Monetary Policy Under an Exchange Rate Anchor

IMF Working Papers, September 4, 2020

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The paper argues that there is scope for monetary policy under an exchange rate anchor, and discusses the related monetary policy design and implementation.
It shows that the exchange rate can be used as the main monetary policy instrument while the policy rate can target the exchange rate.
An exchange rate anchor is compatible with an inflation objective, provided:
- fiscal dominance is not an issue,
- monetary conditions are supportive of the peg,
- and the level of international reserves is adequate.
The paper argues that, while an exchange rate anchor is more prone to policy inconsistencies, there is ample scope for strengthening monetary policy design and implementation under soft pegs.
In that context, the principles of dichotomy and interest rate parity are critical.

Exchange rate as primary instrument:
- The exchange rate can serve as the main monetary policy instrument.
- The policy rate can be deployed to target the exchange rate rather than being the primary instrument itself.
Compatibility with inflation objectives:
- Compatibility is conditional on the absence of fiscal dominance.
- Compatibility is conditional on supportive monetary conditions for the peg.
- Compatibility is conditional on adequate international reserves.
Policy consistency and vulnerabilities:
- Exchange rate anchors (especially soft pegs) are more prone to policy inconsistencies.
- There is nevertheless ample scope to strengthen monetary policy design and implementation under soft pegs.
Critical principles for success:
- Dichotomy (separation of fiscal and monetary responsibilities) is critical.
- Interest rate parity is a critical guiding principle for policy design.

Subject: Banking, Central bank policy rate, Exchange rate anchor, Exchange rate arrangements, Exchange rate policy, Exchange rates, Financial services, Foreign exchange, Monetary policy
Keywords: banking system, C. central bank monetary policy, Central bank policy rate, current account, exchange rate, Exchange rate anchor, exchange rate appreciation, Exchange rate arrangements, exchange rate band, Exchange rate policy, exchange rate policy stance, exchange rate regime, exchange rate volatility, Exchange rates, foreign exchange interventions, Global, interest rate, interest rate parity, monetary operations, monetary policy, monetary policy credibility, monetary policy framework, monetary policy implementation, monetary policy rule, monetary policy rules, nominal exchange rate, policy stance, Singapore dollar, WP

IMF Working Paper: Monetary Policy Under an Exchange Rate Anchor (Working Paper No. 2020/180).