Conference: Monetary Policy and Economic Developement of the Republic of
Macedonia, November 18, 1999, Skopje
LOW INFLATION AS A MAIN PREREQUISITE FOR DYNAMIC AND SUSTAINABLE ECONOMIC GROWTH
First of all, please allow me to express my gratefulness to the organizer for
selecting me as a keynote speaker for today's conference.
Nevertheless, there is a problem. Should I address this auditorium as Trpeski
the professor, or Trpeski the Governor. Let me stress
that very often, these two persons argue, enter bilious arguments, but Trpeski,
the professor is much more free in his statements than
Trpeski, the Governor.
Having in mind the title of the discussion: "Monetary Policy and Economic
Development of the Republic of Macedonia", as well as from the theses stated in
the invitation, please allow me first of all to emphasize what has been widely
accepted throughout the world, and what is written in all standard university
textbooks in this field, including the textbooks at the Faculty of Economics in
Skopje, and that is that one should distinguish between implementation of
monetary policy on short and long term.
In all standard textbooks it is stated that basic goals that the authorities
want to achieve with the economic, including the monetary policy on a short run
- achieving a certain rate of economic growth, i.e. achieving a certain level of
- maintaining stability of the general price level;
- maintaining the equilibrium in the balance of payments, i.e. stability of the
denar exchange rate.
If the aforementioned goals are analyzed, it is obvious that some of them are of
a growth character, and others are of a stabilizing character.
There is a certain incompatibility between these goals, although at first
glance, there should not be any incompatibility between growth and stability of
the economy. Namely, the experience (both international and domestic) shows that
it is impossible to accomplish all goals to the same extent at the same time.
If an expansive monetary policy acts in direction of acceleration of the
economic growth and output, such policy, at the same
time, has a negative impact on the prices and balance of payments. For these
reasons, the need of synchronized action on all instruments of the economic
policy is more than necessary.
On a long term, there is a consensus that the monetary policy,
i.e. the changes in the monetary policy influence only the prices,
whereas on a short run it is possible to influence certain real variables such
as output, import, export, etc.
One of the central issues in the contemporary monetary theory is the issue of
the influence of monetary aggregates on economic movements. This issue is
especially popular in the countries with a market economy, and therefore it is
logical that it is most widely studied in those countries. In the highly
developed market economies, the issue of the influence of money and credits on
the economic movements is a problem that appears throughout a longer historical
Regarding this issue (but not only this one), monetary theorists in the western
contemporary theory are divided mainly in two major
groups. One group follows and develops the theory of Keynes and is called
Keynesianism, whereas the other group follows the traditions of the quantitative
theory of money and is generally called Monetarism. These are two wide and not
completely homogenous groups, which involve numerous subgroups that are more
compact in their attitudes.
Thus, for example, Keynesianism covers the so-called Radcliffe Committee, which
is an extreme version of Keynesianism, and is mostly criticized by the
Keynesianists themselves. For example, Samuelson will evaluate this movement as
"the most fruitless operation of all times".
Keynesianism is nowadays dominated by two wings: one of them includes the
so-called "income school" headed by Modigliani, Albert Ando, Heller and also
Samuelson, although monetary problems are not his direct speciality, and the
other wing, which at this moment is more superior, is headed by the Nobel prize
winner James Tobin (known as "Tobin's school").
Most important and most compact in the group of monetarists is the
with its coryphaeus Milton Friedman, also including Anna Schwartz, Philip Cagan,
John Klein, Richard Selden, Meiselman,
etc. Among monetarists, besides the followers of the "Chicago School", special
emphasis should be given to Karl Brunner and A. Meltzer, who produce the
so-called "Wealth Adjustment" theory, but of course, one must not forget
Patinkin, Mayer, Fand, etc.
produced the so-called reformulated quantitative theory of money, which is today
becoming more and more popular throughout the world, and which has an increasing
influence on the conduct of monetary policy in numerous countries with a market
economy. By this theory, money is the leading factor in the influence on the
economic movements. The incurring changes derive from the changes in money
against the changes in the economic movements. Money demand is the key
determinant, which is a stable function, whereas the influence is expressed in
the process of adjustment of the real quantity of money to the demand, i.e. in
the process of reestablishing monetary balance.
The influence of money on the economic movements is evident after a certain
period of time which is uneven and depends on series of factors influencing the
processes of reestablishing balance between the permanent quantity of money and
the money demand. Since this time lag can not be determined with a high level of
certainty, according to Friedman it is logical that most efficient monetary
policy will be conducted with money growth rate being constant. Stating this, he
actually denies that a successful stabilization policy can be conducted by
having a discretionary monetary policy.
The increasing popularity of this theory is a result of its sound empirical
foundation. Abundantly using the latest achievements in statistics and
econometrics, the followers of quantitative theory proudly emphasize that they
do not claim that Keynes' theory is incorrect, but that their empirical research
shows that there is a firm link between monetary and real aggregates.
Other competitive western theories are not empirically tested and verified.
Those are basically the neokeynesian theories, such as the Portfolio Balance
theory of James Tobin. It is actually a wealth choice. The individual or the
community allocates its savings among alternative wealth. According to the
Portfolio Balance theory, money is only one type of wealth, being not higher
appreciated compared to the other types of wealth. Changes in the economy may
occur if the relative wealth structure is changed, initiated by any type of
However, according to the Wealth Adjustment theory of Brunner and Meltzer, money
should not be equalized with the other types of wealth because money is a
"special type of wealth". Actually, Brunner and Meltzer claim that, differences
between money and other wealth are much more noticeable than in theory and it
does not take much effort to prove that the changes in the quantity of money are
far more closely related to the economic activity than any other type of wealth.
However, unlike Friedman, other followers of the Chicago School Brunner and
Meltzer do not have firm attitudes that only changes in the money supply
influence the economic activity, but according to them, changes in the money
supply are a dominant factor, however not the only one. One of the largest
problems regarding the influence of monetary aggregates on the economic
movements is through which transmission mechanism these effects are transferred.
According to the Reformulated Quantitative Theory, changes in money result in
direct changes in income and prices. According to Keynes' Liquidity Preference
Theory, changes in the money supply result in changes in the interest rate and
in the profit rate of capital, so in that sense, changes in the money supply can
directly influence economic movements.
In Tobin's Portfolio Balance Theory, changes in the money supply or changes in
any other type of wealth result in changes in the structure of interest rates.
According to this theory, the transmission mechanism is as follows: changes in
money (or any other type of wealth) - changes in interest rates (not one, but
all interest rates) - changes in the demand for capital - changes in the
economic activity. There are differences also in the understanding of the
direction of effects. Both the Quantitative Theory and the Liquidity Preference
Theory affect the economic activity in same direction by changing the quantity
of money. According to the Portfolio Balance Theory it is possible, however it
does not have to be the case - even the direction may be opposite.
However, contrary to the academic circles that are free to enter endless
arguments, policy-makers do not have that freedom, they have to make decisions.
In the 1960s, especially after Phillips curve appeared, there was an opinion
that by conducting more liberal monetary policy, i.e. by allowing certain growth
in prices, it is possible to act in direction of decreasing unemployment on a
However, popularity of Phillips curve was very short, because in 1970s the world
faced with another phenomenon - coexistence of high inflation and high
Since that time, it has been widely believed that the effects from the higher
inflation on the increase in employment (which occurs through the decrease in
real wages) are very small and they quickly disappear, by including the
mechanism of inflatory expectations, which the economic entities implement in
all their decisions. In that way, the positive effect on growth disappears, and
the unemployment rate returns to the initial level. The only thing that remains
is the higher level of inflation. This has been proved in many countries
throughout many years, and has been supported by a large number of empirical
In other words, in the 1960s the belief that on a long term there is no positive
relation between inflation and employment, and that on a short term there is a
certain relation between the increase in inflation and employment, prevailed.
Since 1970s, and especially in the past 10 years, the consensus that on a long
term there is no positive relation between inflation and employment remains,
whereas regarding the relations on a short term, the opinion about the positive
relation between the inflation and employment has completely changed, and now
the prevailing opinion is that the damages from the inflation on a short term
are so much bigger than the possible short benefits, so that the monetary policy
should not have any other objectives - except achieving low inflation.
Most of the countries (highly developed) have implemented this in their central
bank acts - that their concern is to maintain low
The question that raises is - how low inflation?
Alan Greenspan says: "Inflation should be so low that the economic entities
would not take it into consideration when making economic decisions".
It means that price stability is achieved at the moment when economic entities
would not incorporate inflatory expectations in their decisions.
Does that mean that monetary policy should have zero inflation for its target?
In highly developed countries, where the ultimate goal of the monetary policy is
inflation - almost in all of them, an incorporated goal of the monetary policy
which should be accomplished by monetary policy and other instruments of
economic policy is an inflation of 2%.
The question that raises is - why not zero?
Zero inflation is not advisable because prices of goods may increase by 1% to 2%
due to their improved quality, and it should not be destimulated.
Also, in these 20 developed industrial countries, there is a widely accepted
opinion that the central bank should intervene if the inflation increases by one
percentage point above the 2% target, or if it decreases by 1 percentage point,
and if it is estimated that there is a tendency that increase or decrease to
For the countries in transition somewhat higher rates are tolerated, but however
they are within the zone of a single digit inflation.
As a matter of factly, all empirical studies point to the negative influence of
inflation above 10% on employment and growth. There are no empirical studies
about the negative influence of the single digit inflation on employment and
Also, the opinion that prevails nowadays is that the policy of low inflation is
the main precondition or sine qua non for a stable and high growth and favorable
developments in employment. Therefore, separate discussions in our country
regarding higher inflation as a remedy for solving certain economic problems,
has been long considered an anachronism in the world.
If a low inflation is maintained for a longer period of time, it inevitably
leads to a decline in interest rates, and lower interest rates have a positive
influence on economic growth and increase of employment.
Low and predictable inflation on a longer term acts in direction of inflow of
foreign direct investment, which also, especially in countries in transition,
has an influence on increase in growth.
However, the challenge to use monetary policy in order to stimulate employment
still exists. There is such danger even in developed countries, especially
before elections or during elections.
For these reasons, in order not to misuse the monetary policy, in all countries
(highly developed) laws were enacted or amended to provide high level of
independence of central banks.
is expressed at two levels:
with respect to the executive authority.
with respect to the Parliament.
Almost all central banks in the highly developed countries are independent with
respect to the executive authority.
A smaller number of central banks (such as Bundesbank, Central Bank of
are independent with respect to the Parliament, too.
What does this mean? That means that they independently determine the tasks and
objectives of the monetary policy regardless of what the intentions of the
Government and of the Parliament are.in that respect, a significant progress was
made by the establishment of the European Central Bank within the framework of
the European Monetary Union.
The European Central Bank is a fully independent institution, both in
formulating the targets of the monetary policy and in their realization.
In addition, the European Union took a step forward. It urges the countries
attempting to enter the European Union to change their legislation, and the
status of their central banks to be equalized with the status of the European
is in negotiations with the European Union. One of the requirements is that the
Bank of Slovenia Act to be amended and the status of the Bank of Slovenia to be
equalized with the status of the European Central Bank.
Another thing on which the European Union insists is that the countries
attempting to enter the European Union should implement provisions in their
central bank acts stipulating that their main task is to maintain low inflation
Third thing on which they insist is to pass a law with which the Central Bank is
prohibited from financing the deficit in the Budget.
The issue of determining the goal of the monetary policy and its quantification
is really very complex, and I think that one should approach with a long-term
vision. In my opinion, the Republic of Macedonia should cease determining annual
inflation targets, and start determining mid-term inflation target instead,
which could be defined as maintaining the inflation rate within the interval
4%-5% in the period up to 2005. Why is it necessary to adjust the time horizon
when projecting the inflation from short to medium term? There are several
1) Monetary policy and its goals do not simply end up on December 31 and they do
not start on January 1 each year. Monetary policy conduct is a continuous
process with clear goals, and they should be determined in advance in order to
achieve maximum transparency and disclosure for the economic entities about the
long-term vision of the macroeconomic and monetary policy;
2) Correction of relative prices in the
has only started, but is has not been finished yet. It is a process that
requires sufficient time: first, to neutralize the inherited distortions; and
second, to incorporate standard and continuous processes of adjustment of
relative prices, which reflect the changes of productivity and costs of
operations in the domestic and foreign economies;
3) The long-term inflation target would be consistent with our strategy for
entering EU and EMU. Tighter pegging of our currency to the EURO implies
creation of conditions for maintaining the inflation at a low level, but also a
significant reduction of interest rates;
4) Monetary policy is actually a combination of ex ante inflation target and
discretionary reply to certain shocks. By the long-term target, more space would
be given for larger flexibility in defining the short-term projections, without
losing the clear long-term goal. This would enable to incorporate the
information about possible shocks which could hit the economy in the short-term
projections, except those that acting purely on the supply side. Having a
long-term inflation target, monetary policy will be in position to decide
whether to react to those shocks on a short term, or it will estimate that
conducting counter-cyclical monetary policy is economically irrational and
A potential problem with the long-term inflation target could be the possibility
that the short-term results will deviate from the long-term objective, with a
risky impact on the credibility of the Central Bank. However, the long-term
inflation target will have to incorporate the expectations of the economic
entities on a long term, and the National Bank should have a positive influence
on building those expectations.
If price stability is the best contribution that the monetary policy can give to
the economic growth, a question raises - how and by which concept to achieve
this? In general, successful monetary strategies have two common
characteristics: they are long-term oriented and they provide a transparent
standard for policy evaluation. With that respect, central banks use various
goals, which express the dedication of monetary authorities to maintaining price
stability in the most convincing way. Therefore, with variable success in
various countries, three strategies are used: monetary aggregates targeting,
direct inflation targeting and exchange rate targeting.
The strategy of monetary aggregates targeting, which was dominant in the
until 1995, is not a good solution for the country's current stage of
development. Out of 27 transition countries, 12 have implemented this strategy,
but none of them belongs to the group of 10 most successful economies in
transition. Of the developed countries, this strategy was most successfully and
most permanently applied in
and in certain form in
entered the EMU, the Bundesbank strategy was only partially transferred in the
monetary policy of the ECB, which uses a sort of combination of the monetary
strategy targeting and direct inflation targeting.
The second alternative is direct inflation targeting, which as a strategy has
been applied by approximately ten developed countries, but recently it has been
widely popular with some pilot countries from
The initial results from this recent monetary strategy are positive, having
transparency, relative flexibility and avoiding the problem of estimation of the
velocity of money, as main attributes of this strategy. However, this concept
has a basic weakness: direct control of the inflation can not be achieved by
monetary policy. Having in mind that it can easily cause initiate repressed
inflatory expectations, this strategy for the
also remains in the zone of future solutions.
The current strategy of monetary policy in the
exchange rate targeting, has been applied in half of the countries in
transition: in four countries in the most rigid form of a currency board and in
nine countries in the form of pegging the exchange rate to one or a basket of
several world currencies. In five of these countries there is a regime of fix
central parity of the exchange rate with bands between +- 2.25% (in Hungary) and
+- 7% (Poland and Slovakia). The advantage of this strategy is in the
transparency of the exchange rate signals sent to all economic entities. With
strict application of this strategy, in the
monetary, fiscal and wage policy were successfully disciplined, which enabled
the inflation to be reduced at a low and stable level.
However, just as any other strategy, this one also has its disadvantages, which
are obvious especially when it is applied for a long time. Thus, the basic
disadvantage of this strategy is that pegging to a fixed parity with relation to
the currency of another country means losing the autonomy of the monetary policy
and impossibility to amortize certain domestic shocks, or shocks transferred
from the anchor country. In the past years, a serious problem were the
difficulties to amortize certain shocks through the monetary policy, at least
those that acted on the demand side, which together with the shocks on the
supply side were abundant throughout the past years. Consequently, the positive
effects from the application of this strategy were gradually exhausted, and the
potential weaknesses become more and more apparent. In other words, the burden
of maintaining the fix parity in conditions of structural problems, unused
capacities and other economic rigidities, is born by
the monetary policy. Throughout the past years, fiscal policy has provided
adequate support for the monetary policy, and the policy of wage restriction has
also acted in that direction. However, the room for maneuver of the monetary
policy is much too small, which is especially apparent in conditions of global
shortage of foreign currency (as it was the case during the war in SRY), or
permanent high inflow of foreign currency (as it was the case in the past four
months). In both cases, pressures on the foreign exchange market are transmitted
to the money market, causing high interest rates oscillations.
What will be the optimum solution for the
in the next several years? According to all positive and negative arguments, the
most efficient way to maintain price stability is to maintain the fix central
parity of the Denar against the EURO. The elaborated reasons indicate that a
certain dose of flexibility is needed in this set-up of the exchange rate
regime, which will be provided by allowing oscillations of the exchange rate
around the central parity within certain bands. On the basis of the rule for
uncovered interest parities, bands could be 5% above and below the central
parity, which is somewhat below the level of interest rate disparities between
as an anchor country. In this way, the control over the inflation rate and
inflatory expectations will be maintained, and the monetary policy will be given
more room to amortize the shocks in the domestic economy, which are on the
However, one must not forget that the exchange rate regime and the exchange rate
are not a supplement for the structural reforms. Monetary policy can not take
the economy where we all want. The money supply growth can only facilitate or
support the economic growth. The problems of the long term development of
Macedonian economy lie in structural rigidities, limited resources,
inefficient allocation of assets and in all other incomplete processes of
micro and macro restructuring. It involves conduct of responsible and consistent
long-term policy, in which the concept of price stability would not be
abandoned, but understood only as stability and not unchangeableness. This may
from time to time make central bankers unpopular among the public, which is
within the scope of their operations. The strive to
give the monetary policy another role - will only draw the attention off the
Finally, let me conclude:
Nevertheless, we better be modest when evaluating what we believe we know today.
Summers in his work: Why central banks should implement low inflation on a long
run has stated: "It will be a wrong reading of history to think that we have
discovered the ultimate truth and that some of the opinions here will not look
obsolete in 20 years".
This is an incurring and challenging statement. Just think how
boring life will be if we discover the ultimate truth.
November 18, 1999
Ph.D. Ljube Trpeski
Governor and President of the National Bank
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