Alternative monetary-policy instruments and limited credibility: an exploration

BIS Working Papers  |  No 1020  | 
14 June 2022

This paper was produced as part of the Final Conference of the BIS-CCA Research Network on "Monetary policy frameworks and communication (2019-2022)".



Inflation-targeting frameworks has led the literature to focus on monetary policy rules with a short-term interest rate as the main instrument. However, this is not representative of monetary policy implementation around the world. According to IMF AREAER database, in 2019 only 21% of 192 countries use such an instrument. Also, most studies analyzing rules for interest rates assume rational expectations and a high degree of credibility. However, many low-income and emerging countries face limited credibility. This paper study on what extent the instrument choice depends on the limits to credibility.


The comparison uses a small and open economy model with price and wage rigidities. To capture limits to credibility, we assume that inflation expectations are not rational, they are determined by econometric models that use past data to forecast (adaptive learning). In particular, the role that exchange rate movements may influence medium- and long-term inflation. Three simple policy rules are compared: a Taylor rule for interest rate, monetary aggregate growth rate, and an exchange rate peg. The pros and cons of using each of them are analyzed when the economy faces a shock to external borrowing costs.


The benefits and costs of these alternatives depend largely on the credibility framework. With high credibility (rational expectations) there is a trade-off between the dynamics of activity and inflation when a Taylor rule and money growth are compared, while maintaining a peg is costly. With limited credibility (adaptive learning), if exchange-rate surprises persistently change inflation expectations, the potential benefits of money-based rules are more limited. Thus, reducing exchange-rate volatility may be desirable to limit the costs associated with un-anchored expectations


We evaluate the dynamics of a small and open economy under simple rules for alternative monetary-policy instruments, in a model with imperfectly anchored expectations. The inflation-targeting consensus indicates that interest-rate rules are preferred, instead of using either a monetary aggregate or the exchange rate as the main instrument; with arguments usually presented under rational expectations and full credibility. In contrast, we assume agents use econometric models to form inflation expectations, capturing limited credibility. We compare the dynamics after a shock to external-borrowing costs (arguably one of the most important sources of fluctuations in emerging countries) under three policy rules: a Taylor-type rule for the interest rate, a constant-growth-rate rule for monetary aggregates, and a fixed exchange rate. The analysis identifies relevant trade-offs in choosing among alternative instruments, highlighting specially the role of exchange-rate volatility in shaping medium- and long-term inflation forecasts, and its consequences for policy design.

JEL classification: E52, E31.

Keywords: monetary policy rules, credibility, inflation expectations.