from the World Bank is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Publica- tions Sales Unit at the address in the copyright notice or from Publications, World Bank, 66, avenue d'1ena, 75116 Paris, France. Gerard Caprio, Jr., is a senior financial economist, Financial Policy and Systems Division, Country Economics Department, World Bank. Patrick Honohan, a research professor at the Economic and Social Research Institute, Dublin, was at the time of writing a senior econ- omist in the division. Library of Congress Cataloging-in-Publication Data Monetary policy instruments for developing countries / edited by Gerard Caprio, Jr., Patrick Honohan. p. cm. - (WorldBank symposium) Papers from a conference sponsored by the Country Economics Department of the World Bank Includes bibliographical references. ISBN0-8213-1969-8 1. Monetary policy-Developing Countries-Congresses. I. Caprio, Gerard. II. Honohan, Patrick. III. International Bank for Reconstruction and Development. Country Economics Dept. IV.Series. HG1496.M635 1991 332.4'91724-dc2O 91-38837 CIP a Foreword Rapidstructural change and widespreadadoption of fi- from industrial and middle income countries, together nancial sector reforms in developing countries have with some of the Bank's own financialsector specialists placed pressure on traditional instruments of monetary and those of the International MonetaryFund, to discuss control. It is widelyaccepted that, if the necessarymac- the lessons of recent experiencewith indirect methods of roeconomiccontrol can be maintained,a move to an in- monetary control. The seminar formed part of the direct, market-oriented system of monetary policy Bank's ongoing effort to evolve and disseminate best instruments will help the financial sector perform in a practice in various aspects of financialsector reform. It sounder and more efficient manner, resulting in the is hoped that this volume,which reports the edited pro- maximum contribution to economic development. ceedingsof the seminar,will be of value to policymakers It is not long since many industrial countries adopted and students of developingcountries. sweepingadjustments of their systems of monetarycon- In keeping with the informal character of the semi- trol, dismantling bank-by-bankcredit ceilingsand sec- nar, the viewsexpressed should be regarded as personal toral credit allocations. A number of middle-income ones: they do not necessarilyreflect the viewsof any in- countries have also progressed along similar paths. stitution. Manyother countries are now lookingat the experience of these pioneersto see what lessons can be learned. MillardF. Long With these developmentsin mind, the FinancialPol- Chief,Financial Policyand SystemsDivision icy and SystemsDivision of the WorldBank organized a TheWorld Bank seminar in May, 1990, which brought together experts Acknowledgments The editors acknowledgethe contribution of a number of peopleto the productionof this volume.Robert Katt pro- vided invaluableassistance in editing the transcribed portion, proofing,and laying out the finishedvolume. Karin Waeltidiligently assisted in the transcription process itself,while Wilai Pitayatonakarnand MeganPomeroy orga- nized the word processingfor later drafts. Regardingthe seminar itself,Yahaya Doka and Susan Sebastianassisted with organizationalissues, while MillardLong and AlanGelb contributedthe inspirationand impetus for both the seminar and this volume.We also gratefullyacknowledge J.B. Zulu and DouglasScott of the InternationalMonetary Fund's Central BankingDepartment for providingthe assistanceof their unit, and severalanonymous referees for helpful comments. Nonetheless,the opinions expressedherein reflect only those of the authors, participants,and the editors. The WorldBank conference "Monetary Policy Instruments for DevelopingCountries" took place on May16-18, 1990,in Washington,D.C., under the sponsorship of the CountryEconomics Department. iii Contents Contributors and Participants ix 1. The Useof MarketInstruments for MonetaryPolicy 1 GerardCaprio, Jr. and Patrick Honohan The Objectivesof MonetaryPolicy 1 Instrumentsfor SmoothingBank Liquidity 3 Copingwith Shocks 6 The Impact of GovernmentDeficit Financing 7 ExternalFlows and MonetaryPolicy 7 ConcludingComments and Outline of the Volume 8 PARTI. NUTSAND BOLTS: PRACTICAL ISSUES ON MOVINGTO INDIRECTIMPLEMENTATION OF MONETARYPOLICY Introduction 13 2. Central Bank LiquidityManagement and the MoneyMarket 15 Paul Meek Central BankMonetary Management 15 GeneralGuidelines for MoneyMarket Development 22 The Caseof Indonesia 24 Discussion 29 3. The Useof MonetaryPolicy Instruments by DevelopingCountries 37 R. Barry Johnston WhyIs There a Need to ReformMonetary Control Techniques? 37 KeyElements in a LiberalMonetary Control Framework 38 Managingthe Reformin MonetaryControl Techniques 42 Discussion 44 v 4. BuildingFinancial Institutions for a Market-BasedMonetary Policy 49 Steven Grenville AnotherModel for OpenMarket Operations 49 Issues for the AustralianModel 51 Use of OpenMarket Operations to AffectMonetary Demand 53 Conclusions 60 Discussion 61 PARTII. MONETARYTARGETING AND CONTROL Introduction 65 5. MonetaryTargeting: Lessons from the U.S. Experience 67 David Lindsey 1970 through October1979 67 October1979 Through the Fall of 1982 68 The Fall of 1982to October1987 70 October1987 to the Present 73 Discussion 80 6. MonetaryTargets: European Experience 83 CharlesGoodhart On MonetaryTargets 84 The EuropeanMonetary System 87 Central Bank Independence 88 Comment:Policy Constraints in DevelopingCountries DonaldJ. Mathieson 91 Discussion 93 An Elaboration 98 PARTIII. BUDGETDEFICITS AND MONETARY POLICY Introduction 103 7. Impact of GovernmentDeficits on MonetaryPolicy: The Caseof Italy 105 Cesare Caranza The Economicand FinancialPicture 105 A NewStrategy for MonetaryPolicy 105 Resultsof the NewPolicy 106 The RemainingProblems 107 Potential Solutions 107 vi 8. Impact of GovernmentDeficits on MonetaryPolicy: The Case of Chile 109 Juan AndresFontaine Factorsin Chile'sFinancial Liberalization 109 ManagingMonetary Policy in Chile 110 Debt-EquitySwaps 112 9. MonetaryManagement with High Inflation:The BrazilianExperience 115 CarlosAlberto Queiroz Developmentof the MoneyMarket and MonetaryPolicy 115 The Yearof Super-HighInflation 116 Discussion 118 PARTIV. THE INTERACTIONOF EXCHANGERATE AND MONETARY POLICY Introduction 123 10.Exchange Rate Policy 125 Charles Freedman Some Definitions 125 FixedVersus Flexible Rates 125 MonetaryPolicy and Intervention Policy 127 Sterilizationof Changesin InternationalReserves 128 11. Interaction of ExchangeRate Policy and MonetaryPolicy: The Caseof Malaysia 131 Lin See Yan Malaysia'sEconomic Background 131 ExchangeRate Policyand MonetaryPolicy 132 Conclusion 134 Discussion 134 vii Contributorsand Participants Contributors MichaelKlein Country Department, Europe, the Middle East and GerardCaprio, Jr. North Africa,The WorldBank Financial Policyand SystemsDivision, The World Bank DavidE. Lindsey Board of Governorsof the Federal ReserveSystem CesareCaranza ExecutiveDirector, The WorldBank Paul Meek Paul MeekAssociates, formerly Federal ReserveBank of CharlesFreedman New York Bank of Canada DonaldJ. Mathieson Stanley Fischer ResearchDepartment, InternationalMonetary Fund MIT,formerly Chief Economist, The WorldBank Ann-MarieMeulendyke Jean AndresFontaine Federal ReserveBank of NewYork Consultant,formerly Banco Central de Chile CarlosAlberto Queiroz Peter Garber BancoCentral do Brasil BrownUniversity DouglasScott Steven Grenville Central Banking Department, International Monetary ReserveBank of Australia Fund Charles Goodhart RezaVaez-Zadeh