Area III
Monetary Policy and Price Stability

A Average Annual Growth Rate of the Money Supply during the Last Five Years (weight .349)
minus the Growth Rate of Real GDP during the Last 10 Years

B Standard Deviation of the Annual Inflation Rate during the Last Five Years (weight .326)

C Annual Inflation Rate during the Most Recent Year (weight .325)

Monetary policy and price stability are important for the smooth operation of a market economy. The three components in this area are designed to measure the degree to which each country is following a monetary policy consistent with stability in the general level of prices. Taken together, the three components reflect the consistency of domestic monetary policy with sound money principles and economic freedom.

Slow growth of the money supply (relative to the economy's long-run real growth) is indicative of monetary policy consistent with price stability. In contrast, rapid monetary expansion will lead to high rates of inflation and uncertainty with regard to the future value of the monetary unit. Thus, countries with low rates of monetary growth relative to real GDP are given higher ratings for Component III-A.

Instability in the general level of prices also generates uncertainty. When the inflation rate changes in an unpredictable manner (for example, when it is 10 percent one year, 40 percent the next, and 20 percent the year after that), it is extremely difficult for individuals and businesses to plan for the future. Since unpredictable changes in the rate of inflation undermine the efficacy of money, countries with the more stable and, therefore, more easily predictable rates of inflation are given higher ratings for Component III-B.

Component III-C is included in order to give countries that have recently moved toward greater price stability credit for this achievement. If it was not included, countries with rising rates of inflation during the last five years (for example, inflation rates of 5 percent, 10 percent, 20 percent, 40 percent, and 80 percent) would receive the same rating as those with declining rates (for example, 80 percent, 40 percent, 20 percent, 10 percent, and 5 percent.) Inclusion of this component provides a remedy for this situation.

All three of the components in this area are continuous variables for which higher values are indicative of less economic freedom. Because price stability is the ideal criterion and exceedingly high rates of inflation reduce the efficacy of our standard formula, it was necessary to alter slightly our usual procedure to derive the zero-to-10 ratings. A country's component rating in this area is equal to: (Vmax - Vi) / (Vmax -- Vmin) multiplied by 10. For the money growth and inflation components, the upper limit for Vmax was set at 50 percent, and Vmin was set equal to zero. Thus, countries with annual money growth and inflation rates close to zero would receive ratings close to 10; those with values near 50 percent would receive ratings near zero. The same procedure was followed for the standard deviation of the inflation rate, except the upper limit for Vmax was set at 25 percent. The numbers above in parentheses e.g., (weight .349), represent the portion of the area rating that is determined by a specific component. These values were determined by principal component analysis. The graphic on the following page indicates the 1997 country ratings for this area.

Area III Graphic: Monetary Policy and Price Stability, 1997

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Last Modified: Wednesday, October 20, 1999.