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Publisher : Elsevier - Science Direct (الزویر - ساینس دایرکت)
Journal : World Development, Volume 39, Issue 5, May 2011, Pages 712–724
We investigate inflation targeting (IT) in emerging markets, focusing on the role of the real exchange rate and the distinction between commodity and non-commodity exporters. IT emerging markets appear to follow a “mixed strategy” whereby both inflation and real exchange rates are important determinants of policy interest rates. The response to real exchange rates, however, is more constrained than in non-IT regimes. We also find that the response to real exchange rates is strongest in those countries following IT policies that are relatively intensive in exporting basic commodities; and present a theoretical model that explains these empirical results.
Inflation targeting is becoming a standard operating procedure for central banks around the world. By mid-2008, most central banks in the OECD countries1 and a growing number of developing economies had adopted inflation targeting. There is no international coordination to promote this monetary regime change, and countries do not join an internationally recognized monetary system nor follow common “rules of the game.” Adopters of inflation targeting do so primarily because of the framework’s perceived success in delivering low and stable inflation. Despite its popularity, there is substantial controversy and mixed empirical evidence in the evaluation of the inflation-targeting framework. There are two main empirical approaches. The first approach focuses on the macro-economic outcomes of countries following inflation-targeting regimes as compared to non-targeting countries. Although few argue that inflation targeting has harmful effects, there remains a vigorous academic and policy debate over whether the adoption of this monetary regime in advanced industrial countries has contributed to substantial declines in average inflation, lower inflation volatility, and general macro-economic stability compared to those countries not following inflation-targeting rules.2 The second empirical approach evaluating inflation-targeting (IT) policies focuses on central bank behavior under inflation targeting and non-targeting and how they operate in an IT environment. Even in this strand of the literature there is mixed evidence over whether formal adoption of an inflation-targeting regime substantively changes the behavior of central banks, and in particular their responses to inflation and output gaps. This paper investigates the empirics of inflation targeting in emerging-market economies within the context of the second strand of the literature—central bank operating behavior. We focus in particular on emerging-market central banks’ responses to inflation, output gaps, and real exchange rates using Taylor rule models (as in Clarida, Gali, & Gertler, 1998). Our aim is to distinguish between episodes when central banks are committed to an explicit inflation-targeting monetary regime and those periods of time when they are not (including central banks that have never followed inflation targeting). We focus on two factors critical to the conduct and control of monetary policy in emerging markets—wide swings in the real exchange rate and the extent to which the countries are concentrated in commodity exports. We demonstrate, in the context of a simple illustrative model, that these distinguishing characteristics are in principle important in designing the form of the monetary policy rule. For a commodity exporting country that is vulnerable to terms-of-trade shocks, in particular, when experiencing large real exchange rate shocks that can affect potential output a modified version of inflation targeting dominates a pure inflation targeting strategy. Our empirical work is based on panel-data so as to distinguish between group characteristics, respectively, of the inflation-targeting and non-targeting central banks in emerging markets and further between commodity exporting inflation targeters from other IT regime countries. We characterize inflation targeting strategies in the context of a modified Taylor rule operating procedure, and demonstrate that this rule varies markedly from non-targeting emerging markets (as well as inflation-targeting industrial countries). Moreover, our focus is on the role of the real exchange rate in the policy rule and how this is affected by the countries’ exposure to commodity-intensive production (and, hence, terms-of-trade shocks). Four factors motivate our empirical research. Firstly, the great bulk of the research in this area is concerned with inflation targeting in advanced industrial countries and relatively less research addresses the particular features of inflation targeting in emerging markets.3 There are many reasons that emerging markets may differ from industrial countries in the approach to inflation targeting. These reasons include different institutional arrangements, especially those relating to the credibility and political independence of the central bank, different inflation and macro-economic histories, different exposures to terms-of-trade shocks, and different levels of financial development. Aghion, Bacchetta, Ranciere, and Rogoff (2009) demonstrate that countries with relatively less developed financial sectors are more likely to suffer output losses associated with exchange rate volatility. In this case, greater concern for real exchange rate volatility may lead central banks in emerging markets—countries with lower levels of financial development than industrial countries—to follow a monetary policy rule (Taylor rule) that captures some form of target inflation, output deviations from the natural rate, and real exchange rate fluctuations. Secondly, our emphasis is on introducing real exchange rate fluctuations into the inflation-targeting framework. Real exchange rates are likely to play an important role in the formulation of optimal monetary policy in emerging markets, as shown theoretically in our illustrative model (Appendix A), and we examine this connection in our estimations of de facto policy rules. Thirdly, the distinction between heavily concentrated commodity-exporting emerging markets and non-concentrated emerging markets is potentially important in how inflation targeters work in practice. This difference accounts for different vulnerability to terms-of-trade shocks. We explore this distinction. Fourthly, we follow a panel methodological approach in examining these issues. Most other studies in this area have relied upon individual country time-series analysis. A panel analysis provides some advantages since it allows clear focus on characteristics of policy rules common to inflation-targeting countries treated as a group and allows us to distinguish them from non-inflation-targeting countries. Our results indicate that the publically announced adoption of inflation targeting strategies by central banks in emerging markets, often with much fanfare, is a substantive deviation from past monetary policy formulation and sharply different from non-targeting emerging markets. As our theoretical model predicts, however, inflation targeting emerging markets are not following “pure” inflation targeting strategies. Rather, we find that external variables play a very important role in the policy rule—inflation-targeting central banks in emerging markets systematically respond to the real exchange rate. Of the inflation targeting group, those with particularly high concentration in commodity exports change interest rates much more pro-actively to real exchange rate changes than do the non-commodity-intensive group. Overall, our results are robust to a variety of model formulations and estimation strategies. The next section discusses the inflation targeting literature as it applies to emerging markets, and highlights the gap in the empirical literature which we address in our contribution. Section 3 presents the data, descriptive statistics, and empirical model. Section 4 presents the empirical results and Section 5 concludes. Appendix A presents the theoretical model that motivates our empirical formulation of the policy rule equations.