The Exchange Rate Dimension of Inflation Targeting: Target Levels and Currency Volatility

The surprising volatility of floating exchange rates have puzzled macroeconomists and challenged policy makers since the seventies. This is no less true in South Arica where the Rand's volatility is a longstanding policy and business challenge. This paper extends the literature on nominal and institutional factors associated with currency volatility. Rose's description of inflation as “Bretton Woods in reverse” is the departure point and is read with Berganza and Broto's recent demonstration in a time series study that inflation targeting emerging market economies have experience higher exchange rate volatility. Meanwhile Bleaney and Tian have shown the cross-sectional connection between the level of inflation and exchange rate volatility. We build on Bleaney and Tian's cross-sectional approach to investigate the association between the level at which inflation targeting countries target inflation and exchange rate volatility over the long run. Crucially, we control for the average level of inflation and distinguish between inflation targeting countries that target high and low levels of inflation, in order to investigate whether the choice of the level of the inflation target (an institutional feature) is associated with greater exchange rate volatility.