1. Introduction

Greater trade integration in Latin America is progressing, with the Free Trade Agreement for the Americas (FTAA) being negotiated with prospects of a final agreement by the end of the decade, and a myriad of bilateral agreements and regional arrangements negotiated or in force. Closer trade integration has brought with it an important degree of institutional development for economic policy.¹ Some authors (Mundell, 2000) see this as a first step in a process of deeper economic integration (a logical consequence of "globalization") that will inevitably lead to the establishment of regional currencies, or indeed a world currency. On a smaller scale, the idea of monetary integration has been proposed by Argentina within the context of Mercosur (as analyzed in Eichengreen, 1998), and some economists (notably Dornbusch, 2000) have called for Mexico to adopt the US dollar - presumably a first step towards making NAFTA a currency union.

Although a full blown currency union seems somewhat far off for Latin America, it can be argued that many countries of the region are already laying the foundations for this kind of deeper integration. At one extreme, some Latin American economies have adopted the U.S. dollar as their currency, eschewing exchange rate problems and monetary policy altogether. At the other extreme, countries with flexible exchange rates have adopted a monetary policy centered around inflation targeting to anchor nominal price expectations. The stated aim of inflation targeting in the most important Latin American economies (Brazil, Mexico, Chile, Colombia) is to get inflation rates down to the levels of their major trading partners, (largely the U.S. and the EU), implicitly gearing monetary policy over the long-run to maintaining stable real exchange rates with respect to the Euro and the U.S. dollar.² This can be seen as a step towards de facto, if not de jure, macroeconomic policy coordination.

Between these two extremes are countries that have pegged exchange rates with varying levels of rigidity. On the one hand is pre-crisis Argentina with a currency board pegged to the dollar. On the other are exchange rate bands or crawling pegs, a strategy which may increasingly become less tenable as trade and financial integration progresses.

This paper briefly reviews the options of monetary policy integration that exist in Latin America, (the adoption of the dollar, pre-crisis Argentina currency board, and inflation targeting with flexible exchange rates) with an emphasis on the institutional requirements (particularly for inflation targeting).³ It presents the case of the adoption of inflation targeting in Colombia as an example of the challenges of implementing this kind of monetary regime. Some considerations of the institutions for fiscal policy required to maintain a credible inflation targeting regime are then considered. The point of these reviews is to suggest that the process of globalization is pushing countries to adopt institutions for economic policy making that are consistent with greater trade and financial openness and macroeconomic stability, thus paving the way for closer integration in the future.

2. Extremes of Monetary Policy Integration Adopting the U.S. Dollar

In the area of monetary policy, the first and most radical extreme of integration is to give up monetary independence altogether by adopting the currency of another country. In this extreme instance, control of the institution of money as a public good, with its functions as a means of effecting transactions and as a store of value, is given over to the central bank of another country. As long as that central bank is responsible and credible in its monetary policy, and the money is accepted as legal tender, this strategy has a number of benefits, most prominently price stability. If this currency is the U.S. dollar, widely accepted for trade and payments in international markets, and the currency of a major trading and financial partner, then there are added benefits: no exchange rate problems for a large proportion of trade and payments, and easier access to international capital markets. The common problem of currency mismatch within the banking system, where banks have liabilities in hard currency but assets in domestic currency, largely disappears. With the elimination of the uncertainty related to exchange rate variability, domestic interest rates fall and launch spreads for international bond issues are reduced. This leads to a more propitious environment for investment and growth.

Two countries in Latin America have gone this route: El Salvador and Ecuador. Ecuador adopted the U.S. dollar in 2000 and El Salvador in 2001. These countries have seen significant benefits in terms of a decline in inflation, interest rates and spreads on foreign bonds. Ecuador, for example, has seen inflation fall from rates of over 100 percent in 2000 to under 20 percent today. In addition, the overnight U.S.$ lending rate has fallen from 8 percent in 2000 to 3 percent today, and the Ecuador Emerging Markets Bond Index (EMBI) spread over U.S. treasuries has fallen from over 300 basis points during 1998-2000 to roughly 150 basis points today.

But this strategy also comes with a number of costs. First is the abdication of all control over monetary policy. When the Federal Reserve acts to influence interest rates in the U.S. in response to U.S. domestic economic conditions, domestic interest rates in El Salvador, Panama and Ecuador will be affected. There may still be scope to affect domestic credit conditions through changes in bank regulations, but the main channel for affecting interest rates - a change in the money supply - has effectively been removed. Thus any scope for counter-cyclical monetary policy is removed. Second, the supply of dollars is determined by the flows in the balance of payments. Credit conditions and domestic growth are now tied to investor confidence, capital flows and other flows of dollars in the balance of payments. An increase in foreign investment or a positive change in the terms of trade will lead to an inflow of dollars and an easing of domestic credit. But adverse changes in the terms of trade or a fall in confidence in the economy and capital flight will lead to a scarcity of credit and high interest rates. Third, there is no exchange rate flexibility to buffer against foreign terms of trade shocks. When the price of international commodities falls, adjustment in the domestic economy will have to take place through a decline in real wages and prices as opposed to a change in the nominal exchange rate. Often these adjustments are more difficult to effect and may take longer.

What kind of countries benefit from this kind of regime? The literature on the theory of optimal currency areas (Eichengreen 1998) suggests a number of characteristics:

• Small and open economies, whose currencies would be subject to considerable variability from terms of trade shocks and shifts in international capital flows;
• Countries whose economic cycles move in tandem with the U.S., either because they have a similar commodity composition of trade and production (as might be the case with Ecuador and the energy sector of the U.S. economy, for example) or because they have very strong trade and financial linkages with the U.S. - as is the case with El Salvador (and many other countries in Latin America);
• Perhaps most relevant for this paper, countries with very limited institutional capacity. This is not a sufficient condition in itself, but paired with the above conditions creates a more compelling case for dollarization.

Currency Boards

A currency board, in which the amount of domestic currency issued is held in strict proportion to the number of dollars (or other hard currency) in the central bank reserves, can be seen as a variant of dollarization. In advantages and costs it is to a large extent indistinguishable from dollarization, with the important exception that a currency board can be challenged by speculators.⁴ By setting up a strong rule to control monetary policy and eliminating exchange rate flexibility the currency board essentially removes all policy discretion from the central bank, just as in dollarization. But by maintaining the rule, as opposed to full dollarization, it implicitly leaves the option open that parity might one day be broken.

Thus the issue of credibility arises with a currency board that would otherwise not arise with complete dollarization. To be successful in the implementation of a currency board, a government has to convince economic agents that it is committed to the maintenance of convertibility. This commitment has to be manifest in the backing of every unit of domestic currency with hard currency. But in economies such as those of Latin America, with a large reliance on foreign savings, the commitment must also extend to maintaining a prudent fiscal policy, and implementing structural reforms that will enhance the competitiveness of the economy.

The sources of the current crisis in Argentina are a case in point. The currency board initially was spectacularly successful in reducing inflation and interest rates and spurring growth. Between 1991 and 1997 Argentina grew by more than 5 percent per annum. But the rigidity of the exchange rate led to an appreciation of the real exchange rate and made the economy vulnerable to external shocks. This effect was not overwhelming, however, as the real exchange rate appreciated only 15 percent over the course of four years from 1997 to 2001, a movement which included the large devaluation of the Brazilian real.

More important was the lack of fiscal consolidation, which, combined with the overvaluation of the real exchange rate, led to a persistent and growing current account deficit. In order to finance this deficit Argentina began to rely to a large extent on foreign financing. But given large and mounting fiscal deficits, a stagnation in growth, and little political consensus for fiscal reform, investors became increasingly reluctant to make long-term commitments. Foreign financing became more expensive and was granted at ever shorter maturities. Despite belated attempts to establish fiscal balance by enacting a zero-deficit law, severe doubts about the economy's ability to reestablish economic growth and meet its external payment obligations persisted. After several failed attempts to buy time with IMF loans and partial debt restructuring, the situation became unsustainable and the largest international default in history ensued.

Inflation Targeting

But what about countries that don't meet the criteria for dollarization or strict currency pegs? These are typically larger countries, such as Mexico, Brazil and Colombia, that have moved recently to floating exchange rates, enjoy diversified trade and financial relations, and are relatively diversified. For these countries the challenge is to establish a nominal anchor for inflationary expectations and a monetary policy that is flexible enough to respond to external shocks, but sufficiently disciplined and credible to reduce inflation. In the last five years, the major economies in Latin America, including Brazil, Mexico, Chile, Colombia and Peru have all moved toward implementation of inflation targeting to provide this function. The adoption of inflation targeting follows on the successful use of this monetary framework among some industrial countries, and the adoption of most of the elements of the strategy by a small group of emerging market countries outside of Latin America.⁵

Latin American countries have been moving towards an inflation targeting framework because of the advantages it offers over using the level of monetary aggregates or the exchange rate as a nominal anchor. First, it does not require a stable relationship between monetary aggregates and inflation, a relationship which has become increasingly volatile with innovations in financial intermediation, complicating the use of intermediate monetary aggregates to control inflation. Instead of focusing on a monetary aggregate or the exchange rate as an intermediate instrument, inflation targeting allows all relevant information to be used to forecast inflation and to develop policy actions to achieve the target (Mishkin et al., 1997). Second, the inflation target is easily understood by the public, and if implemented in a transparent and consistent fashion, increases the accountability of the monetary authorities and credibility of monetary policy. Third, unlike targeting the nominal exchange rate, inflation targeting allows the monetary authorities to respond to short-term shocks with some flexibility, while keeping the long-term focus of monetary policy on price stability (IMF, 2000).

While there are different institutional and operational issues in the conduct of inflation targeting in the various countries, the main elements comprise:

1. The public announcement of medium-term numerical targets for inflation
2. An institutional commitment to price stability as the primary goal of monetary policy, to which other goals are subordinated
3. An information-inclusive strategy in which many other variables, and not just monetary aggregates or the exchange rate, are used for deciding the stance of monetary policy
4. A transparent monetary policy that ascribes a central role to communicating to the public and the markets the plans, objectives and rationale for the decisions of the central bank
5. Mechanisms that make the central bank accountable for attaining its inflation objectives (Mishkin et al. 2000).

In essence, inflation targeting countries use the inflation forecast as an intermediate target for monetary policy, and implement their policy in a transparent and accountable framework (Svensson, 1998).

However, the successful implementation of inflation targeting is quite demanding, requiring a strong fiscal position (as discussed below), a well developed and healthy financial sector, a good knowledge of the monetary transmission mechanisms through which the instruments of monetary policy affect inflation, and the ability to forecast inflation relatively accurately. The benefits are commensurate however, as can be seen by the improved inflation performance of countries in Latin America that have adopted this strategy.

3. Inflation Targeting in Colombia⁶

In order to give a flavor of the complexities involved in the adoption of inflation targeting this section present an overview of the recent adoption of the main elements of this monetary policy regime in Colombia. In September of 1999 Colombia abandoned its crawling peg exchange rate regime and allowed the peso to float, beginning a period of greater flexibility in monetary policy. Before this, the Banco de la República had operated monetary policy through a complicated system in which base money and the nominal exchange rate were chosen within tolerance bands to reach the objectives of the government's economic program for real GDP growth and inflation.⁷ While this system could be considered to have some of the elements of inflation targeting (in particular, the inflation objective was announced annually since 1991), it was not until the end of 2000 that the government decided formally to adopt inflation targeting as the framework for its monetary policy (Banco de la República, 2000).

Monetary Policy Before Inflation Targeting

The announcement of inflation objectives of government policies began in Colombia in the early 1990s. In 1991, a new constitution established the independence of the Banco de la República and mandated that the design and execution of monetary, exchange rate and credit policies was the exclusive purview of its Board of Directors. In addition, the Colombian constitution stated that the Banco de la República had the responsibility to "preserve the purchasing power of the currency" (article 373), and in 1992 a new law (Law No. 32) mandated that the Board of Directors must announce a quantitative inflation objective each year (Darío Uribe et al., 1999). ⁸

In the early years of this regime, the conduct of monetary policy depended on the selection of the monetary base as an intermediate target for reaching the objectives of inflation and real GDP. The Board of Directors of the Banco de la República announced a yearly band for the growth of base money, which was to remain valid unless there were substantial changes in macroeconomic indicators or severe disturbances in financial markets (Darío Uribe et al. ibid). In addition to the monetary base, from 1994 until 1999 the Board of Directors also announced a band for the nominal exchange rate with respect to the U.S. dollar, adjusting the rate of crawl of the central parity of the band to approximate the difference between the domestic inflation target and the inflation forecast of Colombia's main trading partners.⁹

Despite the explicit announcement of an inflation objective, a number of analysts have pointed out that the central bank often gave priority to other objectives, principally the targets for output, at the expense of its inflation goals (Gómez et al., 2000). Before 1999 the inflation objectives were rarely achieved and never sustained. In addition, the announcement of multiple intermediate targets (base money and the nominal exchange rate) led to confusion among market agents about which target represented the constraint for monetary policy. While the monetary authorities maintained that the priority intermediate target was the monetary aggregate, the market increasingly considered the nominal exchange rate to be the main constraint. During the late 1990s the monetary authorities devalued the exchange rate band a number of times and widened it to provide more flexibility and resolve the conflict between these intermediate targets. However, in the face of strong persistent capital outflows during 1999 the exchange rate band was abandoned, and the peso was allowed to float.

One of the results of the persistent and relatively high inflation that prevailed during the 1990s was that it became imbedded in the institutional structure of the economy. Wages, pensions, taxes, mortgage payments and some financial instruments were formally indexed to inflation (Darío Uribe et al., 1999), increasing the cost of disinflation and eroding the credibility of the central bank's inflation objectives. It was not until the crisis of 1999, when real GDP fell by 4.3 percent due to a rapid decline in asset prices and large increases in real interest rates, that inflation fell below the target of 15 percent to single digits for the first time since the 1970s. This recession and the decline in inflation may have weakened some of the backward indexation mechanisms in the economy and set the stage for the successful implementation of inflation targeting.¹⁰

The Implementation of Inflation Targeting

In September 2000, as part of its quarterly report on inflation, the Banco de la República published the new guidelines for incorporating inflation targeting into its operations (Banco de la República, 2000). Many of the institutional elements of inflation targeting have been in place for some time, and with this policy statement the central bank took steps toward implementation of the operational aspects of inflation targeting.

A. Institutional Framework

Central Bank Legal Framework

As mentioned above, the legal framework for central bank operation of inflation targeting was put in place in Colombia in 1991 and 1992. Under the constitution and subsequent laws the central bank has complete instrument independence and a mandate to pursue price stability. Central bank financing of the government deficit is tightly limited to cases in which the Board of Directors of the Central Bank votes unanimously in favor.

Design of the Inflation Target

The inflation target is defined as the annual rate of CPI inflation which includes volatile prices of energy and agricultural products. The central bank has chosen this more volatile price index (as opposed to core inflation, for example) because it is widely understood by the public, and because prices, wages and financial contracts have traditionally been linked to this "headline" index. The CPI has also been chosen as the target in other emerging market countries that have adopted inflation targeting, where the object is to achieve disinflation and thus it is important to influence inflationary expectations directly. In most industrial countries the target is chosen in terms of core inflation and the objective is to maintain prices at their actual level (IMF 2000).

The Target Horizon

The central bank has been mandated by law to announce a yearly target for inflation since the early 1990s. In its recent statement it announced targets for more than one year in advance for the first time. The target for 2001 is 8 percent while for 2002 it is 6 percent. These targets are consistent with the history of gradualism in Colombia that seeks to limit the costs of disinflation. The multiyear target follows from the central bank's recognition that there are long lags between the use of monetary policy instruments and their effect on inflation (typically estimated at six to eight quarters - see below).

Point Target or Target Range

The inflation targets have been defined in terms of points rather than ranges, because these are thought to provide a better guide to inflationary expectations and communicate a higher degree of commitment by the monetary authorities to the inflation target (Darío Uribe et al., 1999). Most countries have defined their target in terms of ranges, given the difficulties associated with hitting point targets (IMF 2000).¹¹

Accountability and Transparency

In addition to announcing yearly targets for the inflation rate, the central bank also announces the target ranges for monetary aggregates which it continues to use as indicators of the stance of monetary policy. In addition, each month the central bank makes the results of analyses of inflation forecasts and the observed outcomes of inflation known to the public through press releases, public pronouncements and monthly inflation reports. The central bank publishes a quarterly inflation report which contains information on policy, on all the relevant information the central bank collects to measure inflation, forecast inflation outcomes and measure inflationary expectations. In addition, twice a year the Board of Directors of the central bank presents a report to congress on economic developments and its policy position.¹²

B. Operational Issues: Conduct of Monetary Policy

Policy Implementation

The behavior of monetary aggregates, especially base money, continues to play an important part in the conduct of monetary policy. For this reason the central bank will establish a reference level for the monetary base which it considers to be consistent with the inflation target, the projected growth of real GDP and any change in the velocity of money. Under normal circumstances, strong deviations of the monetary aggregate from its reference level would signal an increased risk of not attaining the inflation target. If base money differs significantly from its reference level for a period of two weeks or more, the Board of Directors will take policy measures to correct the level of base money or will explain publicly why no measures have been taken.¹³ On a routine basis, the Board of Directors of the central bank will also evaluate the reference level for base money and can modify it if there are solid technical reasons to do so, always with the aim of achieving its inflation target (Banco de la República, 2000). This was done in July 2000 when base money grew faster than indicated by its band. The authorities considered that a permanent shift in the demand for base money (mostly currency) had taken place, related to the introduction of a financial transaction tax, and thus the upward shift of the base money corridor was not inflationary.

Under the floating exchange rate regime, the central bank can intervene in the exchange rate market only in a limited form and under very specific circumstances. First, for the purpose of accumulating reserves it can intervene by selling a limited amount of put options for foreign exchange to operators in the market (giving them the right to sell foreign exchange to the central bank). These options can be exercised if the reference exchange rate on any particular day during the month after the auction is more appreciated than its twenty-working-day moving average. Second, for the purposes of curbing the volatility of abrupt changes in the exchange rate, the central bank can sell put and call options on foreign exchange which can be exercised if the reference exchange rate on any particular day is more than 5 percent above or below its twenty-working-day moving average. In practice, the central bank has not yet intervened in the market to curb volatility since the exchange rate was floated in 1999.

Inflation forecasting

Aside from monitoring monetary aggregates and the exchange rate, the Board of Directors examines a broad range of indicators for inflation, including aggregate supply and demand, salaries and wages, employment, capacity utilization, the stance of fiscal policy, the international economic context and the results of a quarterly survey on inflationary expectations. To these are added the results from a number of inflation forecasts produced using time series and linear regression models. Two time-series models are used: an autoregressive integrated moving average model (ARIMA) model and a Smooth Transition Regression (STR) model. The linear regression models are intended to capture the effects of different determinants of consumer price inflation, including the output gap and devaluation (Phillips Curve model), food price shocks (Relative Price of Food model), and growth in the money supply (P-star model). These models are used to produce a consensus point forecast for inflation at different time horizons from less than six months to up to two years.

Policy Transmission Channels

There is still some uncertainty in Colombia about the transmission mechanisms from changes in policy variables (particularly the interest rate), their effect on the real economy and ultimately on inflation. Research is underway at the central bank to clarify the transmission mechanisms and allow a prospective approach (as opposed to retrospective models mentioned above) to the analysis of inflation. In particular, the central bank is working toward the implementation of a model of the transmission mechanism similar to the one used in the Bank of England. This model uses a forward looking approach and includes regular Phillips Curve and Aggregate Demand equations together with a policy rule equation intended to relate interest rates to inflation. However, it does not include some transmission mechanisms that might be important in Colombia, such as the effects of changes in fiscal policy or in the external economic environment, as well as the effects of changes in the exchange rate. The model is currently being tested and modified, but is not yet being used in the definition of monetary policy.

Existing research has focused on three main transmission channels from interest rates to inflation. The first is the channel that relates changes in interest rates to changes in inflation through changes in aggregate demand. This is the strongest channel in Colombia, as one might expect in an economy that, although open in its policy stance, is still relatively closed in terms of the ratio of imports to GDP.¹⁴ However, this channel takes effect with long lags, typically of 18 to 24 months, which makes it less useful as a method to control inflation in the shorter term.

The second channel relates interest rates to inflation through the direct effect of changes in the nominal exchange rate. An increase in interest rates leads to a nominal appreciation which leads to a decline in the domestic price of imports and hence inflation. This channel takes effect quickly (typically with a lag of 2 to 4 months), but it is not very potent because the pass-through from the domestic price of imports to CPI inflation is only partial (about 23 percent). Hence the use of this channel implies considerable volatility in the exchange rate and interest rates. Rincón (1999), as cited in Darío Uribe et al. (1999) has estimated that a one percent decline in CPI inflation requires a nominal exchange rate appreciation of about 11 percent. In the long-run, the effect of changes in the domestic price of imported inputs on inflation is very small.

The third channel relates interest rates to inflation through changes in the real exchange rate. Changes in the nominal exchange rate lead to changes in the real exchange rate which affect aggregate demand and inflation. This channel has been estimated to be very weak and to take effect only after very long lags (Darío Uribe et al., 1999).

This research provides a useful first step in the investigation of transmission policies for inflation targeting. However, there are inherent uncertainties in the transmission mechanisms due to recent changes in the exchange rate regime, which might lead to instability in the structural relationships presented in these models. The prospects of changes in these structural relationships implies that research will have to be ongoing to continue to refine the links between policies and outcomes. Experience in other emerging market economies indicates that as inflation declines the structural relationships become more stable and the implementation of inflation targeting is facilitated (IMF, 2000).

4. Fiscal Policy Requirements

As can be seen from the above, the adoption of inflation targeting is quite complex and requires a certain level of expertise and institutional depth. Colombia has most of the institutional features in place to begin to practice inflation targeting. As outlined above, most of the challenges lie in the implementation. In particular, more knowledge of the transmission mechanisms of monetary policy and a better framework for forecasting inflation will help the central bank implement policies that will ensure the achievement of the inflation target. This will be particularly important in the face of internal or external shocks that may put the inflation target in question. Prompt action in the face of external shocks and the announcement of the central bank's policies and the reasons for its actions are necessary to maintain credibility in its inflation target.

The economic environment in which inflation targeting is being implemented may present another challenge. In particular, one of the preconditions for the successful application of inflation targeting in both developed and developing countries is the absence of fiscal dominance and the existence of a healthy financial sector. The credibility of the Central Bank's rests on its ability to make independent decisions about monetary policy. If the Central Bank is faced with a situation of fiscal dominance, where considerations of fiscal policy force the hand of monetary policy, then obviously the free operation of monetary policy is compromised. Fiscal dominance may arise if the Central Bank is forced to buy government bonds to finance increasing government deficits, or where it is restricted from tightening monetary policy for fear that the increase in interest rates will affect the government's interest bill and lead to unsustainable deficits.¹⁵

Inflation targeting must thus be supported by the reform and reinforcement of fiscal institutions as a way of ensuring fiscal sustainability and the absence of fiscal dominance (Eichengreen, 2001). One way of institutionalizing fiscal sustainability is through Fiscal Responsibility Laws, in place in a number of countries in Latin America (Brazil, Colombia and a failed law in Argentina). Such laws dictate limits to fiscal deficits of the public decided on by the executive and legislative branches together. A good example of such an institutionalization is Brazil's Fiscal Responsibility Law, which sets a limit to the combined public sector fiscal deficit several years in advance. In addition, and more importantly, it bans the federal government from bailing out debt-ridden states and municipalities. It also presents both domestic and foreign investors with a framework for the conduct of fiscal policy that is predictable and transparent, helping create a tradition of good governance. This framework has resulted in visible improvements in state and municipal fiscal performance.

5. Conclusion

Trade liberalization is already producing a greater degree of policy convergence in Latin America, and this effect will be even greater given the successful completion of the FTAA by the end of the decade. The increasing openness of Latin American economies, particularly with respect to financial transactions, is resulting in further pressure to move towards policies that ensure low inflation, stable exchange rates, a predictable and stable monetary policy regime, and sustainable fiscal policy. The full spectrum of monetary policy integration is already being implemented in Latin America, and some authors see it as only a matter of time before this continent follows the way of the European Union.

While it is difficult to predict whether a Latin American Currency Union will ever become a reality, this paper argues that the institutions for economic policymaking being put in place in some countries in Latin America constitute a step in the direction of policy transparency and de facto coordination that will make such a union easier if it does arise in the future. At one extreme are Ecuador and El Salvador, that have already adopted the U.S. dollar as their currency. These countries benefit from using the U.S. currency because they are small, open economies with strong trade and financial linkages with the U.S. economy. At the other extreme are the larger countries with diversified trade and financial relations that require flexible exchange rates. These countries have adopted inflation targeting as a strategy to bring inflation down to the level of their major trading partners, in itself a step towards policy coordination. In addition, because of the problems of central bank credibility attached to inflation targeting such countries are forced to maintain prudent fiscal policies, in some cases putting in place legal frameworks to ensure fiscal prudence. This also can be seen as a step towards fiscal transparency and accountability that is necessary for monetary integration.

Endnotes

1. The North American Free Trade Agreement (NAFTA) and of South American Common Market (MERCOSUR), for example, brought about the creation of trade dispute settlement mechanisms, the establishment and application of anti-trust law, and the refinement of laws relating to foreign direct investment and trade in services among their members. Subsequent bilateral agreements have extended these institutional developments beyond NAFTA and MERCOSUR to other countries in Latin America. The Uruguay Round Agreements and subsequent creation of the WTO can also be mentioned as a motor for institutional developments related to trade-related policy making.

2. Note that this does not imply in any way targeting the nominal exchange rate in the short-run. In addition, there are many other short-term benefits for domestic macro policy of bringing inflation down to manageable levels.

3. The paper does not deal extensively with intermediate regimes, thus avoiding the thorny issue of whether these are viable or optimal for countries given certain economic conditions. For a discussion of this point see Williamson (2000).

4. Another important distinction is that, with a currency board, a government can reap the benefits of seignorage.

5. The industrial countries include New Zealand, Canada, Sweden, Finland, The United Kingdom, Australia and Spain. The emerging market developing countries include Israel, Czech Republic, Poland and South Africa.

6. This section draws extensively from Bannister (2001)

7. In practice, the path for the monetary base was set as an intermediate target and the path for the exchange rate was adjusted to eliminate the discrepancy between international inflation and the inflation objective of the government's program (Darío Uribe et al., 1999).

8. In addition, the legal framework prohibited the central bank from financing public sector activities and placed tight limits on the bank's financing of government deficits.

9. Before 1994 the exchange rate regime was kept to a crawling peg system which had been in place since the late 1960s.

10. Although a recent judgment by the constitutional court mandating wage increases in the public sector indexed to past inflation may put these institutional gains in doubt if this behavior spreads to the rest of the public sector or the private sector.

11. Use of headline CPI increases likelihood of not making targets directly. Similarly, the use of a point instead of a band increases likelihood of not making point estimate. This will require much more communication of the central bank with the public about why the point target is missed in the case of shocks.

12. It is not clear how accountable the central bank is for reaching its targets and whether there are any consequences for consistently breaching its inflation objectives.

13. In practice intervention takes place through open market operations that affect the short-term inter-bank interest rate.

14. The ratio of imports of goods and services to GDP on average between 1995 and 2000 was about 17 percent, well below that of many countries.

15. Similar considerations might exist with the conduct of monetary policy and its effects on the financial sector. Increases in interest rates may put weak banks over the edge into bankruptcy, and changes in the exchange rate may exacerbate the problem of currency mismatches on bank balance sheets. In this case, prudential reguations to maintain banking soundness are the first institutional prescription.

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