THE ROLE OF EXCHANGE RATES IN MONETARY POLICY RULE: THE CASE OF INFLATION TARGETING COUNTRIES

Abstract

This paper examines two main issues for the case of inflation targeting countries. The first is to investigate whether monetary authorities react to the exchange rate movements, in addition to inflation and output gap, as in simple monetary policy rule. The second is to investigate whether reactions to the exchange rates have any implications for the inflation targeting performance. The main result of the analysis indicates that some inflation targeting countries react to the exchange rate movements. The policy to stabilize the exchange rate movements helps achieve the inflation target; however, this is not robust across different specifications. In contrast, the real exchange rate variability worsens the inflation targeting performance. The other main finding from the panel data model is that the deviation of the inflation from the target rate exhibits a high and systematic persistence. Additionally, central banks with constant inflation targeting are more successful controlling inflation in the target path compared to banks with a nonconstant inflation target. Finally, restriction on capital controls helps the inflation targeting performance.

Keywords

• Monetary policy rules, Exchange rates, Inflation targeting, GMM, Panel data

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