There is a consensus among central bankers, academics and even the public at large that price stability is beneficial and monetary policy should be tasked to achieve it. This general policy recommendation is valid for both industrialized and emerging economies, although in the latter case, as financial markets are less mature and operate with less diversified instruments, it might be a more challenging task for central banks to deal with real and nominal shocks. Such shocks could come from unanticipated movements in food and energy prices, administered prices and, last but not least, from massive capital flows. The above-mentioned limits to monetary policy efficiency make the case for a coherent policy mix even stronger in emerging economies. Without support from the other economic policies, monetary policy may find it difficult to achieve sustainable low inflation. In other words, delivering price stability may come at the expense of other macroeconomic equilibria and may ultimately be self-reversing.
Central and Eastern European transition economies in particular have been confronted with large FDI inflows, both independent of and associated with the privatization process, and also with portfolio investment, fostered by the presence of a significant interest rate differential against advanced economies. Large capital inflows raise a dilemma to policymakers. On the one hand, they foster economic development and thus support real convergence; they also help subdue inflationary pressures in the short run through their effects on exchange rate appreciation and through shifting consumption towards tradable goods. On the other hand, through the same effects on exchange rate appreciation, capital inflows may erode external competitiveness of the economy, widen external imbalances and thus result in depreciation and higher inflation. In addition, large external imbalances render an economy more vulnerable to a change in the market sentiment or to shocks associated with high volatility in external financial markets This paper examines the particularities of monetary policy and the constraints it faces in the small open emerging economies in Central and Eastern Europe (with a special focus on Romania) and evaluates its role in the policy mix.
Section 1 and 2 discuss the reasons for setting price stability as the main goal of monetary policy and explore the interlinks between price stability and financial stability, in order to identify particularities and limits of monetary policy in small open emerging economies. Section 3 focuses on reviewing literature and country experiences with capital flows, which point to both macroeconomic benefits and potential risks to macroeconomic and financial stability. Section 4 deals with challenges faced by the authorities of Central and Eastern European countries and argues in favor of a macroeconomic policy mix that supports real convergence with the EU while maintaining macroeconomic stability. Section 5 describes Romania’s experience with liberalizing capital flows concomitantly with adopting inflation targeting.