Inflation Targeting and Real Exchange Rates in Emerging Markets

Inflation Targeting and Real Exchange Rates in Emerging Markets

Joshua
Aizenman

Department of Economics

University of California, Santa Cruz

Michael
Hutchison

Department of Economics

University of California, Santa Cruz


and

Ilan
Noy

Department of Economics

University of Hawai‘i at Mānoa


Working Paper No. 08-10
December
2008

Abstract
We examine the inflation targeting (IT) experiences of emerging market economies, focusing
especially on the roles of the real exchange rate and the distinction between commodity and non-
commodity exporting nations. In the context of a simple empirical model, estimated with panel
data for 17 emerging markets using both IT and non-IT observations, we find a significant and
stable response running from inflation to policy interest rates in emerging markets that are
following publically announced IT policies. By contrast, central banks respond much less to
inflation in non-IT regimes. IT emerging markets follow a “mixed IT strategy” whereby both
inflation and real exchange rates are important determinants of policy interest rates. The response
to real exchange rates is much stronger in non-IT countries, however, suggesting that
policymakers are more constrained in the IT regime—they are attempting to simultaneously
target both inflation and real exchange rates and these objectives are not always consistent. We
also find that the response to real exchange rates is strongest in those countries following IT
policies that are relatively intensive in exporting basic commodities. We present a simple model
that explains this empirical result.

Keywords: Inflation targeting, real exchange rate, commodity exporters, emerging markets

JEL codes: E52, E58, F3

* We thank Mahir Binici, Nan Geng, Gurnain Kaur Pasricha and Kulakarn Tantitemit for helpful research assistance
and Inessa Love for providing us her STATA routines. We are grateful to Scott Roger and Mark Stone for providing
data. We also thank participants of the Research Seminar of the IMF, especially Herman Kamil, and participants of
the Third NIPFA-DEA Program Meeting on Capital Flows Conference (New Delhi), especially our discussant
Vincent Coen, for very helpful comments.

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1. Introduction

Inflation targeting is becoming a standard operating procedure for central banks
around the world. By mid 2008, most central banks in the OECD countries1 and a
growing number of developing economies had adopted inflation targeting. There is no
international coordination to promote this monetary regime change, and countries do not
join an internationally recognized monetary system nor follow common “rules of the
game.” Adopters of inflation targeting do so primarily because of the framework’s
perceived success in delivering low and stable inflation.

Despite its popularity, there is substantial controversy and mixed empirical
evidence in the evaluation of the inflation-targeting framework. There are two main
empirical approaches. The first approach focuses on the macroeconomic outcomes of
countries following inflation-targeting regimes as compared to non-targeting countries.
Although few argue that inflation targeting has harmful effects, there remains a vigorous
academic and policy debate over whether the adoption of this monetary regime in
advanced industrial countries has contributed to substantial declines in average inflation,
lower inflation volatility and general macroeconomic stability compared to those
countries not following inflation-targeting rules. The second empirical approach
evaluating inflation-targeting (IT) policies focuses on central bank behavior under
inflation targeting and non-targeting and how they operate in an IT environment. Even in
this strand of the literature there is mixed evidence over whether formal adoption of an
inflation targeting regime in advanced industrial economies substantively changes the
behavior of central banks, and in particular their responses to inflation and output gaps.
This paper investigates the empirics of inflation targeting in emerging market
economies within the context of the second strand of the literature—central bank
operating behavior. We focus in particular on emerging-market central banks’ responses
to inflation, output gaps and real exchange rates using Taylor rule models (Clarida et al.,
1998). Our aim is to distinguish between episodes when central banks are committed to
an explicit inflation-targeting monetary regime and those periods of time when they are

1 Fourteen of the 30 OECD countries have explicit inflation targets. However, twelve of these
countries are in the EMU and operate under a single central bank (ECB). Hence, fourteen of the
19 “operational” central banks in the OECD target inflation.

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not (including central banks that have never followed inflation targeting). We focus on
two factors critical to the conduct and control of monetary policy in emerging markets—
wide swings in the real exchange rate and the extent to which the countries are
concentrated in commodity exports. We demonstrate, in the context of a simple
illustrative model, that these distinguishing characteristics are in principle important in
designing the form of the monetary policy rule. In particular, when a country is
experiencing large real exchange rate shocks that can affect potential output—
characteristic of emerging markets—a modified version of inflation targeting dominates a
pure inflation targeting strategy.
Our empirical work is based on panel-data so as to distinguish between group
characteristics, respectively, of the inflation-targeting and non-targeting central banks.
We develop an empirical model that investigates the nature of inflation targeting
strategies followed in emerging markets. We characterize inflation targeting strategies in
the context of a modified Taylor rule operating procedure, and demonstrate that this rule
varies markedly from non-targeting emerging markets (as well as inflation-targeting
industrial countries). Moreover, our focus is on the role of the real exchange rate in the
policy rule and how this is affected by the countries’ exposure to commodity-intensive
production (and, hence, terms-of-trade shocks).
Four factors motivate our empirical research. Firstly, the great bulk of the
research in this area is concerned with inflation targeting in advanced industrial countries
and relatively little research addresses the particular features of inflation targeting in
emerging markets2. This is a shortcoming in the literature since there are many reasons
that emerging markets may differ from industrial countries in the approach to inflation
targeting. These reasons include different institutional arrangements, especially those
relating to the credibility and political independence of the central bank, different
inflation and macroeconomic experiences, different exposures to terms-of-trade shocks,
and different levels of financial development. Fraga et al. (2003), for example, argue that
inflation targeting in emerging markets has been successful overall, but not as successful
as in developed economies, largely because of challenges associated with weak

2 Some exceptions are IMF (2005), Conçalves and Salles (2008), Schmidt-Hebbel (2002),
Mishkin and Schmidt-Hebbel (2007), Corbo et al. (2001) and Edwards (2006).

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institutions, limited credibility and large external shocks. Aghion et al. (2006)
demonstrate that countries with relatively less developed financial sectors are more likely
to suffer output losses associated with exchange rate volatility. In this case, greater
concern for real exchange rate volatility may lead central banks in emerging markets—
countries with lower levels of financial development than industrial countries—to follow
a monetary policy rule (Taylor rule) that captures some form of target inflation, output
deviations from the natural rate and real exchange rate fluctuations.
Secondly, our emphasis is on introducing real exchange rate fluctuations into the
inflation-targeting framework. Real exchange rates are likely to play an important role in
the formulation of optimal monetary policy in emerging markets, as shown theoretically
in our illustrative model (appendix A), and we examine this connection in our estimations
of de facto policy rules. Thirdly, the distinction between heavily concentrated
commodity-exporting emerging markets and non-concentrated emerging markets is
potentially important in how inflation targeters work in practice. We explore this
distinction. Fourthly, we follow a panel methodological approach in examining these
issues. Other studies in this area have relied upon individual country time-series analysis.
A panel analysis provides some advantages since it allows clear focus on characteristics
of policy rules common to inflation-targeting countries treated as a group and allows us
to distinguish them from non-inflation targeting countries.
Our results indicate that the publically announced adoption of inflation targeting
strategies by central banks in emerging markets, often with much fanfare, is a substantive
deviation from past monetary policy formulation and sharply different from non-targeting
emerging markets. As our theoretical model predicts, however, inflation targeting
emerging markets are not following “pure” inflation targeting strategies. Rather, we find
that external variables play a very important role in the policy rule— inflation-targeting
central banks in emerging markets systematically respond to the real exchange rate. Of
the inflation targeting group, those with particularly high concentration in commodity
exports change interest rates much more pro-actively to real exchange rate changes than
do the non-commodity intensive group. Overall, our results are robust to a variety of
model formulations and estimation strategies.

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The next section discusses the inflation targeting literature as it applies to
emerging markets, and highlights the gap in the empirical literature which we address in
our contribution. Section 3 presents the data, descriptive statistics and empirical model.
Section 4 presents the empirical results and section 5 concludes. Appendix A presents the
theoretical model that motivates our empirical formulation of the policy rule equations.

2.
Inflation targeting in emerging markets
There is a large empirical literature on inflation targeting, most of which focuses
on advanced industrial countries. These studies generally take one of two approaches.
The first approach measures the effects of inflation targeting on inflation, inflation
volatility, and other macroeconomic variables. The second approach focuses on
characterizing central bank operating procedures, attempting to distinguish between
policy functions of inflation targeting countries and those not targeting inflation. Studies
in the first strand of the empirical literature employ both individual country time-series
and multi-country panel methods, while the second strand of literature is almost
exclusively focused on individual country time-series.

Macroeconomic Effects of inflation targeting
Empirical studies generally find mixed results on the effects of inflation targeting
on inflation and other macroeconomic variables. For example, Johnson (2002) undertakes
a panel study consisting of five IT (Australia, Canada, New Zealand, Sweden and the
United Kingdom) and six non-IT advanced industrial countries. He finds that the
announcement of inflation targets materially lowers expected inflation (controlling for
business cycle effects, past inflation and fixed effects). Also in the context of a panel
regression framework, Mishkin and Schmidt-Hebbel (2007) similarly conclude that
inflation targeting does make a difference in advanced industrial countries by helping
them achieve lower inflation in the long run and have smaller inflation responses to oil
and exchange rate shocks. However, the results for advanced country inflation-targeters

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are very similar to their high-performing country control group.3 Rose (2007) argues that
inflation targeting is a very durable (long-lasting) regime compared to other monetary
regimes and that inflation targeters have both lower exchange rate volatility and less
frequent “sudden stops” of capital flows.4 By contrast, Ball and Sheridan (2005), in a
cross-section investigation, reject any long-term differences between advanced industrial
inflation targeters (seven countries) and non-targeters (thirteen countries).
The experience and relative success of emerging markets with inflation targeting
is somewhat more supportive, although relatively little empirical work has explored this
issue. Mishkin and Schmidt-Hebbel (2007) find that inflation targeting in emerging
countries performs less well than in advanced industrial countries, although the pre- and
post-inflation targeting reductions in inflation in emerging markets are substantial.5 The
IMF (2005), using the methodology of Ball and Sheridan (2005), presents results of a
study focusing on 13 emerging market inflation targeters compared with 29 other
emerging markets. They report that inflation targeting is associated with a significant 4.8
percentage point reduction in average inflation, and a reduction in its standard deviation
of 3.6 percentage points relative to other monetary strategies. Conçalves and Salles
(2008) also apply the methodology of Ball and Sheridan (2005) to a 36 emerging market
economies. Similar to the IMF study, they find that adoption of an inflation targeting
regime leads to lower average inflation rates and reduced output growth volatility
compared to a control group of non-targeters. A recent edited volume published by the
OEDC (De Mello, 2008) on inflation targeting in emerging markets, focusing mainly on
individual country case studies, also finds quite positive outcomes associated with the
adoption of IT regimes.


3 Thirteen advanced industrial countries that “…are at the international frontier of macro-
economic management and performance.” (p. 4)
4 Rose (2007) considers a broad group of advanced industrial and developing countries in his
empirical work.
5The authors do not consider a control group of emerging countries that are not targeting
inflation.

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Policy Functions in IT Regimes
In terms of central bank policy functions, Clarida, Gali and Gertler (1998) focus on
six major industrial countries and suggest that the G3 (Germany, Japan and U.S.) have
followed an implicit form of inflation targeting since 1979. The main evidence for this
conclusion is that these central banks are forward looking, and respond to anticipated as
opposed to lagged inflation. Clarida et al. (1998) argue that the success of the G3 in
lowering inflation and keeping inflation at a low level may be attributable to this implicit
inflation-targeting policy. They conclude that inflation targeting may be superior to fixing
exchange rates as a nominal anchor (as was prevalent in their sample period for the E3
countries of France, Italy and the United Kingdom). They found the response to real
exchange rates is significant and of the expected sign, but small in magnitude for
Germany and Japan.
Other studies have investigated differences in IT and non-IT policy regimes by
explicitly estimating “Taylor rule” equations for individual countries. A number of
studies in this genre, focusing on advanced industrial countries, find some evidence that
countries are following significantly different policy rules in IT regimes (e.g. Mohanty
and Klau, 2005; Edwards, 2006; Corbo et al., 2001). For example, Corbo et al. (2001)
find somewhat mixed evidence for seventeen OECD countries estimated individually.
They find that inflation targeters exhibit the largest inflation gap coefficient (response to
inflation) relative to the output gap coefficient (response to output), although in most
cases the coefficients are not statistically different from zero. Lubik and Schorfheide
(2007, JME) estimate a calibrated small-scale GE model for a small open economy using
data for Australia, Canada, New Zealand and the United Kingdom over 1983 to 2002
(quarterly data). They consider Taylor-type rules, where the authorities respond to output,
inflation and exchange rates. They find that Australia and New Zealand change interest
rates in response to exchange rate movements, but that Canada and the United Kingdom
do not respond to exchange rates.
Dennis (2003) investigates several models for the Australian experience and finds
that the authorities should optimally focus not just on inflation but also on real exchange
rate fluctuations and terms of trade when they set interest rates to the extent that import
goods are consumption goods (and enter into CPI). Ravenna (2008) considers the

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Canadian case with IT targeting. He estimates a DSG model and is able to determine
whether the good inflation performance of Canada since adopting an IT regime is due to
the IT policy or to “good luck.” He finds that low average inflation since adopting the IT
regime is associated with the credibility of policy under this regime. However, the lower
volatility of inflation is mainly associated with “good luck” in that few major adverse
shocks have impacted the Canadian economy during this period.
Other studies suggest that monetary policy operating procedures do not
fundamentally change with the move to an IT regime. Drueker and Fischer (2006), for
example, find “no difference” in the monetary policy rules followed by IT countries and
comparable non-IT countries in their own empirical work, and at best mixed evidence
supporting any substantive difference in numerous studies in their survey of the subject.
They estimate individual country time-series regressions and compare high-performing
advanced industrial countries that are following an IT regime and those that are not.

Policy Rules in Emerging Markets, Real Exchange Rates and Commodity Export
Concentration
Only a few empirical studies focus on central bank reaction functions in emerging
markets, and this is done on a case by case basis. Schmidt-Hebbel and Werner (2002)
apply common empirical framework (VAR models) to compare the experiences of Brazil,
Chile and Mexico with inflation targeting. They estimate Taylor rule equations for each
country with the real interest rate as the dependent variable. Only for Brazil is the
expected inflation gap statistically significant, whereas only for Chile is the output gap
statistically significant. They do find that the trade surplus (lagged) enters negatively and
significantly in most cases (i.e. trade surplus leads to decline in real interest rate) and that
this effect dominates all other variables. They find that these countries continue to
respond to exchange rate changes in the short-term, if not the medium-term, and
characterize them as “dirty” floaters.6

6 One drawback of these time-series regressions is the very short sample periods. The authors use
monthly data for Brazil and Mexico, and quarterly data for Chile.


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Cordo et al. (2001) estimate Taylor-rule type equations for eight emerging-market
economies over 1990-1999 using quarterly data. They classify countries during the 1990s
as IT, potential IT and non-IT.7 Two emerging markets are in their IT category (Chile
and Israel), five are in the potentially targeting category (South Africa, Brazil, Colombia,
Mexico and Korea) and one is in the non-IT category (Indonesia). In the IT and potential
IT categories, four (two) central banks appear to respond to inflation (output) deviations
from target in setting interest rates. The authors do not test, in their Taylor rule estimates,
whether central banks in emerging markets consider external variables.
Mohanty and Klau (2004) estimate modified Taylor rules for 13 emerging market
and transition economies, complementing inflation, the output gap and lagged interest
rates with current and lagged real exchange rate changes. They find that the coefficients
on real exchange rate changes are statistically significant in ten countries (OLS
estimates), with the significant contemporaneous effect ranging from -0.33 (Brazil) to
0.35 (Chile). The policy response to exchange rate changes is frequently larger than the
response to inflation and the output gap. They conclude that this supports the “fear of
floating” hypothesis. Mohanty and Klau (2004) do not explicitly address the inflation
targeting issue in this context, but it is apparent that these countries, whether or not they
profess to follow an IT regime, are attempting to stabilize real exchange rates as well as
control inflation and stabilize output.
Edwards (2006) investigates the determinants of the exchange rate response in the
Taylor-rule regressions, building on the work by Mohanty and Khau (2004). He runs
cross-country regressions of the exchange rate coefficient on several explanatory
variables (each regression with 13 observations). Edwards (2006) finds that countries
with a history of high inflation, and with historically high real exchange rate volatility,
tend to have a higher coefficient (response) to the real exchange rate in Taylor rule
equations.
De Mello and Moccero (2008) estimate interest rate policy rules for four Latin
American emerging markets—Brazil, Chile, Colombia and Mexico—characterized by

7 They estimate one equation for each country over the 1990s. Hence, in most cases, their
estimated coefficients average periods of both inflation-targeting and non-targeting for countries
that eventually adopted an IT regime.

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inflation targeting and floating exchange rates in 1999. They estimate an interest rate
policy function in the context of a New Keynesian structural model with equations for
inflation, output and interest rates. They find inflation targeting, in a post-1999 regime,
has been associated with stronger and persistent responses to expected inflation in Brazil
and Chile. Mexico is the only country they find where changes in nominal exchange rates
were found to be statistically significant in the central bank’s reaction function during the
IT period.

Importance of Real Exchange Rates for IT Regimes in Emerging Markets
The theoretical importance of the real exchange rate to the conduct of monetary
policy in an IT regime is presented in appendix A. We illustrate these considerations in a
simplified version of Ball (1999), where the policy maker is concerned about exchange
rate volatility. The wish to mitigate exchange rate volatility follows the logic of Aghion
et al. (2006), who show that exchange rate volatility reduces potential output (or output
growth rate) in developing countries, attributing it to financial channels. The adverse
effect of volatility may be the outcome of increasing the expected cost of funds in
circumstances where agency and contract enforcement costs are prevalent, the financial
system is shallow, and trade openness is significant.8 These conditions tend to be
exacerbated in developing countries relying heavily on mineral and commodity exports.
We simulate a simple model that confirms that a greater weight on mitigating exchange
rate volatility tends to increase the responsiveness of the policy rule to exchange rate
changes, possibly with sizable welfare effects. Given these considerations, we test the
degree to which the policy rule adopted by IT commodity-intensive developing countries

8 A growing literature has identified financial intermediation, in the presence of collateral
constraints, as a mechanism explaining the hazard associated with credit cycles induces by
shocks. The prominent role of bank financing in developing countries suggests that balance sheet
valuation problems associated with shocks may lead to higher cost of borrowing, reducing
average growth, and possibly to recessions in the aftermath of adverse shocks. In these
circumstances, real exchange rate changed induced by adverse terms of trade shocks or contagion
may impose adverse liquidity shocks, propagating lower output growth. This channel is of greater
potency in countries where most financial intermediation is done by banks, relying on debt
contracts. Less efficient judiciary, higher monitoring and enforcement costs tend to magnify the
adverse impact of real exchange shocks on the costs of credit; for further references and models
of the credit channel in developing countries see Aghion et al. (2006) and Aizenman (2008).

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