A Model for Monetary Policy Analysis in Uruguay

IMF Working Papers, July 23, 2015

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Uruguay has recently reverted to a money targeting (MT) framework in the context of a disinflation strategy.
The authors develop a quantitative model for monetary policy analysis that incorporates money targets in the policy framework while retaining a central role for interest rates in the transmission of policy.
The model is used to show that tight financial conditions for a period may be necessary for inflation to converge to the middle of the target band.
Two issues highlighted regarding MT frameworks:
- Excessive focus on hitting money targets can result in undesirable changes in the policy stance.
- Targets that incorporate elements of money demand forecasting are superior to targets that are excessively smooth or do not adjust for base effects.

The quantitative model integrates:
- money targets in the policy rule,
- interest-rate-driven policy transmission.
Key modeled outcome:
- Tight financial conditions for a period may be necessary for inflation to converge to the middle of the target band.
Discussion points on MT frameworks:
- Risks of overemphasizing mechanical target attainment.
- Advantages of incorporating money demand forecasting into target design versus using excessively smooth targets or ignoring base effects.

Policy stance should avoid excessive mechanical adherence to money aggregates if such adherence induces undesirable changes in overall policy.
Design money targets to incorporate money demand forecasting and adjust for base effects rather than relying on overly smooth or fixed trajectories.
Retain the central role for interest rates in the transmission mechanism even when using money targets as part of the framework.

Subject: Demand for money, Exchange rates, Financial services, Foreign exchange, Inflation, Money, Prices, Real exchange rates, Real interest rates
Keywords: core CPI inflation, Demand for money, exchange rate, Exchange rates, Forecasting, Global, Inflation, inflation path, inflation stabilization process, inflation tradeoff, interest rate target, monetary policy, monetary policy shock, money demand, money growth, money target, Money Targeting, output stabilization, overnight interest rate, peso interest rates, Real exchange rates, Real interest rates, WP, yoy inflation dynamics

Content derived from the IMF web landing page for "A Model for Monetary Policy Analysis in Uruguay" (IMF Working Papers, 2015, 170).