KARACHI, Nov 15: The question whether Pakistan should switch over to inflation targeting regime or it should be used to indicate the future impact of inflation on exchange rates remained unresolved as the economic researchers found it difficult to adopt any complete model for developing economies like Pakistan.
The two-day State Bank Conference on “Monetary-cum-Exchange Rate Regime” ended on Tuesday with concluding remarks by Shaghil Ahmed, acting managing director of the Social Policy and Development Centre (SPDC) and senior economist, Board of Governors of the Federal Reserve System, Washington DC.
The researchers who presented their papers came out with three main conclusions to find out the relations of inflation with the exchange rate.
The first was that greater exchange rate flexibility removes any fear of a currency crisis and that an inflation targeting regime that involves a flexible exchange rate should work best for emerging market economies.
The second was that greater exchange rate flexibility causes its greater variability which is disruptive in developing countries, and thus an “exchange rate targeting” monetary policy is more appropriate.
And, the third viewpoint was that emerging markets need to focus on the virtues of good governance and the establishment of credible fiscal, monetary, and financial institutions over and above any particular strategy or regime.
Mr Shaghil said that the research papers in the conference had dealt with six major issues:
1. What type of interest rate rules might be appropriate?
2. Exchange rate flexibility versus exchange rate stability.
3. Is inflation targeting the best practice for emerging market economies?
4. Determinants of inflation.
5. Is the money supply endogenous?
6. Importance of improving institutions
“Of course, these issues are very interrelated. If interest rates should respond to exchange rate changes, you would be arguing that some stability of exchange rates is desirable. If you want to target inflation you would find it desirable to have a model to forecast inflation and, hence, the determinants of inflation would be relevant. Whether or not you follow an interest rate rule affects whether or not money supply is endogenous. And, so on”, he said.
Some researchers concluded that this might be a good time to seriously consider switching to an inflation targeting regime in Pakistan. This is because Pakistan has made significant progress in several areas—providing autonomy to the central bank, privatization of commercial banks, building up foreign exchange reserves, development of domestic bond market, and launching of bonds in the international market.
However, there were disagreement on this issue and researchers were not ready to propose any final or complete model to deal with the inflation in relation with the exchange rate regime.
Some researchers argued that the model itself should be allowed to determine what the quantitative targets for inflation, exchange rate, etc., should be. A suggestion that using a new open economy macroeconomic model, in which there is incomplete risk sharing because of incomplete asset markets, is that policy should respond to exchange rate changes, but not completely stabilize the exchange rate either. Thus, a managed or dirty float is the optimal policy.
Versions of new open economy macroeconomic models are being increasingly applied to various emerging market economies to get insights about monetary policy issues.
“Irrespective of what exchange rate regime and what monetary regime you follow, you need to know what the long-run equilibrium real exchange rate is and how far you are from it. Unfortunately, there is no widely accepted model of an economy’s long-run real exchange rate,” said Shaghil.
He said that there was an understating during discussion that there was no substitute for improving institutions and for structural reforms.
“If bad shocks hit the economy and if institutions and policies are weak, the adverse effects of these things will manifest themselves somewhere, somehow. Similarly, if there are good shocks and policies and institutions improve, the beneficial effects will show, irrespective of the particular regime being followed,” he concluded.
