William Davidson Institute Working Paper 402
Monetary policy reform should be embedded into a coherent policy-mix to be
set up simultaneously; the latter would include incomes policy and low budget
deficits, themselves grounded in a tight control and streamlining of public spending
and the imposition of financial discipline on firms and households. Ceteris paribus,
high deficits come with high interest rates, and call for a laxist monetary policy to
offset this effect, though this policy has major pitfalls in an open economy. More
competition in the goods and labour markets as well as effective anti-trust measures,
by curbing the market power of dominant blocks of suppliers, would also work
against additional and unwarranted price increases.
As an upshot, there is a dual challenge for the NBR, for monetary policy, in
order to subdue inflation: to control liquidity (base money) effectively and to break
powerful inflationary expectations after years of almost “programmed inflation”. But
expectations react to monetary policy changes. As long as major policy changes are
not implemented, either because there is no political will or because of the lack of
institutions and infrastructure, there can hardly be a decisive change in expectations.
What would be the suitable exchange rate mechanism to accompany the
reform of monetary policy?
a) Should Romania give up an autonomous monetary policy and adopt a
currency board? A currency board would, by its internal structure, put an
end to quasi-fiscal operations and deficit monetization: both these actions
have poisoned NBR activity in the nineties. Under a currency board, the
scope for devaluation is almost negligible, especially if the choice of the
initial parity is rigorous. However, the behaviour of the money stock is less
predictable. If the only way to acquire foreign exchange reserves consisted
in running a trade surplus, the scope for a destabilising outcome is very
limited; a sustained trade surplus implies more money, higher prices and
less competitiveness, which has an adverse effect on exports. But
additional foreign exchange reserves may be brought by massive capital
inflows, related to direct investment but also to more speculative
investment. Such an institution is therefore not a “miracle” solution and its
implementation would come with new risks. It may leave the country
defenceless to adverse shocks that may hit the economy prior to EU
integration. While it contains the government spending fervour by ruling
out deficit monetization, it may favour excessive borrowing from abroad.
This could lead to speculative lending and asset price inflation, with major
financial risks. Even under a currency board, speculative attacks on the
currency could occur, especially if the currency seems overvalued. In
addition, potentially high real interest rates associated to a large foreign
debt may strain fragile banks overwhelmingly.
b) A flexible exchange rate may avoid the accumulation of nominal
imbalances and may provide for the needed flexibility to adjust to adverse
shocks. The main advantage for Romania of implementing a genuine fully-
fledged flexible exchange rate regime is its simplicity. This would allow
policymakers to focus on short term goals as limiting the monetary base
growth and stabilising the base multiplier. Whatever the objective of the
central bank, low inflation or a stable exchange rate, a successful anti-
inflation policy calls for a severe tightening of monetary policy today. A
tough monetary policy may come with some increase in interest rates and a
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