Evaluating Proxies for Monetary Policy
An economist is studying the historical monetary policy of two countries from a period before they joined a monetary union.
- Country A consistently issued its government debt in its own domestic currency, over which its central bank had full control.
- Country B, to attract foreign investment, issued the majority of its government debt in a stable foreign currency.
For which country would the interest rate on its government bonds serve as a more reliable proxy for its domestic policy interest rate? Justify your answer by explaining the role of default risk.
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An economist is analyzing the monetary policy of a country during a historical period when it issued a significant portion of its government bonds in a foreign currency (e.g., U.S. dollars) instead of its own domestic currency. Why would the interest rate on these foreign-currency-denominated bonds be a poor proxy for the country's domestic policy interest rate?
In the pre-euro era, the interest rate on Spanish government bonds served as a valid proxy for Spain's policy interest rate. The primary reason for this validity is that the Spanish government had a strong reputation for fiscal responsibility, which minimized the perceived risk of default.
Evaluating Proxies for Monetary Policy
Choosing a Reliable Proxy for Historical Policy Rates
For each scenario describing a country's borrowing, match it with the correct assessment of whether its government bond rate is a good or poor proxy for its domestic policy interest rate.