In this case, the price stability (stability of the purchasing power of the national currency) means a moderate increase in consumer prices, and not the rigidity thereof.

Inflation decreases the purchasing power of money, reducing the real value of monetary incomes and savings of the households and organizations, because over time for the same amount of money you can buy less goods and services than before.

Under the conditions of unstable and high inflation, households tend to materialize their depreciating monetary resources in goods and services as soon as possible or to transfer them in assets, primarily in foreign currency, which serve as a “shelter” from inflation. As a result, the pressure on the exchange rate increases and inflation further intensifies.

Inflation suppresses incentives for investment, reduces the ability of the economy to implement its production potential. High inflation impedes the implementation of long-term investment projects, thereby increasing the decline in business activity, as well as the reduction in production and volume of employment.

As a result, high and unstable inflation negatively affects the long-term growth of the economy and the well-being of citizens.

The absence of inflation and deflation (price reduction) are also dangerous for the economy. When commodity prices are steadily declining, consumers begin to postpone purchases hoping for further price reductions. As a result, producers stop developing, hiring personnel and maintaining the same level of salaries. Therefore, consumers spend even less, further worsening the opportunities for producers. Strengthening each other, these effects have a negative impact on the long-term growth rates of the economy.

The optimal value of inflation reflects those price conditions that do not violate the positive dynamics of economic growth and do not create macroeconomic and financial imbalances.

Research results show that, depending on the country, the average annual inflation parameters in the range of 1–5% ensure better conditions for economic growth. Lower inflation will restrain structural changes in the economy and reduce the flexibility of wages, while a higher inflation will increase the costs of ensuring the well-being of citizens.

The majority of modern scientists and practitioners agree that such inflation rates correspond to price stability. The target level must be above zero. A positive target reduces the likelihood of reaching the lower zero level by nominal interest rates and makes it possible to avoid the risk of deflation, which incurs greater costs than inflation.

In developed countries with a fairly long period of price stability, high confidence in monetary authorities and low inflation expectations, the medium-term objective is set at 1-3%.

The level of inflation in developing countries and emerging markets is usually higher than in developed countries. This is due to a number of factors: the Balassa-Samuelson effect, unfinished transformation of prices in these countries, optimization of the mechanism for allocating resources, high inflationary expectations. Based on these effects, inflation targets in emerging markets may differ by 1-2 percentage points.

The inflation target is established annually in Monetary Policy Guidelines, approved by President of the Republic of Belarus.

Central banks are responsible for price stability, since inflation has a monetary nature, and in the long run, the growth of the money supply is to the full extent transformed into the price growth.

Source: King, M. No money, no inflation – the role of money in the economy / M.King // Bank of England Quarterly Bulletin. – 2002.

In the long run the inflation rates are determined by the growth rate of money supply. The interrelation of money and inflation over a long-term period is close to 1.

It is the central banks that have a monopoly on the issue of money in the economy and the ability to control the money supply.

Despite the fact that certain outbursts of price growth may be caused by external shocks or administrative influence, the overall control over the money supply in the long term allows controlling inflation, which is the reason for the worldwide trend of transferring the function of ensuring price stability to the area of responsibility of central banks. Ensuring price stability is the goal of monetary policy in many countries of the world (European Central Bank, Central Bank of the Russian Federation, National Bank of Kazakhstan, etc.).

The monetary policy transmission mechanism is a set of channels through which monetary policy impulses affect economic activities and the level of prices in the economy in the short and medium term. In the long-term period, in accordance with the concept of the neutrality of money, monetary regulation does not affect the real economic variables (GDP, interest rate, etc.).

The transmission of a monetary impulse is carried out in three main stages, which causes the presence of a time delay – a lag. At the first stage, the change in the operating instrument of monetary policy affects the variables of the financial sector, prices of non-financial assets and the economic agents’ expectations. At the second stage, the behavior of economic agents is adjusted, which is reflected in the dynamics of consumer and investment activities, as well as foreign trade. At the third stage, the production volume in the country changes, which is reflected in the dynamics of the money supply and domestic prices for goods and services.

The channel of the monetary policy transmission mechanism can be defined as a system of economic relations emerging between sectors of the economy in the course of the consistent transfer of the monetary policy impulse through a specific economic category into the real economy and inflation. Typically, the following channels of the transmission mechanism are defined: interest rate, exchange rate, credit, asset prices and expectations.

More details on the theoretical representation of the monetary transmission can be found in the works of Mironchik (2015), Kharitonchik and Dmitriev (2018).

Long-term economic growth is determined by supply-side factors (structural factors). These include the available technologies, the size and qualification of labor resources, the amount and state of fixed capital, functioning economic institutions, etc. The state is able to influence long-term growth by improving the market system of economy functioning, changing fiscal policy, the mechanism of state regulation of the economy, and not by measures of monetary policy. Stimulation of economic activity by monetary instruments in excess of the potential opportunities of the economic system will inevitably lead to an excessive growth in the money supply, which will have negative inflationary consequences and, as a result, social costs. For more details on the factors of long-term economic growth, see the works of Mironchik and others (2016), Demidenko and Kuznetsov (2012), and Komkov (2011).

In the short and medium term, monetary policy can have a significant impact on economic activity. Adjustment of prices for goods and services in response to the change in monetary policy is not carried out one-step, but with a time delay. This means that as a result of the application of monetary policy, there is a temporary change in the conditions of functioning (for example, the real cost of credit resources) of economic entities, which leads to a change in their investment and saving behavior and, consequently, demand in the economy. For more details, see Mironchik and others (2007).

The theoretical basis of monetary targeting is the quantitative theory of money, and the central banks in the decision-making in the field of monetary policy are guided by the rule of Friedman, according to which the increase in money supply should be equal to the sum of the inflation target, the growth rates of equilibrium GDP and the change in the equilibrium velocity of money circulation:

∆MT ≈ πT + ∆Yeq - ∆Veq,

∆MT – target for money supply growth;
πT – inflation goal;
∆Yeq – increase in equilibrium GDP; and
∆Veq – change in the equilibrium velocity of money circulation.

The use of equilibrium rates of change in GDP and the velocity of money circulation is due to the stabilizing role of monetary policy, which consists in fulfilling the declared inflation objective and smoothing out fluctuations of economic activities.

The excess of the growth rates of GDP and the velocity of money circulation over their equilibrium rates will lead to the excess of the demand for money over the established intermediate target, as well as the formation of inflationary pressure in the economy. Under such conditions, the central bank’s control over the implementation of an intermediate target for the growth of the money supply will result in the formation of such a situation in the money market, in which the demand for money will exceed the supply thereof. The balancing of the money market will occur after an increase in the money price – a growth in interest rates in the economy. The increase in interest rates will cause a slowdown in demand in the economy, which will be reflected in the slowdown of economic activity, the velocity of money circulation and, with a certain time lag, in neutralization of the inflationary pressure.

Equilibrium GDP and equilibrium velocity of money circulation represent the volume of GDP and the level of circulation velocity that would have developed in the economy in the current period of time at flexible prices (the absence of nominal rigidities in the economy). Monetary policy does not have a direct impact on the equilibrium GDP and the velocity of circulation, which are determined by structural factors (the level of development of technologies and institutions, demographic trends, the education system, etc.).

If the actual GDP corresponds to the equilibrium one, the production level does not put upward or downward pressure on inflation (the actual level of inflation complies with the inflation expectations of economic agents). If the actual GDP goes beyond the equilibrium one, the use of production factors by firms is at a level that exceeds their normal (most effective) level of use. This means that firms are forced to attract additional labour or capital (for example, machinery or other equipment) or increase the working time of existing employees and capital in order to produce an additional unit of the output. This requires an increase in labour costs and maintenance of the capital. As a result, as production factors are used beyond their efficient level, marginal costs of firms begin exceeding their marginal revenue. Under the conditions of excess demand, firms can increase prices for products to maintain the rate of profit unchanged, or even try to raise it. This leads to the growth of inflationary pressure in the economy. If the equilibrium level of GDP exceeds the actual one, the opposite is true.

For additional information on the equilibrium and cyclic components of economic variables, see the works of Demidenko (in Russian only)(2008), Demidenko and Kuznetsov (in Russian only) (2012).

Demand for money is understood as the need of economic entities in money, resulting from the functions they perform. Behavioral characteristics of economic agents at the micro level form the resultant vector of demand for money at the macro level, which can be represented as a function of a certain monetary aggregate from the variable of transactions’ scale in the economy and the return on assets that are alternative to the monetary aggregate in question.

More details can be found in the works of Pelipas and Kirchner (2015a (in Russian only), 2015b (in Russian only)), Bezborodova (in Russian only: 2014a, 2014b).

The foreign exchange rate means the amount of one currency, which should be paid to purchase another currency, or, in other words, to be converted thereto. That is why the foreign exchange rate is often called the exchange rate.

The exchange rate regime is the system of certain exchange rate ratios between currencies. Depending on the manner of setting exchange rate, two alternatives are possible: an exchange rate may be strictly fixed to a foreign currency or float freely depending on the ratio of demand therefor and supply thereof.

Thus, for example, there are two types of floating exchange rate: free and managed floating. Under the freely floating regime the state does not interfere in the process of the exchange rate setting. The managed floating regime means that the exchange rate is set under the impact of demand and supply, which may be influenced by the state by means of foreign exchange interventions.

The main benefits of fixed exchange rates are their predictability and certainty. But, having regard to the fact that the state undertakes the obligation to maintain the fixed exchange rate, in case of excess of demand for foreign exchange over supply thereof, the central bank begins to sell foreign exchange from its reserves with a view to keeping the exchange rate at the targeted level. At the same time, the state’s foreign exchange reserves are exhaustible and it is impossible to hold the exchange rate of the national currency from decline by means of sale of foreign exchange from reserves for a long time.

The benefit of the floating exchange rate system is the possibility to carry out the more flexible monetary and fiscal policies, as well as to adjust external macroeconomic imbalances.

A foreign exchange intervention is an interference of a state, usually, via a central bank, into the transactions in the foreign exchange market by means of foreign exchange purchase or sale.

As a rule, the key target of carrying out foreign exchange interventions is exertion of an influence on the foreign exchange rate. However, they may be used for the purpose of attaining other objectives, for example, managing of gold and foreign exchange reserves.

Since June 2015 the trades in the main foreign currencies (the US dollar, the euro and the Russian ruble) are carried out at the JSC “Belarusian Currency and Stock Exchange” in the continuous double auction regime.

In the course of the continuous double auction the participants of trades are entitled to submit bids to the trading system during the whole time of the trading session. In the process of trades the bids for purchase or sale of foreign exchange are satisfied as long as the bids are made based on the declared exchange rates.

When a participant makes a bid for purchase, the trading system checks the availability of applications for sale with the exchange rate being less than the exchange rate of a bid for purchase or equal thereto, and, in the case of their availability, satisfies the bid for purchase at the exchange rates of suitable applications for sale starting from the lower one.

When a participant submits an application for sale, the trading system checks the availability of bids for purchase with the exchange rate being higher than the exchange rate of an application for sale or equal thereto, and, in case of their availability, satisfies the application for sale at the rates of the suitable bids for purchase, starting from the highest rate.

Depending on their characteristics, the unsatisfied bids/applications are sent to the queue of bids/applications, or rejected by the system. An entry of a new bid results in the performance of one or several transactions in case of availability of a counter offer in the trading system.

As a result, during one trading session a lot of deals at different rates are entered into under one currency. The average weighted rate of transactions at the close of twinning becomes the official one.

The use of the interest rate policy instruments makes it possible for the National Bank of the Republic of Belarus to make a direct impact on the level of the short-term interest rates of the interbank credit market, thereby ensuring the attainment of the monetary policy operational target.

A change in the short-term interest rates of the interbank credit market leads to the change in the short-term and, subsequently, in the long-term interest rates on bank credits and households’ and enterprises’ deposits.

A change in the rates of credit and deposit market makes an influence on the saving and investment processes in the non-financial sector of the economy and the households sector, that is reflected in the dynamics of credits issuance and demand in the economy. As a result, the broad money supply is changed, that is reflected with a certain time lag in the inflation dynamics.

In the process of analyzing monetary policy, a large number of central banks assess the monetary conditions index. The concept of monetary conditions was for the first time proposed in the early 1990s in the Bank of Canada and subsequently became widespread in central banks.

The monetary conditions index is a combination of deviations of the real interest rate and the real exchange rate from their equilibrium levels.

A key role in determining monetary conditions is given to the interest rate component. It is the interest rate that is used by the majority of central banks, including the National Bank of the Republic of Belarus, as the operational target of monetary policy. The change in interest rates of the central bank has a direct impact on the exchange rate, which is the second component of monetary conditions.

Monetary conditions reflect the combined effect of interest rates and exchange rate on the economy of the state. Tight monetary conditions, as a rule, are formed under the influence of the central bank’s activities aimed at curbing price growth in order to prevent inflation from exceeding the target. On the contrary, if the inflation is expected to be much lower than the target the central bank’s actions are usually aimed at creating easy monetary conditions. Neutral monetary conditions do not lead to either a reduction or an acceleration of inflation.

The concept of a neutral (equilibrium) interest rate is of decisive importance in calculating the interest rate component of monetary conditions. A neutral interest rate is a real interest rate corresponding to a stable presence of inflation and inflationary expectations at the level of the target, and an output in the economy and the exchange rate at mid-term equilibrium levels. Thus, the interest rate component of monetary conditions is a deviation of the actual real interest rate from its neutral level, which directly determines the stance of the interest rate policy being pursued. If the actual real and neutral interest rates are equal, the interest rate policy is neutral.

The neutral interest rate is determined solely by structural (fundamental) factors, and monetary policy does not have a direct impact on its level. According to the uncovered interest rate parity, the level of the neutral interest rate in the countries with small open economies, including the Republic of Belarus, depends on the level of the neutral interest rate in the trading partner countries, the expected change in the equilibrium real effective exchange rate (RER) and the equilibrium risk premium (in Russian only) of foreign investors to protect against the risk associated with changes in the exchange rate.

The change in each of the above-mentioned indicators will have a direct impact on the neutral interest rate in the Republic of Belarus. Thus, other things being equal, the reduction of the neutral interest rate in the trading partner countries will also lead to a decrease in the neutral interest rate in the Republic of Belarus. Reducing the equilibrium risk premium, for example, in case of an increase in the investment rating of the Republic of Belarus, will also result in a proportional decline in the neutral interest rate. The lowering of the neutral interest rate in the Republic of Belarus can also be caused by a slowdown in the equilibrium rate of the national currency depreciation, for example, with a steady growth in the efficiency of the national economy functioning.

The neutral interest rate is an unobservable variable, which involves the use of different methods for calculating it. In the National Bank of the Republic of Belarus, the level of the neutral interest rate is estimated using a set of macroeconomic models, the core one being the medium-term projection model of the National Bank’s monetary policy.

The deviation of the actual real interest rate of the overnight interbank market in Belarusian rubles from the neutral level is published on a quarterly basis in the analytical review “Major Trends in the Economy and Monetary Sphere of the Republic of Belarus” (in Russian only). The analysis of factors that form the neutral refinancing interest rate in the Republic of Belarus is represented in the paper of Mironchik (2018) (in Russian only).

The interest rates that economic agents observe in everyday life are almost always nominal. It is the nominal interest rate that is indicated in the loan or deposit agreement. For example, the nominal rate on a bank deposit shows the amount of monetary funds that a bank pays to a depositor for the use of his/her free resources. However, the nominal interest rate does not reflect the purchasing power of the income received from the placement of the deposit, i.e. the number of goods and services that a depositor will be able to purchase. With a view to determining the income, it is necessary for a depositor to adjust the nominal income from the deposit placement for the change in prices for relevant goods and services. Thus, on a national scale, the real interest rate is the quantity of goods and services that the investor can purchase for the income received from investment, and is calculated by adjusting the nominal interest rate for inflation.

There are two types of real interest rate: ex ante and ex post. The ex ante real interest rate is expected at the time a loan is granted or a deposit is placed and is calculated by adjusting the nominal interest rate for the expected inflation. So, if a depositor places funds in a deposit at 8 percent per annum with a one-year maturity, while expecting a price increase (inflation) for the deposit period by 5 percent, the ex ante real interest rate will be about 3 percent per annum. Let us suppose that the actual inflation rate for the deposit placement period was 4.5 percent instead of the expected 5 percent. In this case, the ex post real interest rate, or the actual real interest rate, will be about 3.5 percent per annum.