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Dangerous Liaisons? An Empirical Assessment of Inflation Targeting and Exchange Rate Regimes

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  • Horacio Aguirre

    ()
    (Central Bank of Argentina)

  • Tamara Burdisso

    ()
    (Central Bank of Argentina)

Abstract

The role of the exchange rate under inflation targeting (IT) remains an unresolved issue in literature and policy discussions -and a challenge for central banks implementing IT, especially in developing countries. This paper aims at assessing whether there is a relation between the nominal exchange rate regime and inflation performance in IT countries. We use a panel of 22 countries that adopted IT between 1990 and 2006, and estimate models in order to determine whether an exchange rate regime that differs from a pure float entails higher or lower inflation. We use two de facto foreign exchange regime classifications (Levy-Yeyati and Sturzenegger, 2005; Reinhart and Rogoff, 2004), and a de jure one (IMF). We estimate regressions through methods that account for the dynamic character of the panel (“difference” and “system” GMM estimators). We deal with potential endogeneity between inflation performance and exchange rate regime choice through the use of instrumental variables. In order to check the robustness of the results, we use alternative specifications –by including different macroeconomic control variables-, and introduce changes in the sample –by using a balanced and an unbalanced panel-. Our results suggest that the choice of exchange rate regime matters for IT countries: de facto arrangements that are less flexible than pure floats appear to deliver lower inflation, especially in developing countries. This is consistent with the fact that those countries have higher pass through coefficients and are more prone to the kind of problems dubbed as “fear of floating”.

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Bibliographic Info

Paper provided by Central Bank of Argentina, Economic Research Department in its series BCRA Working Paper Series with number 200839.

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Length: 40 pages
Date of creation: Nov 2008
Date of revision:
Handle: RePEc:bcr:wpaper:200839

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Related research

Keywords: inflation targeting; foreign exchange regimes; dynamic panel data;

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References

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  1. Frederic Mishkin & Klaus Schmidt-Hebbel, 2002. "A Decade of Inflation Targeting in the World: What Do We Know and What Do We Need to Know?," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 4, pages 171-220 Central Bank of Chile.
  2. R Blundell & Steven Bond, . "Initial conditions and moment restrictions in dynamic panel data model," Economics Papers, Economics Group, Nuffield College, University of Oxford W14&104., Economics Group, Nuffield College, University of Oxford.
  3. Carmen M. Reinhart & Kenneth S. Rogoff, 2002. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," NBER Working Papers 8963, National Bureau of Economic Research, Inc.
  4. Frederic S. Miskin & Klaus Schmidt-Hebbel, 2007. "Does Inflation Targeting Make a Difference?," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.), Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 9, pages 291-372 Central Bank of Chile.
  5. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does the Nominal Exchange Rate Regime Matter?," NBER Working Papers 5874, National Bureau of Economic Research, Inc.
  6. Corrinne Ho & Robert N. McCauley, 2003. "Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies," BIS Working Papers, Bank for International Settlements 130, Bank for International Settlements.
  7. Domac, Ilker & Mendoza, Alfonso, 2004. "Is there room for foreign exchange interventions under an inflation targeting framework ? Evidence from Mexico and Turkey," Policy Research Working Paper Series, The World Bank 3288, The World Bank.
  8. Philipp Harms & Marco Kretschmann, 2007. "Words, deeds, and outcomes: A survey on the growth effects of exchange rate regimes," Working Papers, Swiss National Bank, Study Center Gerzensee 07.03, Swiss National Bank, Study Center Gerzensee.
  9. Windmeijer, Frank, 2005. "A finite sample correction for the variance of linear efficient two-step GMM estimators," Journal of Econometrics, Elsevier, Elsevier, vol. 126(1), pages 25-51, May.
  10. Ashok Bhundia & Mark R. Stone, 2004. "A New Taxonomy of Monetary Regimes," IMF Working Papers, International Monetary Fund 04/191, International Monetary Fund.
  11. M. H. Khalil Timamy, 2005. "Debate," Review of African Political Economy, Taylor & Francis Journals, Taylor & Francis Journals, vol. 32(104-105), pages 383-393, June.
  12. Eduardo Levy Yeyati & Federico Sturzenegger & Iliana Reggio, 2002. "On the Endogeneity of Exchange Rate Regimes," Business School Working Papers, Universidad Torcuato Di Tella veintiuno, Universidad Torcuato Di Tella.
  13. Arellano, Manuel & Bover, Olympia, 1995. "Another look at the instrumental variable estimation of error-components models," Journal of Econometrics, Elsevier, Elsevier, vol. 68(1), pages 29-51, July.
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