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Monetary policy under flexible exchange rates - an introduction to inflation targeting

  • Agenor, Pierre-Richard

In the past few years, a number of central banks have adopted inflation targeting for monetary policy. The author provides an introduction to inflation targeting, with an emphasis on analytical issues, and the recent experience of middle- and high-income developing countries (which have relatively low inflation to begin with, and reasonably well-functioning financial markets). After presenting a formal analytical framework, the author discusses the basic requirements for inflation targeting, and how such a regime differs from money,and exchange rate targeting regimes. After discussing the operational framework for inflation targeting (including the price index to monitor the time horizon, the forecasting procedures, and the role of asset prices), he examines recent experiences with inflation targets, providing new evidence on the convexity of the Phillips curve for six developing countries. His conclusions: Inflation targeting is a flexible policy framework that allows a country's central bank to exercise some degree of discretion, without putting in jeopardy its main objective of maintaining stable prices. In middle- and high-income developing economies that can refrain from implicit exchange rate targeting, it can improve the design, and performance of monetary policy, compared with other policy approaches that central banks may follow. Not all countries may be able to satisfy the technical requirements (such as adequate price data, adequate understanding of the links between instruments, and targets of monetary policy, and adequate forecasting capabilities), but such requirements should not be overstated. Forecasting capability can never be perfect, and sensible projections always involve qualitative judgment. More important, and often more difficult, is the task of designing, or improving an institutional framework that would allow the central bank to pursue the goal of low, stable inflation, while maintaining the ability to stabilize fluctuations in output.

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Paper provided by The World Bank in its series Policy Research Working Paper Series with number 2511.

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Date of creation: 31 Dec 2000
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Handle: RePEc:wbk:wbrwps:2511
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  1. C. John McDermott & Eswar Prasad & Pierre-Richard Agénor, 1999. "Macroeconomic Fluctuations in Developing Countries; Some Stylized Facts," IMF Working Papers 99/35, International Monetary Fund.
  2. Christian H. Beddies, 1999. "Monetary Policy and Public Finances: Inflation Targets in a New Perspective," IMF Staff Papers, Palgrave Macmillan, vol. 46(3), pages 4.
  3. Faust, Jon & Svensson, Lars E O, 2001. "Transparency and Credibility: Monetary Policy with Unobservable Goals," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(2), pages 369-97, May.
  4. Jagjit Chadha & Philip Schellekens, 1999. "Monetary policy loss functions: two cheers for the quadratic," Bank of England working papers 101, Bank of England.
  5. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
  6. Beetsma, Roel & Jensen, Henrik, 1997. "Inflation Targets and Contracts with Uncertain Central Banker Preferences," CEPR Discussion Papers 1562, C.E.P.R. Discussion Papers.
  7. Agenor, Pierre-Richard & Masson, Paul R, 1999. "Credibility, Reputation, and the Mexican Peso Crisis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 31(1), pages 70-84, February.
  8. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," Working Papers 97-32, C.V. Starr Center for Applied Economics, New York University.
  9. Reinhart, Carmen & Arrau, Patricio & DeGregorio, Jose & Wickham, Peter, 1995. "The demand for money in developing countries: Assessing the role of financial innovation," MPRA Paper 14096, University Library of Munich, Germany.
  10. Joshua Aizenman & Pierre-Richard Agénor, 1997. "Contagion and Volatility with Imperfect Credit Markets," IMF Working Papers 97/127, International Monetary Fund.
  11. Drazen, Allan & Masson, Paul R, 1994. "Credibility of Policies versus Credibility of Policymakers," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 735-54, August.
  12. Stephen G. Cecchetti & Michael Ehrmann, 1999. "Does Inflation Targeting Increase Output Volatility? An International Comparison of Policymakers' Preferences and Outcomes," NBER Working Papers 7426, National Bureau of Economic Research, Inc.
  13. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
  14. Robert Dittmar & William T. Gavin & Finn Kydland, 1999. "The inflation-output variability tradeoff and price-level targets," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 23-32.
  15. Stephen G. Cecchetti & Erica L. Groshen, 2000. "Understanding Inflation: Implications for Monetary Policy," NBER Working Papers 7482, National Bureau of Economic Research, Inc.
  16. Cukierman Alex, 1992. "Central Bank Strategy, Credibility, And Independance: Theory And Evidence," Journal des Economistes et des Etudes Humaines, De Gruyter, vol. 3(4), pages 10, December.
  17. Cukierman, Alex & Meltzer, Allan H, 1986. "A Theory of Ambiguity, Credibility, and Inflation under Discretion and Asymmetric Information," Econometrica, Econometric Society, vol. 54(5), pages 1099-1128, September.
  18. Bankim Chadha & Paul R. Masson & Guy Meredith, 1992. "Models of Inflation and the Costs of Disinflation," IMF Staff Papers, Palgrave Macmillan, vol. 39(2), pages 395-431, June.
  19. Haan, Jakob de & Kooi, Willem J., 2000. "Does central bank independence really matter?: New evidence for developing countries using a new indicator," Journal of Banking & Finance, Elsevier, vol. 24(4), pages 643-664, April.
  20. Laurence Boone & Claude Giorno & Pete Richardson, 1998. "Stock Market Fluctuations and Consumption Behaviour: Some Recent Evidence," OECD Economics Department Working Papers 208, OECD Publishing.
  21. Estrella, Arturo & Mishkin, Frederic S., 1997. "Is there a role for monetary aggregates in the conduct of monetary policy?," Journal of Monetary Economics, Elsevier, vol. 40(2), pages 279-304, October.
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