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

Year 2011, Volume: 3 Issue: 2, 181 - 192, 01.12.2011

Mahir Binici

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

References

• Ball, L. (1998), Policy rules for open economies, Working Papers 6760, National
• Bureau of Economic Research. Ball, L. and Sheridan, N. (2003), Does inflation targeting matter?, Working Paper , National Bureau of Economic Research.
• Batini, N., Harrison, R. and Millard, S. P. (2003), “Monetary policy rules for an open economy”, Journal of Economic Dynamics and Control, Vol. 27, pp. 2059
• Carare, A. and Stone, M. R. (2006), “Inflation targeting regimes”, European
• Economic Review, Vol. 50, pp. 1297-1315.
• Clarida, R., Gali, J. and Gertler, M. (1998), “Monetary policy rules in practice:
• Some international evidence”, European Economic Review, Vol. 42, pp. 1033
• Edwards, S. (2006), The relationship between exchange rates and inflation targeting revisited, Working Papers 12163, National Bureau of Economic Research.
• Engel, C. and West, K. D. (2005), “Exchange rates and fundamentals”, Journal of
• Political Economy, Vol. 113, pp. 485-517. Leitemo, K. and Soderstrom, U. (2005), “Simple monetary policy rules and exchange rate uncertainty”, Journal of International Money and Finance, Vol. 24, pp. 481-507.
• Lubik, T. A. and Schorfheide, F. (2007), “Do central banks respond to exchange rate movements? A structural investigation”, Journal of Monetary Economics, Vol. 54, pp. 1069-1087.
• Mishkin, F. S. and Savastano, M. A. (2001), “Monetary policy strategies for Latin
• America”, Journal of Development Economics, Vol. 66, pp. 415-444. Mishkin, F. S. and Schmidt-Hebbel, K. (2001), One decade of inflation targeting in the world: What do we know and what do we need to know?, Working Papers , National Bureau of Economic Research.
• Mishkin, F. S. and Schmidt-Hebbel, K. (2007), Does inflation targeting make a difference?, Working Papers 12876, National Bureau of Economic Research.
• Obstfeld, M., Shambaugh, J. C. and Taylor, A. M. (2005), “The trilemma in history: Tradeoffs among exchange rates, monetary policies, and capital mobility”, The Review of Economics and Statistics, Vol. 87, pp. 423-438.
• Sack, B. and Wieland, V. (2000), “Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence”, Journal of Economics and Business, Vol. 52, pp. 205-228.
• Svensson, L. E. O. (2000), “Open-economy inflation targeting”, Journal of
• International Economics, Vol. 50, pp. 155-183. Taylor, J. B. (2002), The monetary transmission mechanism and the evaluation of monetary policy rules, Working Papers Central Bank of Chile 87, Central Bank of Chile.
• Table 1: Inflation Targeting Adoption Dates, Panel Data Starting Period Country Name Canada 1991 United Kingdom Sweden 1995 Switzerland 2000 2000 Norway 2001 Chile 1991 Colombia 1999 Check Republic Hungary 2001 Israel 1992 Korea 1998 Mexico 1999 Peru 2001 Poland 1998 South Africa
• Source: Mishkin and Schmidt-Hebbel (2007), and Ball and Sheridan (2003), and author. m2