why is a nominal anchor needed for a central bank to perform its functions efficiently?

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Expert Solution

A nominal monetary policy anchor is a single variable or tool used by the central bank to define private agents' expectations about the nominal price level or its direction or what the bank should do to achieve that direction. Generally, the two forms of nominal anchor; nominal quantity-based anchor and nominal price-based anchor.

The nominal anchor-based quantity targets money while the nominal anchor-based price targets exchange rate or interest rate. In the past the Central Bank has used small money supply (M2) as the nominal monetary policy anchor. It is necessary to remember that targeted exchange rates can not achieve the desired impact if the interest rate is also simultaneously subject to regulation. For an effective monetary policy certain rules are important. In this situation, prices such as the exchange rate and the interest rate can not be simultaneously regulated or pegged.

If interest rates are regulated, the exchange rate should be able to move freely in order to materialize the required adjustment in order to achieve market stability.

Rahul Sunny answered 1 year ago

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