Inflation Targeting and Inflation Targeting and Real Exchange Rates in Real Exchange Rates in Emerging Markets Emerging Markets Joshua Aizenman, UC Santa Cruz Joshua Aizenman, UC Santa Cruz Michael Hutchison, UC Santa Cruz Michael Hutchison, UC Santa Cruz Ilan Noy, U. Hawaii Ilan Noy, U. Hawaii Presentation at NIPFP-DEA Conference, New Delhi September 30, 2008
Introduction Introduction � IT: Most OECD CBs and many EM IT: Most OECD CBs and many EM � CBs CBs � No No “ “ Rules of the Game Rules of the Game” ” � � Why? Perceived Benefits Why? Perceived Benefits � � Controversy over benefits, and if IT Controversy over benefits, and if IT � represents substantive policy shift represents substantive policy shift
Motivation Motivation 1. Most work on ICs, but EMs different Most work on ICs, but EMs different 1. Institutions, credibility, exposure to Institutions, credibility, exposure to � external shocks, financial development external shocks, financial development 2. Mixed IT strategy? Real exchange rate Mixed IT strategy? Real exchange rate 2. targeting targeting 3. Distinction Distinction b/ t b/ t commodity and non commodity and non- - 3. commodity export concentration commodity export concentration 4. Advantages of panel approach: focus Advantages of panel approach: focus 4. on common elements associated with on common elements associated with IT regimes IT regimes
Relevance to India? Relevance to India? � Further external and internal Further external and internal � liberalization > > stable monetary liberalization > > stable monetary policy regime? policy regime? � Evaluate existing regime in light of Evaluate existing regime in light of � proven alternatives proven alternatives
Literature Review: IT Macro Effects Literature Review: IT Macro Effects 1. Mixed results for ICs in terms of Mixed results for ICs in terms of 1. average inflation, inflation volatility, average inflation, inflation volatility, expected inflation, output volatility expected inflation, output volatility Johnson, 2002 Johnson, 2002 � Mishkin and Schmidt- Mishkin and Schmidt - Hebbel, 2007 Hebbel, 2007 � Ball and Sheridan, 2005 Ball and Sheridan, 2005 � 2. More supportive results for IT in EMs More supportive results for IT in EMs 2. IMF, 2005 (13 IT, 29 non- - IT EMs) IT EMs) IMF, 2005 (13 IT, 29 non � Conç Con çalves alves and and Salles Salles, 2008 (36 EMs) , 2008 (36 EMs) �
Literature Review: Policy Functions Literature Review: Policy Functions 1. ICs ICs 1. Find differences in IT and non- - IT policy IT policy Find differences in IT and non � rules rules • Mohanty and and Klau Klau (2005), Edwards (2006), (2005), Edwards (2006), • Mohanty Corbo et al. (2001) et al. (2001) Corbo Do not find differences: Drueker and Fisher Do not find differences: Drueker and Fisher � (1996, 2006) (1996, 2006) 2. EMs 2. EMs Schmidt- -Hebbel and Werner (2002): Hebbel and Werner (2002): Schmidt � • Brazil, Chile, Mexico: Taylor Rules, time series • Brazil, Chile, Mexico: Taylor Rules, time series • Short samples (Monthly, Quarterly) • Short samples (Monthly, Quarterly) • Real interest rate equations • Real interest rate equations • Inflation gap significant only for Brazil • Inflation gap significant only for Brazil • Respond to exchange rates: “ “ dirty floaters dirty floaters” ” • Respond to exchange rates:
EM Policy Functions (cont.) EM Policy Functions (cont.) � Cordo Cordo et al. (2001) et al. (2001) • Taylor rules, 8 EMs, 1990 Taylor rules, 8 EMs, 1990-99, Quarterly data, time series 99, Quarterly data, time series • Classification: I T, potential I T, non Classification: I T, potential I T, non- IT IT • I T and potential I T: 4 of 6 respond to inflation I T and potential I T: 4 of 6 respond to inflation • Do not test external variables Do not test external variables � Mohanty Mohanty and and Klau Klau (2004) (2004) • Modified Taylor rules for 13 EMs and transition econom ies Modified Taylor rules for 13 EMs and transition econom ies • Tim es series, and focus on real exchange rates Tim es series, and focus on real exchange rates • RER significant in 10/ 13 cases, frequently stronger than RER significant in 10/ 13 cases, frequently stronger than response to inflation; conclude response to inflation; conclude “fear of floating fear of floating” � Edwards (2006) Edwards (2006) • Cross section regressions on 13 EMs Cross section regressions on 13 EMs • Taylor rule regressions with real exchange rates Taylor rule regressions with real exchange rates • Finds countries with historically high inflation rates and high Finds countries with historically high inflation rates and high real exchange rate volatility tend to respond to RER real exchange rate volatility tend to respond to RER m ovem ents stronger m ovem ents stronger
� Our work Our work � • Focuses on policy functions (Taylor • Focuses on policy functions (Taylor rules) rules) • Compares EM regimes: IT and non Compares EM regimes: IT and non- - I T I T • • Focus: Focus: • � Is it real in EMs? Is it real in EMs? � Mixed IT Strategy: Real exchange rates Mixed IT Strategy: Real exchange rates � Differences Differences b/ t b/ t commodity and non commodity and non- - commodity IT countries commodity IT countries � Panel data Panel data– – common elements common elements
Why might real exchange rates Why might real exchange rates enter in EM policy functions? enter in EM policy functions? RER may influence future inflation, and hence be an RER may influence future inflation, and hence be an � indicator for a forward- -looking central bank looking central bank indicator for a forward Potential output, depends negatively on exchange rate Potential output, depends negatively on exchange rate � volatility: volatility: Why? E.g. Aghion Aghion, , Bachcetta Bachcetta, , Ranciere Ranciere, Rogoff (2006): , Rogoff (2006): Why? E.g. � RER volatility reduces potential output (growth) due to RER volatility reduces potential output (growth) due to financial channels; financial channels; • Increasing expected costs of funds when agency and contract • Increasing expected costs of funds when agency and contract enforcement costs are prevalent enforcement costs are prevalent • • Financial system is shallow Financial system is shallow • Trade openness is significant • Trade openness is significant
Simplification and Extension of Ball’s Model = π + µ (A1) Loss L V ( ) V y ( ) Function ) Modified Loss = π + µ + φ (A2) L V ( ) V y ( ) V e ( ) Function = − β − δ + ε a y r e . IS Curve (A3) π = α − γ + η b . y e Phillips curve = θ + υ c e r . Interest rate- Exchange Rate = π + + Modified IT Rule r a by ce ( A4)
+ α θ ε + + β + α υ + θ µ 2 2 2 2 ( b a ) V ( ) [1 ( b a )] V ( ) ( a ) V ( ) = a . V e ( ) + + α + θ α − 2 [1 B b ( a ) ( a c )] + θ α − ε + β α − − δ υ + µ 2 2 2 (1 ( a c )) V ( ) [ ( a c ) ] V ( ) ( aB V ) ( ) = b . V y ( ) + + α + θ α − 2 [1 B b ( a ) ( a c )] α − θ − γθ ε + β α + γ + δα + γ υ + − θ + µ 2 2 2 ( (1 c ) b ) V ( ) [ ( c b ) ] V ( ) (1 c bB V ) ( ) π = c . V ( ) + + α + θ α − 2 [1 B b ( a ) ( a c )] . , where = β + δθ B
c=1 c=0 Two Parameters for RER Response: Pure IT (c= 0) and Mixed Strategy (c= 1). Note: Feeding (A5) into (A2), Min Loss Function for alternative values of < a, b, c>
Data Data � 16 EMs from Morgan Stanley MSCI EM list 16 EMs from Morgan Stanley MSCI EM list � Exact date of IT from Mishkin and Exact date of IT from Mishkin and Schmidt- - Hebbel (2006) Hebbel (2006) Schmidt � Period: 1989Q1 Period: 1989Q1 – – 2006Q4 2006Q4 � Delete very high inflation periods (above Delete very high inflation periods (above 40% ) 40% ) � GDP Gap: HP filter; real effective ex. rate; GDP Gap: HP filter; real effective ex. rate; money market interest rate; CPI for money market interest rate; CPI for inflation; inflation;
Preliminaries Preliminaries
IT– lower inflation/interest rates, greater rer depreciation, less reserve growth
Methodology : Taylor Equations Methodology : Taylor Equations -Panel Fixed Effects -Hausman-Taylor 3-Step IV Estimator (bias with predetermined or endogenous variables)
Taylor Rules: Persistence, No GDP gap response, Inflation Response in IT, RER response in non-IT
Persistence, Inflation gap in IT, output gap in non-IT, response to RER and reserves in non-IT
Persistence, Inflation gap in IT, output gap in non-IT, response to RER in IT, response to reserves in non-IT
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