Inflation Targeting in Developing Countries: Barking up the Wrong Tree

If one were to choose the most important policy recommendation that the Washington consensus entails in the context of developing countries, inflation targeting would win the contest hands down. It entails central bank minimizing its loss function measured by the deviations of inflation and output from their ‘targeted’ levels. This is subject to a given constraint between inflation and output at a given point in time, a relationship which has been popularly known as the Phillips curve (an upward-sloping curve in inflation-output plane). The present chapter questions the policy prescription by arguing that the theoretical framework from where it follows itself is possibly not applicable to developing economies. Conflict model of inflation, which is the backbone of upward-sloping Phillips curve, is less relevant for a developing country. Bargaining power of the working class in developing countries is extremely limited owing to the vast reserves of labour. We show that instead of a unique non-accelerating inflation level of output (NAILO), there is a range of ex ante states of rest for the economy. The ex post unique state of rest would be determined by the level of aggregate demand. Inflation targetting in a developing economy is not only ineffective but it establishes this by imposing hardships on the working people of the country who end up being at the receiving end of the policy even as the rate of inflation is hardly affected.