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Table of contents
1. Introduction ................................ ................................ ................................ ................................ .............. 3
2. Inflation targeting in emerging market economies ................................ ................................ ..................... 3
3. Structure ................................ ................................ ................................ ................................ ................... 4
4. Justification of the structure ................................ ................................ ................................ ...................... 6
4.1. Introduction ................................ ................................ ................................ ................................ ..... 6
4.2. Goals of macro-economic policy ................................ ................................ ................................ ....... 6
4.3. Monetary policy: alternatives ................................ ................................ ................................ ........... 6
4.4. What is inflation targeting? ................................ ................................ ................................ .............. 7
4.4.1. Constrained discretion ................................ ................................ ................................ ................. 8
4.4.2. Flexible versus strict inflation targeting ................................ ................................ ........................ 8
4.4.3. Definition of inflation targeting ................................ ................................ ................................ .... 8
4.4.4. Characteristics of the framework ................................ ................................ ................................ . 8
4.4.5. Preconditions................................ ................................ ................................ ............................... 9
4.4.6. Features of inflation targeting countries................................ ................................ ..................... 10
4.4.7. Factors influencing the adoption of inflation targeting ................................ ............................... 11
4.4.8. Advantages ................................ ................................ ................................ ................................ 12
4.4.9. Criticism ................................ ................................ ................................ ................................ .... 12
4.5. Operational framework ................................ ................................ ................................ .................. 15
4.5.1. Results ................................ ................................ ................................ ................................ ....... 15
4.5.1.1. Inflation ................................ ................................ ................................ ............................ 15
4.5.1.2. Real economy ................................ ................................ ................................ .................... 15
4.5.1.3. Cost of disinflation................................ ................................ ................................ ............. 16
4.5.1.4. Interest rates and exchange rates ................................ ................................ ...................... 16
4.5.2. Defining the target ................................ ................................ ................................ ..................... 16
4.5.3. Decision-making process ................................ ................................ ................................ ............ 17
4.6. Emerging market economies ................................ ................................ ................................ .......... 17
4.6.1. Characteristics ................................ ................................ ................................ ........................... 18
4.6.2. Implementation of inflation targeting ................................ ................................ ........................ 19
4.7. Inflation targeting during the financial crisis of 2008................................ ................................ ....... 20
4.7.1. Performance ................................ ................................ ................................ .............................. 20
4.7.2. Empirical research ................................ ................................ ................................ ..................... 20
4.8. Case study: Chile ................................ ................................ ................................ ............................ 21
4.9. Case study: Turkey ................................ ................................ ................................ ......................... 22
4.10. Comparison ................................ ................................ ................................ ................................ ... 24
4.11. Conclusion ................................ ................................ ................................ ................................ ..... 24
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5. Conclusion ................................ ................................ ................................ ................................ .............. 24
6. References ................................ ................................ ................................ ................................ .............. 25
6.1 Scientific articles ................................ ................................ ................................ ............................ 25
6.2 Non-scientific articles ................................ ................................ ................................ ..................... 27
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1. IntroductionIn this paper a comprehensive overview of the content and the main structure of the master thesis on inflation
targeting in emerging market economies, to be written in the next academic year, will be given to the reader.
To be able to set up this structure, it was necessary to consult the extensive literature on inflation targeting.
After reading a selected part of the literature, a first insight in inflation targeting was obtained and different
topics within the field of inflation targeting in emerging market economies could be identified.
Based on these topics, it was possible to build a structure. The result is a well-balanced structure, which starts
by giving an overview of existing monetary policy frameworks, continues with an in-depth study of inflation
targeting in general and, later on, particularly of inflation targeting in emerging market economies. In a further
stage, a case study will be made on the Chilean and Turkish experience with inflation targeting. To conclude, a
comparison will be made between the two experiences in an attempt to identify the success factors and pitfalls
of inflation targeting in emerging market economies.
The structure of this paper is as follows. In the second paragraph, the ideas covering inflation targeting will be
given and the research questions will be identified. This part will also include a description of the methodology
that will be used to write the master thesis. In the third paragraph the structure of the master thesis will be
given. The extensive fourth paragraph justifies the structure presented in the third paragraph. In thisparagraph, a discussion of each major topic is included. In this way, the paper can already be seen as a concise
overview of inflation targeting in emerging market economies, of which the master thesis will be an extension.
The last paragraph concludes.
2. Inflation targeting in emerging market economiesAt the beginning of 2011, 27 countries had adopted inflation targeting and only three countries have
abandoned the regime (Hammond, 2011, p. 1). Crucially these exits are not due to a bad performance of the
framework. Finland, Spain and Slovakia are no longer inflation targeters because they entered the euro zone
(o.c., 2011, p. 7).
In the search for a nominal anchor for inflation expectations, three possible frameworks can be distinguished.
Central banks can decide to anchor inflation expectations by targeting the exchange rate, inflation or money
supply growth. Influencing inflation expectations of private agents is very important, as private agents are not
interested in the inflation level of next week. Instead they are more interested in knowing the inflation level on
the medium term (Svensson, 2010b, p. 3). Moreover, current inflation influences the inflation expectations, as
private agents adapt their expectations based on current inflation(Meeusen, 2006, p. 286). If the inflation level
is very high, private agents will expect inflation to rise even more. Therefore, it is of great importance to
influence the inflation expectations (Meeusen, 2006, p. 272).
The money supply growth was targeted under the regime of monetary targeting. In this framework, the
inflation was controlled by targeting the money supply growth. However, due to financial innovation and
deregulation, the framework became less attractive, as the relationship between money supply growth andinflation had become unstable in the 1980s. Afterwards, most countries applied exchange rate targeting. But in
the beginning of the 1990s fixed exchange rates seemed unbearable. Therefore countries preferred to abandon
a pegged exchange rate, opted for a floating exchange rate, and adopt inflation targeting (Hammond, 2011, pp.
5-6).
Most countries adopt nowadays inflation targeting. Countries adopt the framework for different reasons
(Ptursson, 2005). Some countries are forced to switch from an exchange rate peg towards inflation targeting
due to speculative attacks on their currency, which makes it difficult for the central bank to maintain the
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exchange rate peg. Others adopt inflation targeting because they encounter increased incompatibility between
the ultimate goal of price stability and the official anchor. Other central banks implement inflation targeting
gradually.
However, in the literature it is unclear whether inflation targeting is the best option. As set out in Taguchi et al.
(2010, p. 2), it is generally accepted that advanced countries perform better under this framework. However
for emerging market economies the outcomes are unclear, as they face higher inflation levels, which are moredifficult to control. Moreover, output is more volatile (Fraga et al., 2003, p. 4). Issing (2004, p. 171) states that
the performance of emerging market economies is often worse than in advanced economies due to bad fiscal
policies.
The master thesis will try to provide an extensive overview of inflation targeting for emerging market
economies and an attempt will be made to formulate a clear answer on the questions raised hereafter: Is the
inflation targeting framework the most preferable monetary policy for emerging market economies? Does
inflation targeting have the same outcome in emerging market economies as in advanced economies? The
adoption of inflation targeting and the resulting effects in two emerging market economies will be compared,
namely in Turkey, where inflation targeting was not always a success and Chile, where the framework
performed quite well. Which effects were responsible for the success in Chile and the failure in Turkey? Based
on these outcomes, a general conclusion will be drawn on the success factors and pitfalls of the framework.
The methodology to be followed is mainly an extensive literature study, combined with two case studies on
inflation targeting in Chile and Turkey. Moreover, a small empirical research will be performed on the
performance of emerging market economies that were inflation targeters during the financial crisis of 2008.
The outcomes will be compared with the performance of inflation targeting advanced economies during the
same period. In this way, a conclusion can be made on whether the emerging market economies performed
better than the advanced economies during the financial crisis of 2008. More details on the proposed
methodology can be found in paragraph 4.7.2.
3. Structure1. Introduction2. Goals of macroeconomic policy3. Monetary policy: alternatives
3.1 Exchange rate targeting3.2 Monetary targeting3.3 Other
4. What is inflation targeting?4.1 Constrained discretion4.2
Flexible versus strict inflation targeting4.3 Definition of inflation targeting
4.4 Characteristics of the framework4.4.1 Announced numerical inflation target4.4.2 Price stability4.4.3 Intermediate target using all relevant information4.4.4 Forward looking4.4.5 Transparency4.4.6 Accountability
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11. Conclusion12. References
4. Justification of the structure4.1.IntroductionIn the introduction the main structure of the master thesis is built up. Moreover, the research questions are
listed. To introduce the concept of inflation targeting the importance of low and stable inflation will be
highlighted, as this promotes economic growth and efficiency in the long run. In addition, an attempt will be
made to give a comprehensive definition of inflation targeting.
4.2. oals of macro-economic policyThis chapter will be very short and will discuss the goals of macroeconomic policy. Krugman & Obstfeld (2009,
pp. 503-505) state that countries pursue both internal and external equilibrium. To realize the internal
equilibrium, the government wants employment as close to its full employment level as possible. For example,
if the labor market is being characterized by an excess, this will result in an overheating of the economy. On theother hand, the central bank tries to ensure price stability. Therefore it has to control the growth of the money
supply. In this way, prices will remain at a moderate level.
Concerning the external equilibrium, the government has to guarantee a sustainable current account, not
necessarily requiring a current account in equilibrium. An example will explain this more clearly. A shortage can
be preferable if the country has attractive investment opportunities, as such investments generate revenues.
These revenues can be used to repay the loans afterwards. Inflation targeting countries set price stability as the
primary goal of macro-economic policy. Thus, the inflation and the monetary targeting frameworks pursue
primarily an internal equilibrium. Exchange rate targeting focus more on obtaining a sustainable current
account.
4.3.Monetary policy: alternativesIn this chapter, alternatives to inflation targeting will be discussed. Two main alternatives exist, namely
monetary targeting and exchange rate targeting. Both have their own rules, advantages and disadvantages. In
the master thesis a more detailed discussion will be provided on this topic. A strong focus will be put on the
shortcomings of these frameworks, which cause inflation targeting to be the most widely adopted monetary
policy.
Kadiolu et al. (2000, pp. 5-9) give an elaborate overview of the existing alternatives. First of all, exchange rate
targeting will be explained. In this approach, the central bank pegs it exchange rate to the exchange rate of a
large country which has low and stable inflation and conducts an independent monetary policy. This framework
results in a lower inflation level in the exchange rate targeting country and will make it easier to sustain this
lower inflation level. This regime involves a very clear monetary policy. If the central bank fears the currencywill depreciate (appreciate), the monetary policy will be strengthened (loosened). Further on, fixing the
exchange rate effectively anchors the inflation expectations, which are an essential determinant of the interest
rates. Moreover, this regime avoids the time-inconsistency trap. The time-inconsistency trap means that
policymakers pursue an overly expansionary monetary policy in the short-run, which will in the long-run lead to
an increase in input prices.
However, some disadvantages can be recognized as well. By pegging the exchange rate, the central bank
cannot adopt its own policy. It always has to undergo the monetary policies set out by the foreign central bank.
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Thus, if an external shock disturbs the foreign economy, the central bank of this foreign country will take
appropriate action to mitigate the effects of the external shock. These actions will also influence the economy
in the exchange rate targeting country, even if this country is not affected by this external shock. Furthermore,
a speculative attack on the currency leads to increased financial fragility. Such an attack results in a devaluation
of the currency. This will increase inflation and inflation expectations, which will lead to higher interest rates
and lower cash flows for the firms. This will in the end cause a deterioration of the firms balance sheets. A
speculative attack makes it often difficult to maintain the exchange rate peg. In the past, this was often amotive for countries to adopt inflation targeting, as already pointed out in paragraph 4.1. Furthermore,
investors will encounter a lower risk as the exchange rate is fixed to another exchange rate. This will lead to
more lending. Exchange rate targeting performs poorly in stabilizing the inflation (Svensson, 2007, p. 3). Finally,
the domestic exchange rate will fluctuate less. This means that it is more difficult for the central bank to
recognize an overly expansionary monetary policy. If the central bank has serious concerns that it pursues an
overly expansionary policy, it can correct its policy. However, as the exchange rate is far less fluctuating, this
means that the central bank is not able to detect an overly expansionary monetary policy. Exchange rate
targeting has been abandoned as the international capital flows increased and a misaligned exchange rate
made it difficult to defend the currency against speculative attacks on the currency. Finally, this framework was
less able to stabilize inflation (Svensson, 2010b, p. 6).
A second alternative to inflation targeting is monetary targeting. In this framework , the central bank targets themoney supply growth to anchor inflation expectations. Under this framework, it is far easier to deal with
external shocks in the domestic economy, whereas this is virtually impossible under the framework of
exchange rate targeting. Again, the time-inconsistency trap can be easily avoided in this framework. Monetary
targeting has been quite successful. However, two preconditions have to be distinguished, whose existence
determine whether the framework will be successful or result in a failure. First of all, it is of great importance
that the targeted monetary aggregate can be controlled by the central bank. If the monetary aggregate is not
within the central banks control, the central bank is una ble to take appropriate actions to mitigate the effect of
an external shock. The second precondition is that the target variable must be a determinant of the goal, which
can cause problems. As already stated in paragraph 4.1, the relationship between money supply growth (the
targeting variable) and inflation was not stable, which incited countries to adopt inflation targeting (Ptursson,
2005). The Bundesbank used the monetary targeting framework for a long time, but missed the target several
times to ensure meeting its inflation target (Svensson, 2007, p. 3). Svensson argues therefore that the
Bundesbank is more an indirect or implicit inflation targeter (Svensson, 2010b, p. 5). The problem encountered
by the Bundesbank in this case will be further discussed in paragraph 4.4.5.
Two other monetary policies exist that are variations on exchange rate targeting: crawling peg and target zone.
In those frameworks, the exchange rate is not fully floating and often other variables are targeted. As will be
discussed in paragraph 4.4.5, it is essential that the public can clearly distinguish which objective will be
pursued if a conflict exists between the objectives (Masson et al., 1998, p. 35).
Generally, one can argue that inflation targeting and the flexible exchange rate framework perform better than
fixed exchange rate targeting if the economy faces a real shock. However if the country is hit by a nominal
shock, the fixed exchange rate targeting regime performs better (Loayza et al., 2002, p. 8).
4.4.What is inflation targeting?This chapter will be the most extensive one and gives a broad overview of the concept. As already discussed in
paragraph 2, the purpose of the thesis is to determine which factors are responsible for the success or failure
of the policy. Therefore, an attempt will be made to point out the differences and the similarities in the
implementation, results of the framework in both advanced and emerging market economies.
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4.4.1. Constrained discretionAs Bernanke et al. (1999, p. 298) already stated, inflation targeting cannot be classified as either rule or
discretion. Therefore, in the literature inflation targeting is being defined as a framework with constrained
discretion, in which the inflation target can be seen as the constraint. Inflation targeting is discretionary as the
central bank has the flexibility to determine how they react to short-term disturbances in output and financial
stability in its monetary policy (Bernanke et al., 1999, p. 298; Lucotte, 2010, pp. 2 -3; Hammond, 2011, p. 5).
4.4.2. Flexible versus strict inflation targetingFlexible inflation targeting means that the central bank tries to stabilize both inflation and the real economy
(more precisely output), whereas strict inflation targeting only stabilizes inflation. Flexible inflation targeting
performs better than strict inflation targeting if it focuses on forecasts of inflation and the real economy. These
forecasts take the time lags between the actions of the central bank and the final effect on inflation and the
real economy into account. Therefore flexible inflation targeting performs better and is often called forecast
targeting. Based on these forecasts, the central bank will choose an appropriate policy-rate path which will lead
to stable inflation and a real economy performing around a normal level (Svensson, 2010a, p. 1; Svensson,
2010b, p. 13).
In practice, strict inflation targeting is currently not adopted by any country (Svensson, 2010b, pp. 1-2).
4.4.3. Definition of inflation targetingThis paragraph will try to give a definition and the objective of inflation targeting.
Brdsen et al. (2001, pp. 452-453) define inflation targeting as the setting of the policy instrument, which is the
short-term interest rate for inflation targeting, to control the inflation forecast targeting. Therefore, the central
bank needs to understand how this short-term interest rate influences the inflation forecasts. Econometric
research in Norway performed by Brdsen et al. (o.c., p. 453) showed that the short-term interest rate
effectively influences the inflation rate. An increase in the short-term interest rate of 1 % leads to a decrease in
the inflation of 0.4%.
The objective of inflation targeting is defined by Svensson (1999a, p. 625; 2010b, p. 2) as a quadratic loss
function . This function is equal to the sum of the squared difference between inflation and the inflation
target (also called the inflation gap ) and a weight times the squared difference between actual
and potential output (also called the output gap ) or algebraically:
The goal is to minimize the deviation from the inflation target or .
Some functions take into account the policy rate changes as well. At the moment of initial adoption of the
framework, the central bank still needs to build credibility. Thus, the most weight will be put on stabilizing
inflation. Later on, if credibility has been won by the central bank by realizing disinflation, the central bank will
focus more on output stabilization.
4.4.4. Characteristics of the frameworkIn a first paragraph, the main features of inflation targeting are explained. In the literature a general consensus
exists on these characteristics. Bernanke et al. (1999), Mishkin (2000), Svensson (2007), Svensson (2010b),
Horvath (2011) all list the same characteristics. The central bank announces a numerical inflation target some
years in advance to pursue price stability, which is the central banks primary goal. Mishkin (2001, p. 1) cites a
definition of price stability. Price stability implies a rate of inflation that does not have to be taken into account
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in making economic decisions. Therefore, the inflation rate needs to be relatively low. Mishkin (ibidem) states
that an inflation between 0 and 3 % satisfies this definition. However, more specific features need to be
defined, as even non-inflation-targeting central banks announce an inflation target. The European Central Bank
announces an annual inflation target of below, but close to 2 %. However, the ECB is not an inflation targeter
(Svensson, 2000b, p. 7).
One of the difficulties is that inflation is influenced by a lot of variables, which makes it more difficult todetermine an intermediate target, which is the determinant for monetary policy. Therefore, a second specific
characteristic is that models need to be designed that use all relevant information to make forecasts of the
target variables. Alternatives to inflation targeting, such as exchange rate targeting and money supply
targeting, do not face this problem, as they respectively peg an exchange rate or target the money supply.
Inflation targeting focuses therefore on inflation forecasts, which is more effective as a monetary policy
decision influences the target only after some time lag. This means that the monetary policy is forward-looking,
which is better than a reactive policy. This is consistent with the definition of Brdsen et al. (2001, pp. 452-453)
in paragraph 4.4.3. It is clear that the inflation forecasts are very important in order to control inflation.
Another characteristic of inflation targeting is that the transparency of the monetary system is higher because
all central banks publish reports on inflation forecasts. Furthermore, most countries give motivations for their
policy decisions and information on future policy decisions. In case of a deviation from the target, the centralbank needs to account for this deviation. In countries, such as the UK, Turkey, Thailand, Serbia the central
bank needs to formulate the actions it will take to reach the target in an open letter. However, this is the case
in few countries. Most countries does not have to account from deviations in an open letter (Svensson, 2010b,
p. 2; Hammond, 2011, p. 15).
All these reports make the central bank more credible and if the inflation expectations are close to the inflation
target, the credibility of the central bank will rise further. If the central bank has a desirable degree of
credibility, it succeeded already somewhat in anchoring the inflation expectations, meaning that in fact the
inflation has already been stabilized to some extent (Svensson, 2010, p. 3).
The last generally accepted characteristic is accountability of the central bank. As the central bank announces
an inflation target, it is almost obliged to match the target. If the target is missed, the central bank isaccountable towards the public. However, missing the target does not necessarily mean that the credibility of
the central bank will decline. If the central bank gives sufficient disclosure on the reason of missing the target
to the public, the credibility of the central bank is not necessarily undermined (ibidem).
In Loayza et al. (2002, p. 3) the absence of fiscal dominance is assumed to be a characteristic of inflation
targeting. Not pursuing different monetary objectives at the time is seen as a characteristic as well. However, in
literature a general consensus exists that these two conditions should rather be seen as prerequisites to a
successful implementation of inflation targeting, as will be explained in paragraph 4.4.5.
In the literature, nowhere has a distinction been made between characteristics of the framework adopted in
advanced and emerging market economies.
4.4.5. PreconditionsTo design the ideal situation for adopting inflation targeting, it is of great importance to know the prerequisites
that are essential to the success of the inflation targeting regime. This paragraph will discuss the most
important preconditions to the framework based on literature from Mishkin (2000), Kadiolu et al. (2000),
Masson et al. (1998) and Svensson (2010b, p. 48).
It is of great importance that the central bank is both independent as well as accountable for missing a target.
Moreover, it should be clear that the primary goal of the central bank is to guarantee price stability (Lucotte,
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2010, p. 3). Kadiolu et al. (2000, pp. 18-20) state that the central bank should have instrument independence,
so that it is free to determine the instruments which it uses to conduct its monetary policy. In the case of
inflation targeting, the central bank will reduce deviations from the target by changing the nominal interest
rate (Loayza et al., 2002, p. 7). Absence of fiscal dominance and a strong financial system are indispensable
elements for central bank independence.
Mishkin (2000, p. 107) points out some preconditions based on the disadvantages he discusses, of which anoverview can be found in paragraph 4.4.9. First of all, he thinks it is necessary that the government does not
control prices of some goods as this makes it even more difficult to control inflation. Another possibility is to
exclude the goods of which the prices are being controlled by the government from the basket of goods on
which the index price is calculated.
Furthermore, Mishkin states it is important to limit fiscal debt, for the reasons stated in paragraph 4.4.9.
Therefore, it can be desirable to establish an institution that controls the government expenditures. To avoid a
financial crisis caused by exchange rate fluctuations a strong financial system is needed. This idea is confirmed
by Loayza et al. (2002, pp. 9-10), as it is said that the central bank needs to make sure that the exchange rate is
not misaligned. Loayza et al. add that once the framework has been implemented fiscal imbalances need to be
avoided, because this leads to output instability.
Masson et al. (1998, p. 35) define that to avoid fiscal dominance the government should raise taxes and should
not rely on the revenues of seignorage. Seignorage is the revenue that arises for the government due to the
issue of extra money to monetize the fiscal debt via a devaluation of the currency. Moreover, well-developed
models to make forecasts are also needed to set the target efficiently (Svensson, 2010b, p. 48).
Furthermore, Kadiolu et al. (2000, pp. 18-20) and Svensson (2010b, p. 48) argue that it is possible that next to
the inflation target, other variables are targeted, such as GDP growth, the exchange rate, etc. However, if a
conflict arises between those targets, it should be clear which target is the primary target (Masson et al., p. 35),
which raises the transparency and credibility of the central bank.
Mishkin (2004, pp. 6-14) adds that a strong fiscal and financial system and reliable monetary institutions are
indispensable in making inflation targeting work. If the financial system is weak, investors will not invest in
securities issued by the emerging market economies, unless the investors are risk-lovers. However, the
majority of investors will dump these securities or simply not buy them, which is called a sudden stop. This
phenomenon will be discussed in detail in paragraph 4.6.
Lucotte (2010, p. 3) adds that to ensure good inflation forecasts well-developed econometric models are
needed to forecast inflation. In addition, he also states that it is better to adopt inflation targeting after some
disinflation has been achieved.
4.4.6. Features of inflation targeting countriesThis paragraph overlaps with the former paragraph. However, this section discusses characteristics of the
countries that adopt inflation targeting, while the previous section lists preconditions that need to be fulfilled
to be successful in inflation targeting. This means that these preconditions can be considered characteristicsof the inflation targeting countries. However, the following paragraph describes features that are not
necessarily prerequisites of inflation targeting. An example will explain this: most inflation targeting countries
have a high GDP, however this is not a precondition. It is possible that a country with a small GDP is successful
in inflation targeting as well.
Ptursson (2005, pp. 13-15) lists some features by which countries that adopt the framework of inflation
targeting are characterized. The countries are more open, making them more vulnerable for external shocks.
Furthermore, the government debt is usually lower. As stated in paragraph 4.4.5, the absence of fiscal
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dominance is critical for the success of the regime. Therefore, it is logical that countries under inflation
targeting have a lower government debt to avoid fiscal dominance. Furthermore, these countries usually have
a higher GDP, except for the emerging market economies. Finally, Ptursson states that the more independent
a central bank is, the higher the pro bability of adopting inflation targeting.
Kadiolu et al. (2000, p. 21) add that these countries mostly apply fully floating exchange rates and use the
short-term interest rate as instrument. The monetary policies are forward-looking as the inflation target isdetermined by focusing on the inflation expectations. Furthermore, inflation targeting countries adopt the
framework only after they have already realized some disinflation. Masson et al. (1998, pp. 35-36) give an
economic rationale for this. If the countries adopt the framework when they face high inflation levels, the
inflation will need to be lowered substantially. Therefore, the central bank will announce a lower inflation
target, but it risks here that the target will be missed as higher inflation is more difficult to control. On the
other hand, the central bank could opt for lowering the inflation in little steps and announce a high target, but
the public will not accept this target and lose confidence in the central bank, which will lower the credibility of
the central bank.
Furthermore, inflation targeting countries typically have more domestic currency denominated bonds in their
portfolio, in contrast to countries that target for example money-growth (De Paoli et al., 2010, p. 3). The reason
is very simple. If the country is hit by an adverse real shock, which increases the inflation, this will lead to adomestic currency appreciation. This can be explained quite easily: as the inflation has risen, the central bank
needs to raise the nominal interest rate to offset the rise in inflation. A rise in the interest rate will lead to a
currency appreciation. If the domestic currency appreciates, the domestic currency denominated assets of the
investors will have a higher value. Therefore, the portfolio will consist of more domestic bonds denominated in
the domestic currency (De Paoli et al., 2010, pp. 19-20).
If however the country encounters a monetary expansion, the domestic currency will depreciate. A monetary
expansion leads to a decrease in the domestic nominal interest rate. This decline increases the domestic
consumption, causing a higher demand for money. Due to the higher demand for money, the price level
increases in the long run, which leads to a domestic currency depreciation. As the portfolio of the investors in
inflation targeting countries consists mainly of domestic currency bonds, this depreciation will reduce the value
of the assets of the investors and leads to a decrease in the net external wealth position of the country. Hence,a monetary expansion can be seen as beggar-thy-self policy (De Paoli, 2010, pp. 21-22).
4.4.7. Factors influencing the adoption of inflation targetingLucotte (2010) makes an interesting study on the circumstances which influence the adoption of inflation
targeting. He argues that the more independent a central bank is, the more probable it is that the country will
adopt inflation targeting, which was already stated in paragraph 4.4.6 as well. In this way, the central bank will
not pursue an overly expansionary monetary policy, due to which the inflation will increase. In addition, an
independent central bank will be less tempted to finance the fiscal debt (Lucotte, 2010, pp. 4-5).
Another influencing factor is the number of people that participate in the decision process in politics, also
called the number of veto players. If this number is high, this means that a high number of people can block a
decision and that if a decision has been taken, that it cannot be reversed easily. This means that the power to
make decisions is more fragmented and therefore, the central bank will not suffer from a high degree of fiscal
dominance, which will incite the country to adopt inflation targeting (Lucotte, 2010, pp. 7-8). Moreover, if a
country is highly decentralized, the central bank will be more independent as well, because the different parts
can be seen as additional veto players (Lucotte, 2010, pp. 8-9).
Furthermore, a strong banking system is important. Lucotte (2010) gives 5 reasons put forth in the literature.
First of all, if the banking system is strong the banks will adopt the monetary policy set out by the central bank.
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If however, the banking system is weak, it is possible that the banks misunderstand the monetary policies
conducted by the central bank and in this case, the monetary policy transmission mechanism does not work
properly. The transmission mechanism is the mechanism that describes how the conducted monetary policy
influences the inflation expectations and the aggregate demand via the effects on short-term real interest rates
and exchange rates (Svensson, 2000a, p. 158). Secondly, if the banking system is weak, it will be more difficult
for the central bank to raise the interest rates, as this tarnishes the profitability of the banks and could lead to a
collapse. Therefore, the central bank will opt not to raise its interest rates and will miss easily the target.Thirdly, a weak financial system raises the probability of a sudden stop. Together with the phenomenon of
liability dollarization, this will lead to the depreciation of the currency. Finally, if the financial system is strong,
no incentives to finance the public debt can be identified (Lucotte, 2010, pp. 5-6). So, according to the
literature, the stronger the banking and financial system, the more it is probable that the inflation targeting
framework will be implemented by the country concerned. However, Lucotte succeeds to weaken this
argument and could deduct out of his econometric research that this relationship does not hold true (Lucotte,
2010, p. 26).
Another misconception, according to Lucottes survey, is that a country will be more likely to adopt inflation
targeting if the political environment is more stable, as this would have a positive impact on the independence
of the central bank (Lucotte, 2010, pp. 6-7, 26).
4.4.8. AdvantagesIn this chapter an analysis of the advantages of inflation targeting will be made. It seems important to indicate
these advantages, as it is essential in promoting the inflation targeting framework.
Mishkin (2000, pp. 105-106) puts forth some advantages of inflation targeting. In fact, the two main
advantages are simply shortcomings of exchange rate and monetary targeting. As already mentioned in
paragraph 4.3, for central banks that peg their exchange rate it is impossible to pursue their own monetary
policy. Inflation targeting countries can set their own policy and act to mitigate the undesired effects of
external shocks in the domestic economy.
One can argue that monetary targeting has this advantage as well, but the success of monetary targeting
depends on the relationship between money growth and inflation. If this relationship is not stable, monetary
targeting will fail. In the framework of inflation targeting this problem is not encountered, as an intermediate
target is used that is determined based on as much available information as possible. Thus, as Ptursson (2005,
p.8) states, inflation targeting is a best of worlds-solution.
Mishkin (2000) argues that inflation targeting is very transparent because it can easily be understood by the
public by publishing inflation reports. In addition, this framework improves the accountability of the central
bank, as it clearly states that price stability is the primary goal and it announces a numerical inflation target. If
the central bank avoids a history of missing the target, inflation targeting can be named a success.
A last advantage is that the time-inconsistency trap can be avoided, as inflation targeters emphasize that they
want to control inflation in the long run. An overly expansionary monetary policy, due to pressures from
politicians for increasing output growth or diminishing unemployment, will not be carried out because the
primary goal under the inflation targeting framework is clearly price stability.
4.4.9. CriticismTo give a well-balanced exposition, it is important to also discuss criticism expressed on the inflation targeting
framework. A good overview of the disadvantages of inflation targeting can be read in Ptursson (2005, pp. 49-
56). Ptursson formulates each time a counterargument.
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First of all, one can argue that the framework is not flexible because it does not pay enough attention to
evolutions in the real economy, as it should only focus on the inflation level. In this way inflation targeting
would be responsible for a decline in the growth rate of the economy and more pronounced variations in the
business cycle. Ptursson argues that since an intermediate target is being used and since the target is
announced on a medium-term basis, inflation targeting is in fact a very flexible framework.
On the other hand, Ptursson indicates that some people state that the framework is too flexible, due to thefact that for defining the target all relevant information is used. This would lead to higher inflation, because it is
too difficult to control inflation in a proper way. Ptursson formulates a counterargument relating to two
specific characteristics of the inflation targeting framework, namely accountability and transparency. These
two characteristics make that a central bank considers discipline to be very important, which facilitates
controlling inflation.
Secondly, some preconditions are indispensable to the success of the framework. Ptursson argues that some
countries adopted inflation targeting without satisfying these preconditions. So Ptursson is not convinced of
the value of these preconditions. As will be discussed later on, it is not necessary to fulfill all preconditions.
However, a major part of the preconditions named in paragraph 4.4.5 should be fulfilled.
Thirdly, it is said that due to transmission lags the effect of monetary policy on inflation can only be seen after
some time, which means that inflation is very difficult to control. In addition, the length of the lag is dependent
on the business cycle and on the credibility of the central bank. Ptursson points out that in other monetary
policies these transmission lags cause problems as well. However, he admits that central banks of emerging
market economies that target inflation face more difficulties to influence and forecast inflation. It is for
example possible that the government fixes the prices of some goods. If these goods are enclosed in the basket
of goods, which prices are used to calculate the price index, a bias in the price index can exist and the real rate
of inflation can differ significantly from the inflation reflected by the price index.
Svensson (1996, p. 26) argues that controlling inflation is not easy due to the lags in the transmission
mechanism as well. The instrument reacts only after some time to the monetary policy. Therefore, it can be
difficult to reach the inflation target, as at the time the instrument reacts to the policy, other economic
circumstances may exist. Svensson states that this problem can be solved by using inflation forecasts. In thisway, the instrument will be set so that the inflation forecast equals the target and the target will be reached
more easily.
The last criticism treated in Ptursson (2005, pp. 51-54) is the high volatility of the exchange rate. This poses a
big problem in emerging market economies, as the financial system is often very weak and loans from foreign
investors are very common. The latter often means that the balance sheet is denominated in a foreign
currency, which makes the country very vulnerable for sharp fluctuations in the exchange rate. If the domestic
currency depreciates, the currency in which the foreign debt is denominated appreciates. This will make it
more difficult to repay the debt and can even lead to a financial crisis in the domestic country. Ptursson
admits this problem and warns for focusing too much on the exchange rate because this will evolve towards an
exchange rate targeting regime. Thus, he states that modest fluctuations in the exchange rate are preferable.
Mishkin (2000, pp.106-107) and Kadiolu et al. (2000, pp. 11-13) distinguish the following disadvantages:
(1) The framework is too rigid. However, one can argue that constrained discretion is a better term, as the
framework does not provide nice rules to apply in reaction to shocks. The central bank has to use all available
information to conduct its monetary policy (Kadiolu et al., 2000, p. 13).
(2) There is too much discretion in the framework, which will incite policy makers to pursue an overly
expansionary monetary policy. Again, one can refer to the term constrained discretion as transparency is one
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of the main characteristics discussed in paragraph 4.4.3 and makes it tempting for the central bank to follow an
overly expansionary policy (Kadiolu et al., 2000, p. 13).
(3) There is increased output instability.
(4) Economic growth diminishes.
(5) As inflation is hard to control due to the transmission lags, the central banks accountability is weak. Thisdisadvantage is of great importance for emerging market economies, because these economies are
characterized by higher inflation levels, which involve a higher possibility of large forecast errors and frequent
target misses. Further on, in emerging market economies, prices of goods are more government controlled
than in advanced economies, which makes it even more difficult to control inflation, as the inflation level is
biased due to these government controlled prices (Kadiolu et al., 2000, p. 12).
(6) Inflation targeting does not prevent fiscal dominance, because the government is not prevented from
pursuing an irresponsible fiscal policy. In this case, the government has to repay the debt or erode the debt
through a depreciation of the exchange rate, which will lead to a higher inflation and missing the target.
(7) As inflation targeting involves floating exchange rates, the framework will lead to financial instability, if the
financial system is weak. However, Mishkin notes that the central bank should not pay too much attention onthe exchange rate; otherwise the central bank adopts the exchange rate targeting framework.
Mishkin argues that the first 4 disadvantages do not occur in reality if the framework is properly implemented.
It can be concluded that generally Mishkin, Kadiolu et al. and Ptursson recognize the same disadvantages.
Hammond (2011, pp. 16-17) gives some challenges for inflation targeting. The first challenge that has been
pointed out is that typically inflation targeting succeeds in guaranteeing stable and low consumer prices.
However, as the financial crisis in 2008 has dramatically shown, the asset prices, for example housing prices,
can vary extremely. Inflation targeting should in the future focus more on less volatile asset prices. This could
be done by targeting the inflation over a longer time horizon.
Secondly, related to the first challenge, it is questioned whether these asset prices should not be excluded from
the inflation measure, as they are more volatile. Furthermore, one can argue that only domestic inflation
should be included in the inflation measure, to avoid imported inflation.
Hammond adds that one should be aware of deflation as this implies interest rate cuts towards the zero bound.
If on top, the economy is in a recession, it is possible that the economy faces the liquidity trap. This occurs
when further expansionary monetary policy is needed due to the recession, but this is impossible as the
interest rate is set close to 0% (Loayza et al., 2002, p. 10). In this case, non-conventional monetary policy has to
be executed, such as a foreign-exchange intervention to avoid currency appreciation, fixed-rate lending at
longer maturities etc. (Svensson, 2010a, p. 5).
In the light of the recent financial crisis, Svensson (2010a, pp. 4-6; 2010b, pp. 52-60) argues that monetary
policy is not the cause of the financial crisis, but rather weak supervision and regulation of the banking sector.
He adds that one should clearly see the difference between financial stability and monetary policy, which have
different objectives and different instruments to conduct their policies. Svensson argues however that both are
closely interrelated. Financial factors are indicators of the state of the economy and have an impact on the
target variables, i.e. inflation and the real economy (Svensson, 2010a, p. 2). Therefore, more research should
be done on the influence of these financial factors on inflation and the real economy.
Moreover, instead of inflation targeting the price-level could be targeted as well. Advantages of this approach
are that the price-level can be forecasted with a lower risk of making a wrong forecast and that price-level
targeting automatically stabilizes the economy. If the price-level falls below the target, inflation expectations
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increase, while the nominal interest rate remain the same. Due to the rise in inflation expectations, the real
interest rate will decrease, which will stimulate the economy. In this way, the price-level will return to the
target. This is an interesting feature of price-level targeting when the price-level is low and risk of deflation
exists. In this case, automatic stabilization will take place and the classic liquidity trap can be avoided
(Svensson, 2010b, pp. 50-51). Moreover, price-level targeting results in lower long-run variability of the price
level, but higher short-run output and inflation variability than inflation targeting. This can be explained very
easily as under the inflation targeting framework higher-than-average inflation need to be followed by averageinflation, while under price-level targeting (in which the objective is to stabilize the price-level) higher-than-
average inflation should be compensated by lower-than-average inflation, leading to higher inflation variability
in the short-run and also higher output variability (Svensson, 1999b, p. 277). However, in the literature almost
no papers exist on the disadvantages of price-level targeting.
4.5.Operational framework4.5.1. ResultsSvensson (2010b, p. 4) argues that inflation targeting has generally succeeded in stabilizing output and
inflation. In addition, growth, productivity, employment and other measures of economic performance have
not been negatively affected after the adoption of inflation targeting in the particular country.
This section in the master thesis will give an overview of the results of inflation targeting based on empirical
research performed by different authors.
4.5.1.1. InflationFraga et al. (2003, p. 4) and Ptursson (2005, pp. 21-35) argue that a decrease in inflation in the inflation
targeting countries is being observed from the period the moment the countries adopted inflation targeting
until 2005. However, most countries adopt inflation targeting after they successfully realised some disinflation,
which makes it very difficult to conclude whether the decline in average inflation is due to a general trend or
due to the framework. Therefore, Ptursson carried out some further research and he found out that in
industrialized countries inflation targeting was primarily able to lock in the disinflation already achieved in
previous stages. In emerging marketing economies inflation targeting is able to reduce the average level of
inflation. Further on, Ptursson (ibidem) argues that inflation targeting leads to inflation stabilization.
Bernanke et al. (1999) state, in accordance to the arguments of Ptursson, that inflation targeting is only
responsible for a small proportion of the decrease in inflation. Inflation targeting lowers the inflation
expectations only after some time lag (Bernanke et al., 1999). This idea is confirmed by Svensson (2010b, p. 8,
10-11). However, Svensson adds that the effect in emerging market economies is significant and that inflation
expectations are more effectively anchored in those economies.
Hammond (2011, p. 7) points out that inflation targeting is mostly adopted when inflation was already low and
that inflation targeting is especially effective in anchoring the inflation expectations around the target and keep
the inflation low in this way.
4.5.1.2.Real economyPtursson (2005, pp. 35-38) and Svensson (2010b, p. 11) state that it is a general misconception that inflation
targeting is harmful for growth, because it would focus too much on inflation, thus undermining output
stability. Ptursson and Svensson argue that there is no evidence supporting this statement. Ptursson states
that it is difficult to express an opinion on this relationship as no country has yet adopted the framework for a
period of time that is long enough.
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4.5.1.3. Cost of disinflationThe well-known Phillips-curve shows clearly the trade-off between unemployment and inflation. If an economy
is characterized by high inflation, unemployment will be low. Further on, it can be argued that inflation is
procyclical and unemployment anticyclical (Meeusen et al., 2006, p. 275). Based on these two facts, one can
conclude that a decrease in inflation will involve a decrease in output (as inflation is procyclical) and an
increase in unemployment in the short run. In the long run, the trade-off disappears (Issing, 2004, p. 170).Thus, the loss in output and increase in unemployment are the costs associated with disinflation, also called the
sacrifice ratio (Bernanke et al., 1999). As inflation targeting leads to higher credibility of the monetary policy,
the expectations of the public will adapt more easily. Therefore, it is argued that inflation targeting reduces the
cost of disinflation. However, empirical research shows that the sacrifice ratio is not lowered because of
inflation targeting. This means that realizing a decline in inflation always implies a loss in output and an
increase in unemployment in the short run (Bernanke et al., 1999, p. 266).
4.5.1.4. Interest rates and exchange ratesWhen a country adopts inflation targeting the credibility of the central bank increases. Ptursson (2005, pp. 38-
43) argues that this lower credibility will lower inflation expectations and the inflation risk premium in the
nominal interest rate, which in turn will lead to a decrease in the nominal interest rate. Ptursson shows that
the fall in the nominal interest rate is however higher than what can be expected based on the theory.
Furthermore, exchange rate volatility is lower.
4.5.2. Defining the targetIt is of great importance that the target is defined properly because an unrealistic target will not contribute to
the credibility of the central bank as the probability of missing the target is quite high. For example, if inflation
in a particular country is 15 %, it would be unrealistic to target an inflation rate of 2 % next year. This will
definitely lead to a failure and will decrease the credibility of the central bank. Therefore, it seems appropriate
to include a paragraph on defining an appropriate target in the master thesis.
First of all, the central bank needs to find out how it is going to measure the inflation: based on headline CPI or
another measure. It is possible that the central bank measures inflation based on the prices of a basket ofgoods in which food and energy prices are excluded to eliminate the most volatile prices, called core CPI.
Mostly, headline inflation is used to determine the target. However, in some developing economies the CPI
basket of goods consists of 40 % food. Excluding food from the basket would not give a good measure of
inflation. In this case, headline inflation is preferable. Another possibility is to use the GDP Deflator. H owever,
this measure is only published on a quarterly basis, while CPI is published on a monthly basis and is better
known by the public (Hammond, 2011, pp. 9-10). Mostly, the inflation targeting countries publish both core
and headline CPI.
Normally the target is announced for some years in advance and from time to time the target is revised. The
identity of the target setter is defined in institutional arrangements: in some countries the government sets the
target, in others the central bank is responsible for, like in Chile (Horvth, 2011, p. 4). It is also possible that the
central bank confers the target with the government.
The target is dependent on multiple determinants, such as past inflation, GDP growth, credibility... The central
banks define which determinant they judge to be important in setting the target. The main determinant in
Chile is deflation risk. If the Chilean central bank fears deflation, the target will be higher (Horv th, 2011, p. 4).
The target in emerging market countries is usually somewhat higher than in advanced economies.
Furthermore, the country needs to choose whether it will use a point target or a range. If the country opts to
target a point target, the central bank has to determine how much the actual inflation may deviate from the
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target, also called tolerance bands (Dotsey, 2006, p. 11). In addition, using a point target needs a very precise
monetary policy not to miss the target. On top, if the tolerance band is symmetrical, the central bank gives a
clear signal that it puts equal weight to avoiding inflation and deflation (Hammond, 2011, p. 10). If the country
handles an inflation range (which is very common), the range is wider (typically central target +/- 1 %) in
emerging market countries, because the economy is more volatile. The width of the target range depends on
the level of inflation and the inflation volatility. Thus, if both determinants are high, the width will be higher as
well. The target range in Chile was [2%; 4%] in 2008. Thus, the central target is 3 % and the width of the targetis +/- 1 % (Horvth, 2011, p.5).
Moreover, it is important to establish the right numerical value for the target. As already explained in
paragraph 4.4.2, inflation between 0% and 3% is considered to be desirable. These values are good candidates
for the numerical value of the target in developed countries. However, central banks must be aware of the risk
of setting the target too low. If the economy is then hit by a shock which decreases inflation, it is possible that
the economy suffers from deflation, which leads to financial instability as the nominal value of assets decline,
while that of debt remains unchanged (Mishkin, 2001, p. 1; Hammond, 2011, p. 8). Therefore, it is better to set
a positive inflation target as this reduces the risk of deflation. Bernanke (2004, p. 166) calls this positive
inflation target a buffer zone against deflation. In addition, the inflation measures overstate the inflation
typically by 0.5 % points. Targeting a positive inflation level corrects for this bias (Hammond, 2011, p. 8).
In addition, the target horizon needs to be defined. This is the time within which the target needs to be
reached (Svensson, 2010b, p. 41). This horizon is dependent on multiple factors. If for example the inflation
deviates a lot from the target, it is better to use longer target horizons to avoid target misses (Loayza et al.,
2002, pp. 12-13).
Svensson (2010b, p. 41) points out that in the past this target horizon was fixed, i.e. 2 years, whereas nowadays
the target horizon is on the medium-term. The central banks realized that the target horizon is dependent on
the state of the economy to determine the target horizon. Therefore, the target horizon is set more abstractly.
To conclude, the process to define the target is similar in all countries (Horvth, 2011, pp. 10-14).
4.5.3. Decision-making processUnder an inflation targeting regime, the central bank meets preferably on fixed dates to determine the
monetary policy and to decide on how to react on shocks by adapting the interest rate in such a way that the
inflation target is reached (Hammond, 2011, p. 10). The power of decision-making can be delegated to the
Board of the Central Bank or to a Monetary Policy Committee, consisting of experts on monetary policy. This
decision-making committee exists on average of 7 people and the number of people in this body is
independent on the size of the country. Normally, a decision is made based on voting or a consensus has to
exist in the committee (Hammond, 2011, pp. 10-11).
As stated in paragraph 4.4.2, one of the characteristics of the central bank is accountability. The central bank is
accountable towards the government and the public. To fulfill this characteristic, the central bank needs to
undergo governmental hearings and needs to publish open letters to account for its monetary policy and for
deviations from the target. Corrective actions need to be formulated in the open letters if the target is missed
(Hammond, 2011, pp. 14-15).
All publications and communications from the central bank towards the public include preferably an Inflation
Forecast Report, in which inflation, growth and other economic variables are predicted and justification for
policy decisions is given. On top, many central banks publish minutes of the meeting of the decision-making
body (Hammond, 2011, pp. 15-16).
4.6.Emerging market economies
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4.6.1. CharacteristicsThis part will try to describe the general macro-economic situation in the emerging market economies.
However, it is clear that emerging market economies are not as homogenous as advanced economies. Giving
some key characteristics of emerging market economies will be difficult for this reason. Nevertheless, an
attempt will be made to define these characteristics. These characteristics can help identify how the
implementation of the inflation targeting framework will differ from that of advanced economies, based on thedifferences between both types of economies.
Despite the heterogeneity of the emerging market economies, these economies rely more on indirect
monetary policy instruments, need to reform their financial sector and appeal more to the international capital
market (Masson et al., 1998, p. 36).
Fraga et al. (2003, p. 4) observed larger deviations from the target and these deviations occur more commonly
in emerging market economies.
Mishkin (2004, p. 3) describes some extra features. He states that emerging market economies may suffer from
weak fiscal, monetary and financial institutions. Often the financial institutions are not very strictly supervised
and regulated. It is possible that advanced economies face these problems as well, but to a lower degree.
These shortcomings can easily cause high inflation and currency crises.
A currency crisis will incite the people to switch to a foreign currency, which is also called a currency
substitution (Mishkin, 2004, pp. 4-5). In addition, it is common that the liabilities on the balance sheets of the
domestic firms are denominated in USD. This phenomenon is also called liability dollarization. Currency
depreciation is a decline in the value of a currency and makes it harder to repay the loans denominated in USD.
Typically, the assets are denominated in the domestic currency and due to the currency depreciation. The
assets will increase at a slower pace than the increase in worth of the liabilities. In addition, a currency
depreciation leads to higher inflation because of imported inflation due to higher import prices (Miskhin, 2004,
p. 22). As a consequence of this negative shock, the level of investment will decrease and this can lead to an
economic recession. Important detail is that in the balance sheets of emerging market economies, the
proportion of debt is substantially higher than the proportion of assets, which means that such a shock has
even more negative effects on the balance sheets (Mishkin, 2004, p. 8). This is the reason why emerging
market economies do not like exchange rate flexibility and are often still reluctant to adopt inflation targeting.
The last typical characteristic described by Miskhin (2004, pp. 5-6) is the phenomenon of a sudden stop, which
is a dry up of capital inflows in the capital market. Typically the elements causing a sudden stop are external to
the emerging market economies, e.g. the financial crisis in 2008, a crisis in the world financial institutions
Such a crisis makes it less attractive for investors to invest in risky securities of the emerging market economies
and these investors are more likely to invest in more prudent investments if the world economy is in a
recession. Such a sudden stop will also lead to a currency depreciation and cause an economic contraction, due
to the dynamics explained above in this paragraph.
Finally, it is possible that some emerging market economies operate under an IMF conditionality program, e.g.
Brazil. In this case, the implementation of inflation targeting is hampered because this program implies anupper limit on the central banks net domestic assets and a lower limit for the volume of net international
reserves held by the central bank. This floor and ceiling pose some problems. First of all, the lower limit on the
net international reserves means that the central bank cannot easily react on fluctuations in the exchange rate
if these can imply a target miss by using the international reserves because the IMF has set an explicit quantity
for the level of net international reserves. In addition, the IMF fixes the maximum amount of net domestic
assets based on a backward-looking mechanism, while the inflation target is set using forward-looking models
that estimate the future inflation. Thus, the central bank cannot execute a monetary policy in complete
freedom in this case (Loayza et al., 2002, pp. 12 -13).
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4.6.2. Implementation of inflation targetingBased on the characteristics analyzed above, it is clear that emerging market economies have weak institutions.
Therefore a reform program should be executed (Masson et al., 1998, p. 36).
A fiscal reform is necessary if fiscal dominance has a large influence on monetary policy. The government needs
to conduct a more transparent fiscal policy, in a way that the budget deficit can be controlled more effectively
and fiscal dominance can be avoided (Mishkin, 2004, p. 9).
As explained above, the financial system is often weak in these countries as well, therefore it is essential that
the banking sector are regulated and supervised effectively. A well-known problem in the banking sector is
moral hazard, which incites the bankers to take too much risk. This problem exists due to full deposit insurance,
which means that in case of a bank run, the deposit holders are insured for the full amount on their bank
deposit. Therefore, Mishkin (2004, p. 9) thinks the regulations concerning such insurance should be limited to
avoid moral hazard by the bankers, because this increases the possibility on a bank run. He adds that a policy is
needed to limit liability dollarization.
A policy that makes the economy more open is needed according to Mishkin (2004, pp. 9-11). The economic
rationale is as follows: if the economy is more open to international trade, this means that the country trades
more with other foreign economies. To facilitate trade, the assets on the balance sheets of the domestic firms
are therefore denominated in the foreign currency as well, usually USD. If in that case the currency depreciates,
the value of the liabilities as well as that of the assets will increase, which makes the shock less severe. If then a
sudden stop occurs, the currency need to be depreciated less to move towards the equilibrium state.
Lastly, the instrument independence of the monetary institution, as well as the primary goal of monetary
policy, i.e. price stability, should be guaranteed by law and clearly communicated towards the public (Mishkin,
2004, pp. 11-14). If the central bank had in recent years very low credibility, the private agents will doubt that
the central bank will meet the target now. Thus, the private agents think that the inflation in the future will be
higher than the target. This implies an increase in inflation expectations, which will lead to higher inflation. For
this reason, it is really essential to build credibility of the central bank (Fraga et al., 2003, p. 14).
Mishkin (2004, p. 11) makes an important remark when he states that these reforms do not necessarily need tobe implemented before adopting inflation targeting.
In fact, it cannot be said that based on satisfying the preconditions or not, an emerging market economy will
respectively succeed or fail in inflation targeting. For example, it is possible that there is fiscal dominance on
the central bank without inflation targeting to fail (Masson et al., 1998, p. 36).
Furthermore, it is also important that the central bank tries to avoid a depreciation of the currency, as it is clear
that a depreciation has negative consequences. However, the central bank should make sure that it does not
stress the exchange rate too much. Otherwise the exchange rate will become the nominal anchor instead of
the inflation target.
Another important issue is that the central bank needs to be aware of the nature of the shock that causes thecurrency depreciation, because the central bank needs to react appropriate. Two examples will make this clear.
If the domestic currency depreciation is caused by a portfolio shock, inflation will rise. Thus, inflation needs to
be lowered in order to avoid a target miss. This disinflation can be realized by increasing the interest rate. If
however a negative terms-of-trade effect causes the domestic currency to depreciate, the interest rates need
to be lowered. A negative terms of trade effect means that the goods exported by the domestic country are
less demanded by the rest of the world, which leads to a decline in the aggregate demand. This means that
prices and output will decline. To avoid a recession, the consumption needs to be stimulated again. Therefore,
the interest rates need to be lowered, which will raise the aggregate demand again (Mishkin, 2004, pp. 24-25).
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4.7.Inflation targeting during the financial crisis of2008As the financial crisis was the first major shock since inflation targeting has become commonly adopted, it can
be seen as the first real test. Therefore, it seemed interesting to include a chapter on this topic in the master
thesis. First of all, a survey on the performance of inflation targeting countries will be discussed. Secondly, as
the master thesis will focus on inflation targeting in emerging market economies, an attempt will be made to
perform own empirical research on the performance during the financial crisis of inflation targeting emergingmarket economies compared to the performance of advanced economies that have adopted the framework of
inflation targeting. This research will be executed based on the method as described in Carvalho de Filho
(2011).
4.7.1. PerformanceIn a recent study performed by de Carvalho Filho (2011), the performance of inflation targeting countries
during the financial crisis of 2008 is compared to the performance of non-inflation targeting countries during
the same period. This survey demonstrates that the inflation targeting countries performed better than the
non-inflation targeters and confirms the statement of Svensson (2010a, p. 1) that inflation targeting was the
most optimal framework to be executed before, during and after the financial crisis.
The GDP growth of inflation targeting countries recovered more rapidly compared to non-inflation targeting
countries (de Carvalho Filho, 2011, pp. 5-6). Furthermore, in the period prior to the crisis the nominal and real
interest rates were higher in these countries compared to their peers. These higher interest rates made it
easier for inflation targeting countries to execute larger cuts in the interest rates without having to fear
deflation. In this way, it was possible for the inflation targeting countries to cut the interest rates about 1.5 %
more than the non-inflation targeting countries in the sample (o.c., p. 12).
Further on, inflation rates decreased less in the inflation targeting countries, as the inflation targeting countries
had higher interest rates, allowing for higher interest rate cuts, as already explained. As a consequence these
countries did never face deflation during the crisis, while their peers in the sample did (o.c., p. 13).
During the crisis, the real exchange rate of inflation targeting countries depreciated more sharply. However this
depreciation was not accompanied by an increase in the risk premiums. Therefore, this depreciation was
favorable, as this depreciation made domestic goods and exports more attracting (o.c., pp. 14-15).
In this survey it is made clear that inflation targeting performed better than other monetary policy frameworks
during the crisis. A good conclusion to this section cannot be formulated better than by this citation of the
Governor of the Bank of Canada Mark Carney: Just as inflation targeting has proven its ability to prevent the
entrenchment of high and volatile inflation, it also has the power to prevent the onset of persistent deflation.1
4.7.2. Empirical researchAs already stated, own empirical research will be executed wherein the performance of inflation targeting
emerging market economies will be compared to the performance of inflation targeting advanced economies.
The research will be strongly based on the survey performed by de Carvalho Filho (2011). The goal of thissurvey is to find out whether the performance during the crisis was different between the 2 samples.
As the total sample includes only 23 countries, if the criteria set up by de Carvalho Filho (2011) are strictly
applied, it is possible that the sample is for statistical reasons not large enough (o.c., p. 27). However, at the
beginning of 2011 27 countries had adopted inflation targeting. Therefore, it does not seem appropriate to
loosen the criterion of de Carvalho Filho (2011, pp. 4-5) that the nominal GDP in 2002 of the countries needs to
11 CARNEY, M. 2009. Governor Carney Remarks, Remarks to the Halifax Chamber of Commerce, Halifax, Novia Scotia, 27 January 2009 ascited in (de Carvalho Filho, 2011, p. 2)
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be higher than USD 10 billion. The other criterion, which defines that 3 out of 4 variables, namely
unemployment rate, industrial production, policy interest rates and the credit default swap spread, should be
available, will be adopted in the survey as well.
The period covered in the survey will be 2000 to 2010. Differences in real GDP, industrial production, nominal
and real interest rates, 12-month inflation, deflation scares, real effective exchange rate, the EMBI spread and
CDS spread between the emerging market and advanced economies will be investigated. The latter twoparameters are parameters that measure the risk perception of the market. The figures for these parameters
will be obtained by consulting the IMF Database and Eurostat. Based on the results, a conclusion will be drawn
on whether there was a difference in performance of both groups of countries.
4.8.Case study: ChileIn this chapter, the Chilean experience with inflation targeting will be described. The reason why Chile was
chosen cannot be better expressed by Mishkin (2004, p. 15): Chile is the poster child for inflation targeting
regimes in emerging market countries because it has had great success in lowering inflation to levels found in
advanced countries, while at the same time experiencing very rapid economic growth. This shows that Chile
was successful in adopting inflation targeting and therefore it seems a good example of inflation targeting best
practices. This will facilitate to draw conclusions on the reasons for which the framework had less success in
Turkey. This will be done by comparing the Turkish and Chilean experience with inflation targeting.
Chile adopted the inflation targeting framework in 1990. In previous years, Chile was an exchange rate targeter
(Ptursson, 2005). In 1989, Chile endorsed a new central bank legislation, which gave the Chilean central bank
independence and made price stability the primary objective. The target is set by the central bank itself, so the
government does not interact in the process (Hammond, 2011, p. 8). In addition, Chile had a budget surplus of
somewhat less than 1 % from 1991 to 2002 and had a strong financial system, which was regulated and
supervised in a very efficient way. These factors were responsible for the success of inflation targeting in Chile
(Mishkin, 2000, pp. 107-108; Mishkin, 2004, pp. 15-16).
Chile evolved towards inflation targeting gradually, which proves the concern of the central bank for both
output stabilization and inflation (Loayza et al., 2002, pp. 12-13). In the years before adopting the inflation
targeting framework, the country realized some disinflation. In 1990, the Chilean central bank adopted inflation
targeting. The first inflation target was announced in 1991 and required the inflation to be in the range of [15%;
20%] (Kadiolu et al., 2000, p. 24; Fraga et al., 2003, p. 7). However, in these first years the targets were more
official inflation projects than targets. After some years, in 1994, the central bank announced real targets for
which they were accountable (Mishkin, 2004, p. 16). Initially the country used wide target ranges, as the
inflation at the moment of adoption amounted to 27.31 % (Fraga et al., 2003, p. 7). Choosing a too narrow
range would cause frequent target misses, as it is more difficult to control inflation, the higher the inflation rate
is. From the announcement of hard targets onwards (and the abandoning of official inflation projects), the
central bank used point targets (Mishkin, 2000, pp. 107-108). From 1999 onwards, the Chilean central bank
announced multi-year targets (Kadiolu et al., 2000, p. 42). However, Chile did not want the exchange rate to
float because of the negative consequences of a currency depreciation, as explained in paragraph 4.3.
Therefore, Chile used an exchange rate band around a crawling peg. In 2000, the Chilean central bank finallyadopted a full-fledged inflation targeting regime, with a floating exchange rate (Mishkin, 2004, p. 17).
In the beginning, Chile had some difficulties that can be placed within the rules-discretion framework. Chile
realized that the more they applied strict monetary policy rules to build credibility, the less flexible their
monetary policy was. This trade-off was elegantly solved. In the beginning, Chile faced high inflation. Thus,
Chile realized that it had first to build credibility and therefore they used very strict monetary policy rules. Later
on, when disinflation had been realized, the country chose to operate more flexibly, in such a way that it could
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central bank and set out price stability as the primary goal. Moreover, the central bank became accountable for
missing the target and the central bank needed to communicate towards the public on the monetary policy
performed by the central bank. The target is set by the government and the central bank. On top, this Central
Bank Law tried to restrict the fiscal dominance by prohibiting the central bank to grant advances and to give
credit to the Treasury. Furthermore, the Central Bank of the Republic of Turkey was not allowed to buy
instruments issued by the Treasury (Kara, 2006, p. 6).
Kara (2006, p. 11) states clearly that the implicit inflation targeting regime was successful as disinflation was
realized and a target was never missed. In the period in which the implicit inflation targeting regime was
adopted, namely from 2002 to 2005, the central bank developed better forecasting method, which makes it is
easier to control inflation. Secondly, until 2004, the central bank had no fixed timings for announcing its
monetary policy decisions. However, in 2005, the central bank started to announce its monetary policy on fixed
dates and published periodical reports (Kara, 2006, p. 10).
However, Ersel et al. (2007, p. 19) state that Turkey could already adopt formal inflation targeting in the
beginning of 2005. However, two problems impeded this evolution. The first reason was that the institute of
statistics published from 2002 onwards a new consumer price index series. This new system made it difficult
for the central bank to forecast the inflation. Missing the target was thus highly probable. On top, this new
system asked for communication towards the public as the public is unfamiliar with this new system. Thesecond reason to postpone the adoption of the formal inflation targeting regime was that the central bank
introduced a new currency in 2005 as the Central Bank of Turkey dropped 6 zeros from the lira.
From 2006 onwards, Turkey switched to full-fledged inflation targeting as a new stand-by agreement with the
IMF was signed for the period from 2005 to 2007. This agreements goal was to restructure the social security
and financial services and to realize a tax reform. It was expected that based on these 3 reforms, a positive
trend would be recorded in multiple macro-economic variables and would make it easier to control the
inflation (Ersel et al., 2007, pp. 19-23).
Instead of announcing the target one year in advance, the central bank announces a 3-year target and
publishes an Inflation Report. If the target is missed, the central bank needs to justify the reasons for this
deviation and needs to formulate which actions it is going to take (Kara, 2006, pp. 13-14). The point target for2011 amounts to 5.5 % with a tolerance band of +/- 2 %. Inflation is measured by headline CPI. The target is a
multiyear target and more precisely a 3-year target. Thus, the target horizon is 3 years.
In the second quarter of 2006, the first problem was encountered. Due to political problems in Turkey and the
instability on the international financial markets, a depreciation of the lira and a deterioration of the
creditworthiness of Turkey were noted. In addition, the increase in petroleum prices increased the inflation and
inflation expectations in Turkey. This caused the central bank to raise its target (Ersel et al., 2007, p. 22). This
incident shows clearly that Turkey has been unable to reach its target and even needed to adjust its target,
which decreases the credibility of the central bank in 2006. Even in 2007, 2008 and 2009 the central bank
needed to adjust its target during the year (Erdem et al., 2011, p. 6). The governor of the central bank Durmus
Yilmaz, elected in April 2006, has be