2.3.2 Monetary Policy Rules
According to Taylor (1998) the monetary policy rule is defined
as a description, expressed algebraically, numerically and graphically-of how
the instruments of policy such as the monetary base or federal funds rate,
change in response to economic variables. Taken in a general sense, a rule can
be defined as «nothing more than a systematic decision-making process that
uses information in a consistent and predictable way» (Taylor, 1998:2).
The concept of monetary policy rule is the application of this principle in the
implementation of monetary policy by the Central Bank (Poole, 1999). Svensson
(1998) defines a monetary policy rule simply as a prescribed guide for monetary
policy conduct.
In policy conducted by rule, policymakers announce in advance
how the policy will respond in various situations, and commit themselves to
following through. Taylor (1998) notes that one monetary policy rule can be
said to be better than another monetary policy rule if it results in better
economic performance according to the same criteria such as inflation or the
variability of inflation and output.
In the following pages, various economic rules such as the
Exchange Rate Targeting Rule, the Money Supply Rule, GDP Targeting Rule,
Inflation Targeting Rule and Taylor Rule will be discussed in terms of their
abilities to guide Central Bankers.
2.3.2.1 Exchange Rates Rule
Exchange rate regime considerations play a strong role in
influencing monetary policy in a country. The rate of exchange means the price
of one currency in comparison with another currency. Mishkin (1997) argued that
«if a Central Bank does not want to see it currency fall in value, it may
pursue a more contractionary monetary policy and reduce the money supply to
raise the domestic interest rate, thereby strengthening its currency. Similarly
if a country experiences an appreciation in its currency, domestic industries
may suffer from increased foreign competition and may pressure the Central Bank
to pursue a higher rate of monetary growth in order to lower the exchange
rate» (Mishkin, 1997: 523).
The two most noted exchange rates regimes, fixed and floating
exchange rates tend to be extended from pegs to target zones, to floats with
heavy, light, or no intervention.
Initially, in a fixed exchange rate system, the exchange rates
are determined by the governments and Central Banks rather than the free
market, and are maintained through foreign exchange market intervention
(Dornbusch, Fisher and Startz, 2001). On the other hand, the same author
explains that the floating exchanges system is a system in which exchange rates
are allowed to fluctuate with the forces of supply and demand. The terms
flexible and floating rates are used interchangeably.
When it is taken into account that interventions can be made
from the flexible exchange rate depending on whether there is a need to get the
exchange rate floated with heavy or light intervention, as noted above, a third
way classification named the intermediate exchange rate system can be
mentioned. This rate is taken as floating rates, but within a predetermined
range
Accordingly, distinction is drawn between on the one hand,
dirty floating which is a flexible exchange rate system in which the Central
Bank intervenes in foreign exchange markets in order to affect the (short-term)
value of its currency and on the other hand, clean floating which is a flexible
exchange rate system in which the Central Bank does not intervene in foreign
exchange markets (Dornbusch, Fisher and Startz, 2001).
In the conduct of monetary policy based on exchange rate
target a major trading partner country needs to be selected and then a range of
values of the domestic currency to that country needs to be set. The major
partner retained should be characterised by a stable economy with low
inflation. The approach consists of maintaining the exchange rate at a target
range. This situation makes money supply endogenous because the Central Bank
needs to provide the foreign exchange or domestic currency demanded within the
set targets (Musinguzi and Opondo, 1999).
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