Regime of exchange rate targeting means that the central bank pegs the value of the national currency to the rate of exchange (currency basket) of the country (countries) with low levels of inflation, ie. an intermediate guide of monetary policy is a certain level of or a change in the exchange rate. Based on the theory of relative purchasing power parity, this regime assumes that when fixing the exchange rate, inflation in the country should be close to the inflation in the country of the currency peg.
Implementation of the national currency issue (withdrawal) is carried out in the exchange for foreign currency.
With a view to efficient use of this regime, a country should own significant foreign exchange reserves to counter shocks in the foreign exchange market.
Regime of monetary targeting uses one of the indicators of money supply as an intermediate target. Theoretically, based on the equation of exchange of I.Fisher, this regime assumes the availability in the country of close direct relationship between selected intermediate target and the consumer price index.
Equation of Fisher (equation of exchange) is the equation that describes the ratio of money supply, velocity of money, price level, and the volume of output.
M — money supply;
V — velocity of money;
P — price level;
Q — volume of output.
The American economist Irving Fisher justified the formula in his work "The Purchasing Power of Money" in 1911. It is clear from the equation of exchange, that the product of the amount of money and its velocity per year should be equal to the nominal income (ie. the nominal value of the purchased goods and services).
The issue (withdrawal) of the national currency, as a rule, is carried out by means of banks’ refinancing instruments (liquidity withdrawal). The volume of issue (withdrawal) is determined based on the need to achieve the intermediate target.
An important condition for the effective implementation of monetary targeting regime is the availability of a flexible exchange rate of the national currency against foreign currencies. This allows the central bank focusing on solving the problem of managing the money supply through refinancing instruments (withdrawal) and minimizing the impact of foreign exchange channel on the intermediate target.
Regime of inflation targeting assumes that the central bank achieves its ultimate target by means of managing inflation expectations. The inflation forecast serves as an intermediate target. When the risk of inflation deviation from the announced target appears, the central bank uses the monetary policy instruments to bring it in line with the target value.
The main impact of monetary policy is usually carried out through the interest rate channel. Accordingly, the volumes of issue (withdrawal) are determined by the market based on the money price set by the central bank.
The use of this regime requires the availability of basic set of organizational and legal and macroeconomic conditions in the country:
- availability of consensus in the society on the fact that the maintenance of price stability should be the main objective of monetary policy of the central bank;
- availability of sufficiently well-functioning financial institutions and markets;
- reaching an agreement with the Government on the quantitative parameter of the inflation target or independent determination of the target by the central bank;
- absence of fiscal dominance over the monetary policy;
- central bank’s independence in the choice of monetary policy instruments;
- transparent pricing system;
- availability of a close relationship between the level of short-term interest rate in the money market and inflation.