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

  • Horacio Aguirre

    ()

    (Central Bank of Argentina)

  • Tamara Burdisso

    ()

    (Central Bank of Argentina)

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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File URL: http://www.bcra.gov.ar/pdfs/investigaciones/WP_2008_39i.pdf
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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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  1. Richard Blundell & Steve Bond, 1995. "Initial conditions and moment restrictions in dynamic panel data models," IFS Working Papers W95/17, Institute for Fiscal Studies.
  2. Vittorio Corbo & Óscar Landerretche & Klaus Schmidt-Hebbel, 2002. "Does Inflation Targeting Make a Difference?," Central Banking, Analysis, and Economic Policies Book Series, 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 5, pages 221-270 Central Bank of Chile.
  3. Carmen M. Reinhart & Kenneth S. Rogoff, 2004. "The Modern History of Exchange Rate Arrangements: A Reinterpretation," The Quarterly Journal of Economics, MIT Press, vol. 119(1), pages 1-48, February.
  4. Eduardo Levy Yeyati & Federico Sturzenegger & Iliana Reggio, 2002. "On the Endogeneity of Exchange Rate Regimes," Business School Working Papers veintiuno, Universidad Torcuato Di Tella.
  5. Philipp Harms & Marco Kretschmann, 2007. "Words, deeds, and outcomes: A survey on the growth effects of exchange rate regimes," Working Papers 07.03, Swiss National Bank, Study Center Gerzensee.
  6. Amato, Jeffery D. & Gerlach, Stefan, 2002. "Inflation targeting in emerging market and transition economies: Lessons after a decade," European Economic Review, Elsevier, vol. 46(4-5), pages 781-790, May.
  7. Atish R. Ghosh & Anne-Marie Gulde & Jonathan D. Ostry & Holger C. Wolf, 1997. "Does The Nominal Exchange Rate Regime Matter?," Working Papers 97-09, New York University, Leonard N. Stern School of Business, Department of Economics.
  8. 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 3288, The World Bank.
  9. Guy Debelle, 2001. "The Case for Inflation Targeting in East Asian Countries," RBA Annual Conference Volume, in: David Gruen & John Simon (ed.), Future Directions for Monetary Policies in East Asia Reserve Bank of Australia.
  10. M. H. Khalil Timamy, 2005. "Debate," Review of African Political Economy, Taylor & Francis Journals, vol. 32(104-105), pages 383-393, June.
  11. Corrinne Ho & Robert N. McCauley, 2003. "Living with flexible exchange rates: issues and recent experience in inflation targeting emerging market economies," BIS Working Papers 130, Bank for International Settlements.
  12. Ashok Bhundia & Mark R. Stone, 2004. "A New Taxonomy of Monetary Regimes," IMF Working Papers 04/191, International Monetary Fund.
  13. M Arellano & O Bover, 1990. "Another Look at the Instrumental Variable Estimation of Error-Components Models," CEP Discussion Papers dp0007, Centre for Economic Performance, LSE.
  14. 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, 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.
  15. Windmeijer, Frank, 2005. "A finite sample correction for the variance of linear efficient two-step GMM estimators," Journal of Econometrics, Elsevier, vol. 126(1), pages 25-51, May.
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