Handbook of Exchange Rates

28.6 Alternative Nominal Anchors

A government or central bank that is impressed with the advantages of exchange rate flexibility cannot simply opt for a float and figure that it is then finished with the choice of currency regime. It must also consider, if the exchange rate is not to be the anchor for monetary policy, what is to be the nominal anchor instead (and how tightly to commit to it).

There are a variety of possible candidates for nominal anchor. Two are historical anachronisms: the price of gold under the gold standard and the money supply under monetarism. Neither of them has been a popular choice in recent decades. Two more candidates are economists' proposals to address the difficulties of the first two: a commodity standard would soften vulnerability to big fluctuations in a single commodity (the gold market) and nominal income targeting would negate the effect of big fluctuations in velocity (i.e., in the money market). Neither of those two has ever been tried, for some reason.

The leading candidate in recent years has been inflation targeting (IT). There are many variations on this approach to monetary policy: focusing on headline versus core CPI, price level versus inflation, forecasted inflation versus actual, and so forth. Some interpretations of IT are flexible enough to include output in the target at relatively short horizons. But all orthodox interpretations focus on the CPI as the choice of price index. This choice may need rethinking in light of heightened ...