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The Advantage of Transparency in Monetary Policy Instruments

Staff Report 297 | Published July 1, 2006

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The Advantage of Transparency in Monetary Policy Instruments

Abstract

Monetary policy instruments differ in _tightness_—how closely they are linked to inflation—and transparency—how easily they can be monitored. Tightness is always desirable in a monetary policy instrument; when is transparency? When a government cannot commit to follow a given policy. We apply this argument to a classic question: Is the exchange rate or the money growth rate the better monetary policy instrument? We show that if the instruments are equally tight and a government cannot commit to a policy, then the exchange rate’s greater transparency gives it an advantage as a monetary policy instrument.