DP4911 Monetary Policies for Developing Countries: The Role of Institutional Quality

Author(s): Haizhou Huang, Shang-Jin Wei
Publication Date: February 2005
Keyword(s): conservative central banker, corruption, currency board, dollarization, inflation targeting, institutional quality, monetary policy
JEL(s): E52, E58, E61, E62, H50
Programme Areas: International Macroeconomics, Institutions and Economic Performance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4911

Weak public institutions, including high levels of corruption, characterize many developing countries. With a simple model, we demonstrate that institutional quality has important implications for the design of monetary policies and can produce several departures from the conventional wisdom. We find that a pegged exchange rate or dollarization, while sometimes prescribed as a solution to the problem of a lack of credibility, is typically not appropriate in developing countries with poor institutions. Such an arrangement is inferior to an optimal inflation targeting, or a Rogoff-style central banker, whose optimal degree of conservatism is proportional to the quality of institutions. Furthermore, our results cast doubt on the notion that a low inflationary target or a currency board can be used as an instrument to induce governments to strengthen quality of public institutions.