Inflation Targeting as a Framework for Monetary Policy: A Cross‐Country Analysis

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[Author Affiliation]Chi-Young Choi, cychoi@uta.eduYoung Se Kim[Acknowledgment]The authors are grateful to coeditor Kent Kimbrough and two anonymous referees for constructive comments that helped to improve this article. The authors also wish to thank Steve Cecchetti, Kang Liu, Shin-Ichi Nishiyama, Margie Tieslau, Taka Tsuruga, and the seminar participants at the Academia Sinica, National Chung Cheng University, National Sun Yat-Sen University, National Taiwan University, Texas Tech University, and the University of Texas at Arlington for helpful comments and Vikas Kakkar for providing CPI data for Hong Kong. Any remaining errors are the authors'.1. IntroductionVariability in relative prices is known to be a major channel through which inflation can induce welfare costs by impeding an efficient allocation of resources in the economy. Consequently, substantial effort has been devoted in the literature to examining the link between relative price variability (RPV) and aggregate inflation. Although much of the existing theoretical and empirical literature points to a positive monotonic relationship, newer contributions suggest that the relationship between inflation and RPV is more complicated, particularly in terms of its sensitivity to the inflation regime.1The primary purpose of this study is to investigate whether the connection between inflation and RPV is influenced in an important way by the monetary policy framework chosen by a central bank. Specifically, this article focuses on exploring whether the adoption of an inflation targeting (IT) framework exerts any significant impact on RPV as measured by the standard deviations of sectoral inflation rates relative to the aggregate rate. Since it was first implemented in New Zealand more than two decades ago, the popularity of IT has spread, with some twenty-five countries worldwide implementing the framework to date (Freedman and Laxton 2009). The literature is now replete with studies pointing to reductions in both the level and the volatility of inflation in countries that have adopted IT (e.g., Mishkin and Schmidt-Hebbel 2007).2 While studies of the impact of IT on aggregate inflation performance are plentiful, little attention has been paid to the impact of IT on RPV.The question of whether and indeed how IT affects RPV is an important one for several reasons. First, exploring the potential connection between IT and RPV is a worthwhile exercise given the popularity of IT as a monetary framework and the centrality of RPV to the current generation of macromodels. The importance of RPV is recognized in standard New Keynesian Dynamic Stochastic General Equilibrium (DSGE) models, where the variance of relative prices is viewed as a useful summary statistic. As noted by Amano, Ambler, and Rebei (2007), for example, in DSGE models, the optimal rate of target inflation and the optimal variability of inflation relative to output depend on the quantitative effects of price dispersion on macroeconomic equilibrium. Second, answering the question helps us identify the driving force behind the change in RPV, distinguishing between IT adoption itself and its subsequent impact on inflation. If the relationship is monotonically positive, as is often believed in the literature, one should expect that IT adoption would bring about a decline in RPV in the same way as it has led to a decline in inflation. If the relationship is more complex, however, the effect of IT adoption on reducing RPV may hinge on the change in inflation regimes after IT adoption. Third, our answer to the question also sheds additional light on the empirical evidence for the relative effectiveness of IT across different stages of development. While there is strong evidence that developing countries benefit more from IT than industrial countries in combating inflation and its volatility (e.g., Petursson 2004; Lin and Ye 2009), we are aware of no empirical research that has assessed this issue with respect to RPV. …

The transition to an inflation targeting regime represents a pivotal shift for any central bank in shaping its monetary policy framework. This transformation is typically preceded by significant structural changes in the economy, including the development of financial markets, the adoption of fiscal discipline, and the reform of exchange rate regimes, with the transition to floating exchange rates being a critical prerequisite. Initially introduced by New Zealand in 1990, inflation targeting has since gained prominence as a strategy for achieving price stability. While not all developed countries explicitly adopt this regime, the objective of price stability remains a cornerstone of their monetary policies, often integrated alongside other economic goals. For emerging economies, the adoption of inflation targeting has coincided with extensive economic restructuring and reforms. Key reforms include enhancing the independence of central banks, transitioning to more flexible exchange rate regimes, and developing robust capital markets. These changes reflect efforts to meet the institutional and technical prerequisites necessary for the successful implementation of inflation targeting. As a result, many emerging countries have adopted or are preparing to adopt this regime as a credible alternative to monetary targeting and fixed exchange rate frameworks.

The paper assesses the co-movement of local and foreign interest rate for developing countries with a full-fledged inflation targeting framework during and after the 2008 financial crisis. A panel linear optimizing monetary model is estimated by the fixed effects with spatial correlation standard errors over quarterly span from Q12007 to Q2 2019. The results suggest that inflation targeters are highly vulnerable to external monetary shocks, even after years of notable efforts to de-dollarization and complete shift towards a full-fledged inflation targeting. From a regime evaluation prospective, the inflation targeters’ response to world monetary shocks is compared to that of a group of fixed exchange rate rule economies and managed exchange rate countries with other monetary regimes. The findings provide evidence that inflation targeting countries are not different in their interest rate response to world monetary shocks compared to non-inflation targeting countries’, and instead of having more flexibility, inflation targeters show stronger reaction to world monetary shocks. These results are found robust when generated out from different subsamples and under assumptions of strict and flexible inflation targeting and policy inertia. The findings indicate that adopting inflation targeting as a framework for monetary policy does not by itself support the overall macroperformance and independence of monetary policy or force continuing commitment to the inflation targeting conditions.

Banco de la República is celebrating its 100th anniversary in 2023. This is a very significant anniversary and one that provides an opportunity to highlight the contribution the Bank has made to the country’s development. Its track record as guarantor of monetary stability has established it as the one independent state institution that generates the greatest confidence among Colombians due to its transparency, management capabilities, and effective compliance with the central banking and cultural responsibilities entrusted to it by the Constitution and the Law. On a date as important as this, the Board of Directors of Banco de la República (BDBR) pays tribute to the generations of governors and officers whose commitment and dedication have contributed to the growth of this institution.1 Banco de la República’s mandate was confirmed in the National Constitutional Assembly of 1991 where the citizens had the opportunity to elect the seventy people who would have the task of drafting a new constitution. The leaders of the three political movements with the most votes were elected as chairs to the Assembly, and this tripartite presidency reflected the plurality and the need for consensus among the different political groups to move the reform forward. Among the issues considered, the National Constitutional Assembly gave special importance to monetary stability. That is why they decided to include central banking and to provide Banco de la República with the necessary autonomy to use the instruments for which they are responsible without interference from other authorities. The constituent members understood that ensuring price stability is a state duty and that the entity responsible for this task must be enshrined in the Constitution and have the technical capability and institutional autonomy necessary to adopt the decisions they deem appropriate to achieve this fundamental objective in coordination with the general economic policy. In particular, Article 373 established that “the State, through Banco de la República, shall ensure the maintenance of the purchasing power of the currency,” a provision that coincided with the central banking system adopted by countries that have been successful in controlling inflation. In 1999, in Ruling 481, the Constitutional Court stated that “the duty to maintain the purchasing power of the currency applies to not only the monetary, credit, and exchange authority, i.e., the Board of Banco de la República, but also those who have responsibilities in the formulation and implementation of the general economic policy of the country” and that “the basic constitutional purpose of Banco de la República is the protection of a sound currency. However, this authority must take the other economic objectives of state intervention such as full employment into consideration in their decisions since these functions must be coordinated with the general economic policy.” The reforms to Banco de la República agreed upon in the Constitutional Assembly of 1991 and in Act 31/1992 can be summarized in the following aspects: i) the Bank was assigned a specific mandate: to maintain the purchasing power of the currency in coordination with the general economic policy; ii) the BDBR was designatedas the monetary, foreign exchange, and credit authority; iii) the Bank and its Board of Directors were granted a significant degree of independence from the government; iv) the Bank was prohibited from granting credit to the private sector except in the case of the financial sector; v) established that in order to grant credit to the government, the unanimous vote of its Board of Directors was required except in the case of open market transactions; vi) determined that the legislature may, in no case, order credit quotas in favor of the State or individuals; vii) Congress was appointed, on behalf of society, as the main addressee of the Bank’s reporting exercise; and viii) the responsibility for inspection, surveillance, and control over Banco de la República was delegated to the President of the Republic. The members of the National Constitutional Assembly clearly understood that the benefits of low and stable inflation extend to the whole of society and contribute mto the smooth functioning of the economic system. Among the most important of these is that low inflation promotes the efficient use of productive resources by allowing relative prices to better guide the allocation of resources since this promotes economic growth and increases the welfare of the population. Likewise, low inflation reduces uncertainty about the expected return on investment and future asset prices. This increases the confidence of economic agents, facilitates long-term financing, and stimulates investment. Since the low-income population is unable to protect itself from inflation by diversifying its assets, and a high proportion of its income is concentrated in the purchase of food and other basic goods that are generally the most affected by inflationary shocks, low inflation avoids arbitrary redistribution of income and wealth.2 Moreover, low inflation facilitates wage negotiations, creates a good labor climate, and reduces the volatility of employment levels. Finally, low inflation helps to make the tax system more transparent and equitable by avoiding the distortions that inflation introduces into the value of assets and income that make up the tax base. From the monetary authority’s point of view, one of the most relevant benefits of low inflation is the credibility that economic agents acquire in inflation targeting, which turns it into an effective nominal anchor on price levels. Upon receiving its mandate, and using its autonomy, Banco de la República began to announce specific annual inflation targets as of 1992. Although the proposed inflation targets were not met precisely during this first stage, a downward trend in inflation was achieved that took it from 32.4% in 1990 to 16.7% in 1998. At that time, the exchange rate was kept within a band. This limited the effectiveness of monetary policy, which simultaneously sought to meet an inflation target and an exchange rate target. The Asian crisis spread to emerging economies and significantly affected the Colombian economy. The exchange rate came under strong pressure to depreciate as access to foreign financing was cut off under conditions of a high foreign imbalance. This, together with the lack of exchange rate flexibility, prevented a countercyclical monetary policy and led to a 4.2% contraction in GDP that year. In this context of economic slowdown, annual inflation fell to 9.2% at the end of 1999, thus falling below the 15% target set for that year. This episode fully revealed how costly it could be, in terms of economic activity, to have inflation and exchange rate targets simultaneously. Towards the end of 1999, Banco de la República announced the adoption of a new monetary policy regime called the Inflation Targeting Plan. This regime, known internationally as ‘Inflation Targeting,’ has been gaining increasing acceptance in developed countries, having been adopted in 1991 by New Zealand, Canada, and England, among others, and has achieved significant advances in the management of inflation without incurring costs in terms of economic activity. In Latin America, Brazil and Chile also adopted it in 1999. In the case of Colombia, the last remaining requirement to be fulfilled in order to adopt said policy was exchange rate flexibility. This was realized around September 1999, when the BDBR decided to abandon the exchange-rate bands to allow the exchange rate to be freely determined in the market.Consistent with the constitutional mandate, the fundamental objective of this new policy approach was “the achievement of an inflation target that contributes to maintaining output growth around its potential.”3 This potential capacity was understood as the GDP growth that the economy can obtain if it fully utilizes its productive resources. To meet this objective, monetary policy must of necessity play a countercyclical role in the economy. This is because when economic activity is below its potential and there are idle resources, the monetary authority can reduce the interest rate in the absence of inflationary pressure to stimulate the economy and, when output exceeds its potential capacity, raise it. This policy principle, which is immersed in the models for guiding the monetary policy stance, makes the following two objectives fully compatible in the medium term: meeting the inflation target and achieving a level of economic activity that is consistent with its productive capacity. To achieve this purpose, the inflation targeting system uses the money market interest rate (at which the central bank supplies primary liquidity to commercial banks) as the primary policy instrument. This replaced the quantity of money as an intermediate monetary policy target that Banco de la República, like several other central banks, had used for a long time. In the case of Colombia, the objective of the new monetary policy approach implied, in practical terms, that the recovery of the economy after the 1999 contraction should be achieved while complying with the decreasing inflation targets established by the BDBR. The accomplishment of this purpose was remarkable. In the first half of the first decade of the 2000s, economic activity recovered significantly and reached a growth rate of 6.8% in 2006. Meanwhile, inflation gradually declined in line with inflation targets. That was how the inflation rate went from 9.2% in 1999 to 4.5% in 2006, thus meeting the inflation target established for that year while GDP reached its potential level. After this balance was achieved in 2006, inflation rebounded to 5.7% in 2007, above the 4.0% target for that year due to the fact that the 7.5% GDP growth exceeded the potential capacity of the economy.4 After proving the effectiveness of the in

Inflation targeting (IT) is practised in many countries and the real effects of strict inflation targeting were investigated on several occasions and less on other variants of IT. The study investigates the effects of inflation targeting lite on output. In particular, the compatibility of inflation targeting lite with managed exchange rate regime on output stabilization. The inflation targeting regime, the operating environment and exchange rate regimes were reviewed for Zimbabwe. An ARDL model was adopted as the empirical strategy to investigate the compatibility problem and the real effects of IT lite. Modelling output as output gap, inflation targeting lite and the exchange rate regimes were found to be inconsistent with output stabilization. IT lite and exchange rate premium increased the output gap, however the interaction between IT lite and exchange rate premium had negative effects on output. These results hold for both the short run and long run. However, considering the official rate and parallel rate separately, parallel rate has a negative effect but its interaction with IT has positive effects. The study recommends that developing countries should consider the exchange rate systems before the adoption of IT as a monetary policy framework. A floating exchange rate seemed to be compatible with IT lite.

INTERRELATIONSHIP OF INFLATION, EXCHANGE RATE AND INTEREST RATES IN THE CONTEXT OF HUNGARY'S STRATEGIC POLICY

The author examines changes in monetary policy in industrial countries by evaluating, and providing case studies of monetary targeting, and inflation targeting. Inflation targeting has successfully controlled inflation, with some qualifications. It weakens the effects of inflationary shocks, as examples from Canada, Sweden, and the United Kingdom show. It can promote growth, and does not lead to increased fluctuations in output. But inflation targets do not necessarily reduce the cost of reducing inflation. The key to success of inflation targeting, is its stress on transparency, and communication with the public. Inflation targeting increases accountability, which helps ameliorate the time-inconsistency trap (in which the central bank tries to expand output, and employment in the short run, by pursuing overly expansionary monetary policy). Time-inconsistency is more likely to come from political pressures on the central bank, to engage in overly expansionary monetary policy. A key advantage of inflation targeting, is that it helps focus the political debate on what a central bank can do in the long run (control inflation) rather than what it cannot do (raise economic growth, and the number of jobs permanently through expansionary monetary policy). By increasing transparency, and accountability, inflation targeting helps promote central bank independence. Accountability to the general public seems to work as well as direct accountability to the government. Inflation targeting is consistent with democratic principles. In discussing operational design, the author explains, among other things, that: 1) Inflation targeting is far from rigid rule. 2) Inflation targets have always been above zero with no loss of credibility. 3) Inflation targeting does not ignore traditional stabilization goals. 4) Avoiding undershoots of the inflation target, is as important, as avoiding overshoots. 5) When inflation is initially high, inflation targeting may have to be phased-in after disinflation. 6)The edges of the target range, can take on a life of their own. 7) Targeting asset prices, such as the exchange rate, worsens performance.

This article analyzes the feasibility of inflation targeting (IT) in Algeria using data from Q1 2000 to Q4 2021. IT is widely used, although its efficacy in emerging areas, notably MENA, is disputed. Algerian monetary policy dynamics and the central bank's response to inflation and production changes are examined using Taylor Rule and GMM. The Bank of Algeria appears to value interest rate smoothing above short-term economic instability. The central bank's aggressive response to inflation goal deviations supports its price stability promise in an IT environment. The research shows a lower focus on production stability, possibly due to the oil-dependent economy and labor market rigidities. The study finds that Algeria's monetary policy has IT aspects, but its efficacy depends on its economic setting and institutional architecture. To further comprehend Algeria's macroeconomic stabilization efforts, future study should examine global economic circumstances, commodity price volatility, and monetary and fiscal policy. This study adds to the discussion on IT's usefulness in emerging economies by highlighting the necessity to address economic conditions and institutional frameworks. IT may help stabilize prices in Algeria, but executing this monetary policy framework in a unique economic setting is difficult.

Has Inflation Targeting Improved Monetary Policy? Evaluating Policy Effectiveness in Australia, Canada, and New Zealand

Inflation targeting, as a monetary-policy framework, is said to promote economic growth. Yet, when evaluating the macroeconomic performance of inflation-targeting regime, the existing literature only emphasizes the dynamics of inflation and the costs associated with taming inflation. There is hardly any assessment of the growth claim. To fill the gap and to measure the causal impact of inflation-targeting adoption on economic growth, we compare the dynamics of output growth and long-term unemployment between countries that have adopted inflation targeting and the non-adopting countries. Our findings seem to refute the growth claim, and paint a bleak picture of inflation targeting: when compared to the countries that did not adopt inflation targeting, there is a significant reduction in the average growth rate among the inflation-targeting adopters by over ½ percentage point. Additionally, long-term unemployment significantly rises among the inflation-targeting countries by over 1½ percentage points as compared to the non-adopters. These results are robust to both the exclusion of the outlier observations and to the sensitivity tests recommended for such analysis.

Inflation Targeting in Latin America: Empirical Analysis Using GARCH Models

This article examines how the analysis of inflation targeting (IT) adoption is affected by allowing for a structural change after adoption, using panel probit models for 60 countries over the period 1985 to 2008. Our findings suggest that there is a structural change after IT adoption. Including the post-adoption period when estimating the factors of IT adoption leads to biased results when interested in the question as of what drives countries’ decision to adopt IT.

Strengthening the Monetary Policy Framework in Korea

The notion of an ‘independent’ central bank has dominated monetary policy debates for the past three decades. The arguments for the political independence of central banks are closely related to the adoption of ‘inflation targeting’. The arguments for an independent central bank are based on the ‘credibility’ of the ‘conservative’ central bank in comparison to government decision making. The independence of a central bank has been a matter of independence from government but not independence from the grip of the ‘new consensus in macroeconomics’ nor from the interests of the banking and financial sector. That independence has also supported a lack of co-ordination between monetary and fiscal policies, diminishing the effectiveness of macroeconomic policies. In addition, there remain doubts about the effectiveness of ‘inflation targeting’ on the achievement of low inflation. The policy mandates of central banks have begun to shift towards financial stability and paying attention to issues of inequality and the climate emergency.