raising interest rates is a successful method for supporting the exchange rate because of uncovered interest parity. but this ignores the possibility that raising interest rates to defend a fixed exchange - rate regime will simply call into question the durability of the regime itself and raise the probability that the peg or target zone will be abandoned. in such circumstances an increase in interest rates may lead to a fall in the exchange rate. a second example of the same phenomenon is the pressure on sterling during 1992 and its forced departure from the exchange rate mechanism on 16 september of that year. massive speculation on that day led to the announcement in the morning of a 2 percentage points rise in interest rates and, when that failed to dampen the pressure on sterling, of a further 3 percentage points rise in rates. that second announcement, far from bolstering the exchange rate, merely convinced financial markets that britain ’ s membership of the erm could no longer be sustained politically. the strong political commitment to joining european monetary union, which was the effective support for other currencies in the erm, was absent in the united kingdom. following its departure from the erm, the uk introduced an inflation target regime for monetary policy. it succeeded in bringing inflation down to around 2½ percent ( see chart 2 ). chart 2 : uk inflation and inflation expectations, oct 1991 - oct 2003 per cent implied inflation ( a ) from igs rpix inflation rate oct - 91 inflation target announced bank independence oct - 93 oct - 95 oct - 97 oct - 99 oct - 01 oct - 03 ( a ) implied average inflation expectations from 5 to 10 years ahead, derived from index - linked gilts. source : bank of england, ons but long - term inflation expectations did not fall as quickly. only after the announcement in may 1997 by the new labour government that the bank of england would be made independent did inflation expectations fall quickly to the target level, as can be seen from chart 2. that reform created an expectation that it would be in the interests of all political parties not to repeal the legislation. for the first time since the second world war, there was a broad - based and credible commitment in the uk to stable and low inflation. the need for any monetary regime to command sufficient support in order to acquire a reasonable lifeexpectancy was given insufficient weight in the discussions that took place at the imf and elsewhere on brazil and other financial crises of the 1990s. the point is made by guillermo calvo and frederic mis

was inevitably some uncertainty about the prospects of the new regime and the new currency that it issued. the circulation of swiss dinars in kurdish controlled iraq during the 1990s was a market solution to the problem of devising a medium of exchange in the absence of a government with the power to issue currency. changes in the relative price of swiss and saddam dinars show that the value of money depends on beliefs about the probability of survival of the institutions that define the state itself. v. case study 3 : monetary policy in japan and the zero bound on interest rates my third case study shows that institutional arrangements need to be consonant with the underlying economics, or failure will result. recent experience in japan has led to the rebirth of interest in monetary policy when official interest rates are constrained by the zero lower bound. official shortterm interest rates in japan have been approximately zero since the beginning of 1999. of particular interest in this context is the question of how responsibilities should be divided between the central bank, on the one hand, and the finance ministry, on the other. guy debelle and stanley fischer ( 1994 ) introduced the distinction between instrument and goal independence of central banks. that distinction has become the standard framework within which to analyse the optimal constitution of central banks. but such a distinction presumes the existence of a source : compiled by the central bank of iraq, based on data collected by the united nations world food program. policy instrument that is uniquely available to the central bank. that instrument is the level of official short - term interest rates. but when interest rates are constrained at their lower bound of zero, the position is much less clear. indeed, i shall argue that in such circumstances both instrument and goal independence are impossible. rather when interest rates are at their zero lower bound, policy relies on successful cooperation between central bank and finance ministry. i shall assume that, when interest rates are zero, monetary policy takes the form of open market purchases or sales of government securities using central bank money. a well - known policy prescription, which has become known as unconventional monetary policy, is that the central bank should buy long - term government bonds rather than the more conventional shortterm bills. the bank of japan did indeed follow this prescription. the logic of such a proposal is as follows. long - term bonds are likely to contain a significant premium to compensate investors for their lack of liquidity - the fact that, in practice, investors face significant costs when switching between bonds and goods. when the central bank offers to