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Monetary Aggregate Targeting vs. Inflation Targeting: the Case of the Philippines

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1.1 Background of the Study:
In almost all countries, monetary authority is governed by a central bank. In some countries, it is called federal reserve or reserve bank. Other countries like Andorra, Monaco and North Korea do not have a central bank due to various reasons. The central bank has always been responsible in managing the nation’s money supply or its monetary policy through managing interest rates, setting the reserve requirement, and acting as a lender of last resort to the banking sector during financial crisis. In the past years, central banks in industrialized countries have made great pace in the regulation of monetary policy.

The Bangko Sentral ng Pilipinas or BSP is the central bank of the Republic of the Philippines. It was established on July 3, 1993 which it took over from the Central Bank of Philippines or CBP. The BSP enjoys fiscal and administrative autonomy from the national government in the pursuit of its mandated responsibilities. And because the central bank is the one implementing monetary policy, which they discuss in detailed, the primary objective of BSP’s monetary policy is to promote a low and stable inflation conducive to a balanced and sustainable economic growth. In order for the BSP to better achieve this objective, the inflation targeting framework for monetary policy was adopted in January 2002 after the monetary aggregate targeting framework.

Under the monetary aggregate targeting, the BSP fixes money growth so as to minimize expected inflation. However, under the current framework, BSP sets monetary policy so that price level is not just zero in expectation but is also zero regardless of latter shocks (Gochoco-Bautista, 2001). The inflation rate of a country has always been one of the most significant economic indicators. It indicates how well the economy is doing and how well the economy is going to do in the future. According to the Department of Economic Research of Bangko Sentral ng Pilipinas (BSP), the BSP itself followed the monetary aggregate targeting approach to monetary policy in the past. This approach is based on the assumption that there is a stable and predictable relationship of money and output and inflation. In one of the media archives of the BSP entitled “European Economists: High Marks to BSP for Clear and Comprehensive Inflation Report” in June 27, 2003, it stated that the BSP shifted its monetary policy framework from monetary aggregate targeting to inflation targeting only in January 2002.

According also to the article, the BSP received positive feedback from various institutions like the Bank of England and the International Monetary Fund on its successful shift to inflation targeting since then. The framework was changed because BSP wanted to address the fact that aggregate targeting did not account for the long-run effects of monetary policy in the economy. The Department of Economic Research of BSP defined inflation targeting as an approach that focuses mainly on achieving price stability as the ultimate objective of monetary policy. It involves the announcement of an explicit inflation target that the central bank promises to achieve over a given time period. The target inflation rate is set and announced jointly by the BSP and the government through an inter-agency body. The Philippines joined a long list of inflation targeters such as Australia, Canada, Finland, Sweden, New Zealand, the United Kingdom, Israel, Brazil, Chile and Thailand, which have moved from high inflation to low inflation following the successful implementation of inflation targeting in their countries. The BSP, like other central banks, recognized the important features of inflation targeting.

These are: * simple framework which can, therefore, be easily understood by the public; * allows greater focus on the goal of price stability, which is the primary mandate of the BSP; * forward-looking and recognizes that monetary policy actions affect inflation with a lag; * reflects a comprehensive approach to policy by taking into consideration the widest set of available information about the economy; * promotes transparency in the conduct of monetary policy through the announcement of targets and the reporting of measures that the BPS will adopt to attain these targets, as well as the outcomes of its policy decisions; * increases the accountability of monetary authorities to the inflation objective since the announced inflation target serves as a yardstick for the performance of the BSP, and thus helps build its credibility; and * does not depend on the assumption of a stable relationship between money, output and prices, and can still be implemented even when there are shocks that could weaken the relationship. This paper looks at the evolution of monetary policy in the Philippines by studying monetary aggregate targeting and inflation targeting. Moreover, this paper also present data of some economic indicators that may be affected by the monetary policy. The researcher also analyzes these data.

1.2 Statement of the Problem:
The researcher wants to know more about the differences between monetary aggregate targeting and the inflation targeting, and would like to know if the current framework really helps in improving the country’s economy. So, this paper will attempt to understand how the Philippines’ monetary policy is conducted today and how it differs from the manner it was conducted in the past. Moreover, the researcher wants to prove that the current monetary policy framework has relevance and is effective given that there is a global financial crisis.

1.3 Objectives of the Study:
General Objective: To know the significant effects of the two different monetary policy frameworks to the major economic indicators in the country namely inflation rates, unemployment rates, GDP growth rates and reserve money Specific Objectives:

* To understand and explain how monetary policy is conducted today compare to how it was conducted in the past * To see how the inflation rates differ during the period of monetary aggregate targeting and the period of inflation targeting * To show how inflation rates, unemployment rates, Gross Domestic Product (GDP) growth rates and reserve money behaved during the two periods * To compare the target inflation rates during the inflation targeting period to the actual inflation rates of the country * To know how the reserve money of the country behaved during the monetary aggregate targeting period and inflation targeting period * To know the relevance of the inflation targeting given the global financial crisis

1.4 Significance of the Study:
This part of the paper discusses the importance of creating this study to the following: instructors, this will provide sample in discussing how to conduct a research study about monetary policy, monetary aggregate targeting and inflation targeting; students, this will serve as a basis of their learning; future researchers, this will provide them data that can help and support their own researches and studies; and other countries, this will help them see how monetary aggregate targeting differs from inflation targeting in the case of the Philippines.

1.5 Scope and Limitations:
The data in this study cover only the Philippines. This study focuses mainly on monetary aggregate targeting and inflation targeting. In addition, this study also concentrates on the inflation rates of the Philippines under the period of the two monetary policy frameworks mentioned above, specifically from year 1993 to 2012. Moreover, this paper also covers the differences of the GDP growth rates and unemployment rates between the periods of monetary aggregate targeting and inflation targeting. Lastly, this paper also studies the changes in the reserve money of the country during the two periods.

1.6 Hypotheses:
The following null hypotheses will be validated in this study: * Ho 1: The monetary aggregate targeting has no significant effect on the inflation rate of the Philippines. * Ho 2: The inflation targeting has no significant effect on the inflation rate of the Philippines. * Ho 3: The inflation targeting has no significant effect on the global financial crisis. * Ho 4: The inflation rates have no effect on the unemployment rates. * Ho 5: The inflation rates have no effect on the GDP growth rates. * Ho 6: The inflation rates have no effect on the reserve money.

1.7 Definition of Terms:
The following are the terms that are often used in this study. Each of the definitions stated below are derived from official/technical sources: * Bangko Sentral ng Pilipinas (BSP)- is the central bank of the Philippines * Central Bank- is the entity responsible for overseeing monetary system for a nation * Economic Growth- is a long-term expansion of a country’s productive potential * Employment Rate- the proportion of total number of employed persons to the total number of persons in the labor force * GDP Growth Rate- measures how fast the economy is growing and is driven government spending, exports and inventory levels * Global Financial Crisis- is a worldwide period of economic difficulty experienced by markets and consumers

* Inflation- is the overall general upward price movement of goods and services in an economy * Inflation Rate- is the rate of change of prices calculated on a monthly or annual basis * Inflation Targeting (IT)- is an economic policy in which the central bank of a country estimates and makes public a projected or target inflation rate and then attempts to steer actual inflation toward the target through the use of interest rate changes and other monetary tools * Monetary Aggregates- are the various measures of a country’s money supply * Monetary Policy- refers to the actions undertaken by a central bank to influence the availability and cost of money and credit to help promote national economic goals * Reserve Money- is the money supply or the amount of money in the economy * Unemployment Rate- percentage of employable people actively seeking work, out of the total number of employable people Chapter 2: Review of Related Literature and Studies

The dominant issues as examine in this paper was also discussed by some other researchers. In the paper of Alex Cukierman (1996) entitled “Targeting Monetary Aggregates and Inflation in Europe”, he states that the choice between inflation targets and monetary targets involves a tradeoff between visibility and controllability. His analysis reveals that inflation targets dominate base targets when reputation is high and policymakers are sufficiently patient. Moreover, inflation targets have the virtue of being focused on the final objective of interest. This is particularly important when the relation between money and prices is relatively stable. But inflation targets make it easier to exert expansionary pressures on the central bank in order to reduce interest rates and achieve various real objectives. Frederic Mishkin wrote a paper that also evaluates the two monetary policy strategies which are monetary targeting and inflation targeting. Based on his study, the experience with monetary targeting suggests that although it was successful in controlling inflation in Switzerland and especially Germany, the special conditions in those two countries that made it work reasonably well are unlikely to be satisfied elsewhere. He also stated that inflation targeting, therefore, is more likely to lead to better economic performance for countries that choose to have an independent domestic monetary policy.

From the study of Mishkin about the use of monetary targeting by the United States, the United Kingdom, Canada, Germany and Switzerland, he said that using the said policy can be problematic because there was instability of the relationship between monetary aggregates and inflation and nominal income. As the result of this, the monetary targeting has either been downplayed or abandoned. A similar problem of this unstable money-inflation relationship has been found in emerging market countries, such as those in Latin America (Mishkin and Savastano, 2000). Mishkin also said that monetary targeting has been very flexible in practice, and a rigid approach has not been necessary to obtain good inflation outcomes. On the other hand, when it comes to inflation targeting, Mishkin states things differently. According to him, inflation targeting has been successful in controlling inflation.

Based on his studies, inflation-targeting countries have been able to significantly reduce the inflation rate from what might have been expected given past experience. For example, Bernanke, Laubache, Mishkin and Posen (1999) find that inflation remained lower after inflation targeting started. Moreover, Mishkin said that inflation targeting also weakens the effects of inflationary shocks, promotes growth and does not lead to increased output fluctuations. He said that output and employment become high once low inflation levels are achieved. Furthermore, Mishkin also tries to point out that transparency and accountability are the key features of inflation targeting because central banks would be able to have communication to the public. Increased transparency and accountability under inflation targeting helps promote central bank independence. And because of all the statements stated, he concluded that inflation targeting should lead to better economic performance for countries that choose to have an independent domestic monetary policy. However, for it to be successful, one country should learn the lessons from past experiences.

Gottschalk and Moore (2000) studied the effectiveness of inflation targeting regime for Poland. They argued that inflation targeting regime could be successful in Poland with understanding of the linkages between monetary policy and inflation outcomes and analyzed whether the prerequisites for this framework are in place. Few studies have examined financial sector reforms as the essential pre-condition for adoption of inflation targeting and analyzed the preparedness of India for inflation targeting from that perspective (Jha (2008), Kannan (1999)).

According to Mishra, inflation forecasts play a central role in inflation targeting framework because it is a forward-looking regime where central bank attempt to control inflation over a targeting horizon of one to two years.

“The central bank’s inflation forecast is indeed an ideal intermediate target: it is by definition the current variable that is not correlated with the goal, it is more controllable than the goal, and it can be made more observable than the goal. It can also be made very transparent, and may therefore facilitate the central bank’s communication with the public and the public’s understanding of monetary policy (Svensson, 1997).”

Guinigundo states that large fluctuations in velocity have weakened, and in some cases, broken down the relationship between monetary aggregates and their ultimate goal variables. He claims that financial liberalization in 1993 weakened the two key relationships mentioned above. He cites, in particular, the deceleration in the rate of inflation form 9 percent in 1994 to 8.1 percent in 1995, despite the historically high rates of liquidity growth in 1994 and 1995, as a break from the past. He attributes the good inflation performance in part to supply side factors such as the favorable agricultural harvest in 1994 and the casing power shortages.

“With the shift to inflation targeting, it was observed that the expectations channel has taken a more important role in the transmission of monetary policy in the Philippines. The enhance transparency associated with the inflation targeting has increased policymakers’ awareness of the importance of gauging public inflation expectations in the conduct of monetary policy. While the expectations channel has strengthened during the inflation targeting period, the effect of inflation targeting on the interest rate channel, specifically the correlation between the policy rate and the benchmark 91-day T-bill rate, has weakened. This evidence is consistent with inflation targeting as a forward-looking framework of monetary policy.

The robust positive relationship prior to inflation targeting may be an indication that the policy rate then maybe more reactive to prevailing financial developments compared to what is done under the current framework (Guinigundo).” Debelle and Lim (1999) examined the suitability of inflation targeting regime for Philippines as the exiting regime of base money as a nominal anchor for monetary policy was losing its ability to control inflation in the face shifts in money demand and supply shocks. They primarily focused on two preconditions for inflation targeting like establishing necessary institutional infrastructure to build the independence of the central bank in its conduct of monetary policy and defining an appropriate price index and inflation target. Chapter 3: Framework of the Study

In general, monetary policy is exercised by the central bank to influence economic activity. It constitutes the measures and actions taken by the central bank to regulate the supply of money in the economy. Monetary policy actions of the BSP are aimed at influencing the timing, cost and availability of money and credit, as well as other financial factors, for the purpose of stabilizing the price level. The BSP implements monetary policy using various instruments to achieve the inflation target set by the National Government. To contract or to expand liquidity in the financial system, the BSP can do any or a combination of the following actions: * raising/reducing the BSP’s policy interest rates;

* increasing/decreasing the reserve requirement;
* encouraging/discouraging deposits in the special deposit account (SDA) facility by banks and trust entities of BSP-supervised financial institutions; * increasing/decreasing the rediscount rate on loans extended by the BSP to banking institutions on a short-term basis against eligible collaterals of banks’ borrowers; and * outright sales/purchases of the BSP’s holdings of government securities The BSP’s primary monetary policy instruments are its overnight reverse repurchase (borrowing) rate and overnight repurchase (lending) rate. A monetary policy framework is the monetary authorities’ guide for conducting monetary policy. It naturally requires an institutional framework under which monetary policy decisions are made and executed (Lamberte, 2002).

The following factors form basis for detailed characteristics of a monetary policy framework (Fry, 2000): 1. Structural differences, e.g., the structure of the financial sector, types and amounts of debt, openness to trade, commodity dependence, fiscal discipline, etc. 2. Varying degrees of indexation and other nominal rigidities that affect the speed of transmission from monetary policy instruments to inflation 3. Institutional arrangements and analytical constraints (such as data availability) that influence the way in which monetary policy can respond. Figure 1 below shows a simple and general framework for the conduct of monetary policy. As may be gleaned from this representation, transmission mechanism channels allow monetary policy to influence or affect economic variable. Figure 1. A Simple Representation of Conducting Monetary Policy

There are several types of monetary policy which a central bank may employ. One of which is monetary aggregate targeting which focuses on controlling monetary quantities. Rapid growth of monetary aggregates serves as trigger for central banks to increase interest rates, because of the fear of inflation. This strategy comprises three elements: 1) reliance on information conveyed by a monetary aggregate to conduct monetary policy, 2) announcement of targets for monetary aggregates, and 3) some accountability mechanism to preclude large and systematic deviations from the monetary targets (Mishkin, 2000). An advantage of base targeting is that central bank has full control of the variable. However, it is less visible or transparent such that its effects on inflationary expectations may be restricted to only those with sufficient familiarity with financial and monetary matters (Cukierman, 1996).

Under the monetary aggregate targeting, the Quantity Theory of Money can be related. This theory was first developed by Irving Fisher in the inter-war years as a basic theoretical explanation for the link between money and the general price level. It states that the changes in money supply (on the assumption that velocity is stable over time) are directly related to price changes or to inflation. Thus, it is assumed that the BSP is able to determine the level of money supply that is needed given the desired level of inflation that is consistent with the economy’s growth objective. In effect, under the monetary targeting framework, the BSP controls inflation indirectly by targeting money supply. In addition, monetary authorities wanted to address one of the pitfalls of monetary targeting, i.e., it does not account for the long and variable time lag in the effects of monetary policy on the economy. Under the modified framework, the BSP can exceed the monetary targets as long as the cultural inflation rate is kept within program levels. Under this modified approach, policymakers monitor a larger set of economic variables in making decisions regarding the appropriate stance of monetary policy.

This includes movements in key interest rates, the exchange rate, domestic credit and equity prices, indicators of demand and supply, and external economic conditions, among other variables. According to Maria Socorro Gochoco-Bautista (2001), in theory, a narrower monetary aggregate would be assumed to have a closer link to inflation, as narrow money is held primarily for transactions purposes while broader money measures partly reflect the holding of money as a store of wealth. Gochoco-Bautista also stated in her discussion paper that “the results of Guinigundo’s study likewise imply that narrower monetary aggregates are to be preferred as targets since broader aggregates tend to adjust more slowly towards equilibrium after a shock.” “His results imply that the growth rate of income velocity is stable and, therefore, would not potentially pose a problem as far as the reliability of monetary targeting achieving the goal of price stability.” “This means that there is a long-run relationship between money, on the one hand, and output and interest rates, on the other, so that even if there are shocks to the economy, the variables will return to their trend equilibrium levels.” In addition, Guchoco-Bautista (2001) also stated that under the monetary aggregate targeting framework, the monetary authority fixes money growth in order to reduce expected inflation in long-run equilibrium.

Another type of monetary policy which has gained popularity in recent years is inflation targeting. The literature can come up with a lot of definitions of inflation targeting. It is an economic policy in which a central bank estimates and makes public a projected or target inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools. It focuses on maintaining a low level of inflation, that which is considered to be optimal or at least would allow the country to have ample economic growth. Its main desire is to achieve price stability as the ultimate end goal of the monetary policy. In inflation targeting, there are criteria that were proposed by a number of authors. Those suggested by Mishkin and Savastano are representative of those found elsewhere in the literature. These are: a public announcement of a numerical target for inflation; a commitment to price stability as the overriding goal of policy; the use of an information-inclusive strategy; and the adoption of high levels of transparency and accountability. These criteria are not very helpful in defining this policy framework because some criteria are unclear.

According to Amato and Gerlach, the adoption of inflation targeting requires that an appropriate price index be selected and that the exact level of the target be determined. The inflation targeting is considered to be the most important change in the framework of monetary policy since the collapse of the Bretton Woods system in the early 1970s as it was started to be used by a number of countries (Amato and Gerlach, 2001). The hallmarks of the inflation targeting as a monetary policy framework are an explicit commitment by the central bank to keep an inflation index close to a periodically-adjusted target, and the use of an inflation forecast as the intermediate target for policy (O’Connell, 2008).

According also to O’Connell (2008), the initial experience of adopters has been highly encouraging because a careful recent empirical study finds that the 13 emerging-market countries that adopted inflation targeting between 1997 and 2002 experienced lower and more stable inflation subsequent to adoption– and larger improvements on both measure– than did a control group of non-targeting emerging-market countries including Nigeria, and at no detectable cost in terms of real volatility (Batini et al., 2005). Moreover, the success of inflation targeting appeared to be largely unrelated to indicators of exchange rate regime, financial sector robustness, and even fiscal stability (Batini et al., 2005). In an inflation targeting framework, the central bank commits to achieving an announced numerical target (which is usually a number, with specified allowable deviations, such as 2.5 +/-) for the rate of increase in a specified price index– usually the CPI.

Table 1. Characteristics of Inflation Targeting Arrangements

As indicated in Table 1, ranges are narrow among emerging-market countries the average range is barely above two percentage points. The system implies a commitment to bring inflation back into range when it moves outside, but there is a wide variation in the formality of commitments regarding the time horizon over which this is to be accomplished (Truman, 2003). The illustration (Figure 2) below shows the operational guidelines that the BSP has been observing since its implementation of inflation targeting in 2002. Figure 2. Inflation Targeting Framework

The inflation targeting tends to place greater emphasis on price stability in lieu of rigidly maintaining the intermediate monetary targets. This approach also evidently reduces the risk of monetary policy being either too tight or too loose, as may happen with strict adherence to a traditional base money program (Gochoco-Bautista, 2001).

In contrast to what Gochoco-Bautista (2001) stated about the monetary aggregate targeting, she said that under an inflation targeting , the authorities set monetary policy so that the price level is not just zero regardless of later shocks. The price level rule eliminates the effects of demand disturbances. It can be shown that the price level rule is likely to dominate the money supply rule if velocity shocks are large and any weight is placed at all on the inflation objective.

If Quantity Theory of Money is related to monetary aggregate targeting, the Taylor Rule, on the other hand, is related to inflation targeting. Taylor Rule was first proposed by the U.S. economist John B. Taylor and simultaneously by Dale W. Henderson and Warwick McKibbin in 1993. It is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point. This rule is intended to foster price stability and full employment by systematically reducing uncertainty and increasing the credibility of future actions by the central bank. According to Caglayan (2010), the Taylor Rule which is frequently cited with its success in applying inflation targeting in recent years, is defined as the central banks’ control on the interest rates in response of the biases between the actual and targeted values. Figure 3. Phillip’s Curve

Source: www.bized.co.uk

Phillip’s Curve by William Phillips is shown in the figure above. It can also be related to this study. This curve represents the relationship between the rate of inflation and the employment rates. William Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly. According to Kevin D. Hoover, Phillips conjectures that the lower the unemployment rate, the tighter the labor market and therefore, the faster the firms must raise wages to attract scarce labor. In the case of this study, under the inflation targeting, in where the inflation is lower compared to the monetary aggregate targeting, the unemployment rate is supposed to be high. Chapter 4: Methods and Sources of Data

4.1 Methods Used:
The researcher gathered relevant data and information for the study so the whole problem will be summarized and explained in a way that it will be easily understood. Moreover, the researcher analyzed the data gathered through regression. 4.2 Data Gathering Instruments:

The researcher used secondary sources including textbooks, internet articles, news clippings, reports, journals and the like. 4.3 Treatment of Data: The study utilized a descriptive research wherein patterns and characteristics of variables were illustrated and determined rightfully. This study also utilized a correlation research wherein the relationship of the indicator variables of the study to one another was analyzed, and the
quantitative terms were described. Moreover, this study also used regression analysis wherein the relationships between variables were estimated. In this analysis, the conditional expectation of the dependent variable given the independent variables will be estimated. Chapter 5: Presentation and Analysis of Data

The researcher gathered the statistics of inflation rates, reserve money, unemployment rates, employment rates and GDP growth rates under the period of monetary aggregate targeting and inflation targeting. And the data are presented below.

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