5 Inflation Targeting in Dollarized Economies

Adrián Armas, Eduardo Levy Yeyati, and Alain Ize
Published Date:
July 2006
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Leonardo Leiderman, Rodolfo Maino and Eric Parrado1 

5.1 Introduction

An increasing number of emerging market economies have been adopting IT as their monetary policy regime. There is reason to believe that this shift has contributed to the relatively low inflation observed in these economies.2 This outcome has surprised those who maintained that these economies are far away from the preconditions required for implementing IT. In particular, the existence of managed exchange rate regimes under foreign exchange market intervention, of a narrow base of domestic nominal financial assets and the lack of market instruments to hedge exchange rate risks, together with fear of floating, have been stressed as factors that drastically weaken the efficacy of monetary policy. Accordingly, these factors have been frequently seen as obstacles to IT implementation in a typical emerging market economy.

Inflation targeting would seem even more difficult in a highly financially dollarized economy. Consider an emerging market where debts are denominated in dollars while firms depend on local currency receipts. Under these conditions, private sector and banks’ balance sheets can be vulnerable to the type of nominal and real exchange rate shifts that should occur for standard inflation targeting to work effectively. In particular, through balance sheet effects, large real exchange rate depreciations (e.g., due to a sudden stop) could have a contractionary impact on output and be associated with bank failures. This contrasts with their expansionary impact on net exports and output in standard small open economy analysis.3 Another difficulty has to do with the exchange rate pass-through to prices, which has been argued to be relatively high for dollarized economies. Yet, if this is the case, this would make monetary policy more potent in terms of its impact on exchange rates and prices.

In spite of these difficulties, some highly dollarized economies, such as Peru, have successfully adopted IT as their monetary policy regime. The authorities of Bolivia, another highly dollarized economy, have also expressed their interest in making a gradual transition towards IT. In light of such revealed policy preference for IT, the question arises of whether this regime can successfully accommodate the special characteristics and dynamics of high dollarization.

This chapter examines various aspects of monetary transmission and policy formulation in highly dollarized economies. We compare two highly dollarized economies, Peru and Bolivia, with two economies with low levels of dollarization, Chile and Colombia. We conclude that, while high dollarization does introduce significant differences in both the transmission capacity of monetary policy and its impact on the real and financial sectors, it does not seem per se to preclude the use of IT as an effective policy regime. Moreover, the way in which the IT regime is implemented can be adapted to reflect the limitations and risks associated with a dollarized environment. In addition, we find that the way in which an economy responds to monetary policy is very much regime dependent. Thus, a regime shift towards IT will tend over time to induce shifts in underlying behavioural parameters that magnify the response to policy signals, thereby facilitating the conduct of monetary policy.

We start, in Section 5.2, by identifying the key differentiating factors in terms of monetary transmission and monetary policy formulation in a highly dollarized environment. We then briefly review, in Section 5.3, the overall monetary performance of Peru and Bolivia in recent years and conclude that in both cases it was quite good, although of a very different nature.

In Section 5.4, we compare the dynamics of key transmission variables for Chile (an IT economy with very low financial dollarization) against Peru. As expected, we find that the degree of exchange rate pass-through has been higher for Peru than for Chile. Moreover, while in Chile interest rate shocks tend to dominate exchange rate shocks in terms of their impact on inflation, we find the reverse for Peru. However, we also find that Peru’s pass-through has diminished with the implementation of IT, while the impact of interest rates has increased. We also examine whether there are indications of increased financial sector fragility in a dollarized economy that could limit the scope of monetary policy. Indeed, we find that the real bilateral exchange rate Granger causes non-performing loans (NPLs) in Peru but not in Chile. We view these findings as being consistent with balance sheet effects reflecting the higher vulnerability of loan portfolios in more dollarized economies.

In Section 5.5, we estimate monetary policy reaction functions (Taylor rules) for Chile, Colombia, Peru and Bolivia. We find strong evidence of fear of floating. Monetary policy in Chile and Colombia has reacted more aggressively to movements in inflation than in Bolivia and Peru. Instead, we find that monetary policy in the two highly dollarized economies has responded more actively to pressures in the exchange market, as reflected in changes in international reserves or changes in the exchange rate. Section 5.6 concludes with some remarks about further topics for research and a discussion of some policy implications.

5.2 How does dollarization affect monetary policy?

Standard small open-economy inflation-targeting models, such as Ball (1999) and Svensson (2000), embody a central role for the exchange rate in the transmission from monetary policy to inflation. Accordingly, a rise in the domestic interest rate – aimed, for example, at dealing with the potential inflationary impact of a sudden stop in capital inflows – typically leads in the short term to nominal and real exchange rate appreciation, which in turn helps attenuate inflationary pressures through both direct and indirect channels. The direct channel reflects the impact of the exchange rate change on the change in the consumer price index (e.g., through the domestic price of tradables). The indirect channel works through the contractionary impact of real exchange appreciation on aggregate demand, output and prices. In some cases, these changes may be accompanied by fluctuations in the country risk premium.

Turning to the case of a financially dollarized economy, where a substantial fraction of deposits and loans are denominated in dollars, the main differences we see as regards the monetary transmission mechanism are as follows. First, we would generally expect the exchange rate to play a more important anchoring role than in a non-dollarized economy, thereby inducing a higher pass-through of exchange rates on prices. Such effects might possibly be non-linear as larger depreciations may raise credibility issues. Second, it is plausible to argue that balance sheet effects would give rise to contractionary devaluations and induce financial stress. That is, instead of real exchange rate depreciation having a positive impact on output, one would observe a negative impact; quite a different dynamic than in the standard case.

In turn, the potentially adverse impact of large exchange rate fluctuations is likely to induce fear of floating by the authorities and require that they closely target the exchange rate, even when the underlying shocks are transitory.4 To facilitate such targeting, the authorities may consider using direct foreign exchange market intervention as an additional policy instrument. Such ‘leaning against the wind’ can be consistent with, and even strengthen, an inflation-targeting framework, as long as such intervention is not aimed at targeting a specific trend for the real exchange rate.

The possible monetary policy responses to dollarization can be characterized with the help of a simple typology that broadly summarizes recent monetary experiences in Latin America, as shown in Table 5.1.5 Under a conventional full-fledged inflation targeting (FFIT) regime, the primary final target is inflation and the operational target is the interest rate. Thus, shocks are primarily absorbed by the exchange rate and foreign exchange interventions are only used occasionally to help smooth out exceptionally large shocks. Instead, under fear of floating competitiveness targeting (FFCT), the primary final target is competitiveness and monetary authorities limit exchange rate fluctuations by using the rate of crawl as the operational target. Thus, foreign exchange intervention is the norm rather than the exception, and international reserves must bear the brunt of the adjustment against shocks. To help reduce the burden of adjustment on international reserves, FFCT countries also need to adjust the interest rate in response to shocks. To boost and speed up this response, some countries have used an intermediate inflation targeting (IIT) regime, such that a monetary aggregate (typically bank reserves) replaces the interest rate as the operational target. Thus, a decline in demand for bank reserves caused by an incipient capital outflow immediately and automatically boosts interest rates.

Table 5.1Alternative monetary frameworks


targeting (FFIT)
Intermediate inflation

targeting (IIT)
Fear of floating


targeting (FFCT)
Primary final targetInflationInflationCompetitiveness
Secondary final targetCompetitivenessCompetitivenessInflation
Operational targetInterest rateMonetary aggregateRate of crawl
Primary shock absorberExchange rateInterest rateForeign assets
Secondary shock absorberForeign assetsExchange rate/foreign assetsInterest rate

The recent (post-1999) policy regimes followed by Chile and Colombia can be classified as FFIT. Both countries experienced relatively high exchange rate volatility but relatively low international reserves volatility (Table 5.2). The current regime (post-2002) in Peru also approximates FFIT, although it has included more substantial foreign exchange market intervention, resulting in much lower exchange rate volatility than in Chile or Colombia. Previously, Peru’s regime, which used bank reserves as the operational target, resulting in very high interest rate volatility, could be characterized as IIT. Last, the monetary regime in Bolivia during most of the last decade exhibited clear FFCT characteristics, with a large volatility in international reserves and interest rates.

Table 5.2Volatility of selected variables


Source: IFS.

For Peru, the periods considered were 1995-2001 and 2002-5.

Source: IFS.

For Peru, the periods considered were 1995-2001 and 2002-5.

5.3 The recent monetary experiences of Peru and Bolivia

To assess whether FFIT can work in a dollarized economy, Peru’s recent experience since it formally adopted its IT regime in 2002 is worth reviewing in some detail.6 For about a year, up to the first half of 2002, monetary policy faced deflationary risk in the context of an almost zero growth economy, leading to a gradual cut in the policy rate to 2.5 per cent (Figure 5.1). However, changing conditions led to a gradual hike in the policy rate to 3.8 per cent at the end of 2002. After holding the rate at this level for half a year, underlying conditions allowed for a succession of interest rate cuts, which brought the interest rate to 2.5 per cent at the end of 2003. These cuts were compatible with the impressive outcome that the inflation target of 2.5 per cent was achieved in that year. The next turn in the policy stance occurred in 2004, when inflation accelerated mainly as the result of supply shocks. These led to hikes in the interest rate up to 3 per cent towards the end of 2004, a level that was maintained during the first half of 2005.

Figure 5.1Peru: interbank rate, 2002-5

Source: Central Reserve Bank of Peru (BCRP).

The gradual hike of the policy rate to 3.8 per cent by the end of 2002 was certainly influenced by the nominal exchange rate depreciation that resulted from pressures caused by the uncertainty about elections in Brazil. That was about the only time when the authorities sold foreign exchange out of their reserves, in an attempt to lean against the wind. The interest rate hikes appear to have had some impact on capital inflows in the second half of 2004. Notwithstanding persistent intervention by the authorities, a nominal exchange rate appreciation was then observed (Figure 5.2).

Figure 5.2Peru: exchange rate and BCRP intervention, 2002-5

Source: BCRP.

In sum, a casual look at Peru’s conduct of monetary policy exhibits patterns typical of any other standard (i.e., non-dollarized) economies. The policy rate was changed from time to time based on the forward-looking inflation outlook and these changes were implemented in a gradual, serially correlated manner. Having said that, it is remarkable how small the degree of interest rate variability has been, compared with other IT countries such as Chile or Israel. The policy rate varied from a high of 3.8 per cent to a low of 2.5 per cent. At the same time, nominal exchange rate variability has also been relatively low, partly reflecting the impact of abundant foreign exchange market intervention. The gap between the most depreciated level of the nominal exchange rate, in the second half of 2002, and its most appreciated value, in mid-2005, is only 11 per cent. These features suggest that FFIT in Peru, while quite successful overall, remains characterized by substantial fear of floating. The latter, in turn, is likely to reflect the high dollarization.

Bolivia’s recent monetary experience is also worth reviewing. Unlike Peru, Bolivia has been unable so far to let its exchange rate float. Perhaps in part due to credibility concerns, the monetary authorities have continued to consistently target the exchange rate through a slowly adjusting crawl that informally targets the multilateral real exchange rate, subject to inflation remaining low.7 In the wake of the switch to floating rate regimes in Bolivia’s large neighbouring countries, notably Brazil and Argentina, and the large subsequent depreciations of their currencies vis-à-vis the dollar, Bolivia faced a strong appreciation of its real effective exchange rate. To fend off the resulting pressures on Bolivia’s trade and economic activity, the monetary authorities acted countercyclically, by accelerating the rate of crawl. This policy has been seemingly successful in maintaining a competitive exchange rate (albeit with some lag). Although rising in recent years, inflation has remained moderate (Figure 5.3).

Figure 5.3Bolivia: exchange rate crawl, inflation and real effective exchange rate, 1996-20051

Source: IFS and Central Bank of Bolivia (BCB).

Note: 1. An increase in the REER reflects a depreciation.

However, a main potential drawback of the FFCT regime (in addition to the delayed exchange rate adjustments) is that the close targeting of the exchange rate tends to promote dollarization. Instead, FFIT should tend to reduce dollarization.8 While we have not conducted formal tests of such linkages, the much stronger decline in dollarization in Peru than in Bolivia, following the adoption in Peru of the FFIT regime, is consistent with this hypothesis (Figure 5.4).

Figure 5.4Bolivia and Peru: financial dollarization (per cent of total deposits)

Source: BCB and BCRP.

5.4 Monetary policy transmission

The recent declining trend of inflation in most of the less developed economies is closely related to changes in the exchange rate. While this is likely to be also the case for Chile and Peru, there are clear differences in how inflation has become more stable in the two countries. There are many other open questions that still remain in this regard. How has the exchange rate pass-through evolved in these countries? To what extent is dollarization associated with lower monetary control and higher financial vulnerability? Has inflation targeting allowed greater control over inflation?

To address these questions, we use VAR models to characterize monetary policy and analyze the impact of the exchange rate on inflation in both countries. We find that Peru registers a much higher pass-through on average than Chile. However, the pass-through in Peru has diminished together with the implementation of FFIT. Second, we find that while exchange rate shocks had a significant impact on the rate of inflation under the FFCT regime, interest rate shocks have tended to dominate exchange rate disturbances under FFIT. Finally, we find evidence of Granger causality from the real bilateral exchange rate to NPLs in Peru, but not in Chile.

Exchange rate pass-through

Using a baseline vector autoregressive (VAR), which considers seven variables,9 we estimate the effect of the nominal exchange rate in both countries considering our complete monthly sample, from 1993:01 to 2005:07, that covers both the FFIT and IIT periods. Figures 5.5a and 5.5b show the impulse-response functions for Chile and Peru, respectively. There is clear evidence that Chile has a much lower pass-through than Peru. In particular, the Chilean pass-through is low and very short-lived (around six quarters), while Peru registers a much higher pass-through that takes more than two years to die out.

However, the pass-through declined as Peru switched from IIT to FFIT. Using the same baseline VAR, we compare the transmission mechanism before and after implementation of the FFIT framework. We run two VAR models: one from 1993:01 to 1998:12 and a second from 1999:01 to 2005:07. The 1999 threshold is taken to match differences in the behaviour of the real exchange rate. We did not split the data from 2002 – the year that IT was implemented – because there are not enough observations to run sensible regressions. However, the second sample is clearly influenced by the FFIT regime.

Figure 5.5aChile: response of inflation to one SD nominal exchange rate innovation, 1993:01-2005:07

Source: Authors’ calculations.

Figure 5.5bPeru: response of inflation to one SD nominal exchange rate innovation, 1993:01-2005:07

Figures 5.6a and 5.6b show the two samples’ impulse-response functions of inflation for three types of shocks: interest rate, money and the nominal exchange rate. The results are consistent with what one would expect. In particular, in the first sample, exchange rate and monetary shocks have a significant impact on inflation, whereas interest rates shocks do not. The reverse is true during the second period. This clearly suggests that the monetary transmission is endogenous to the policy regime. Unsurprisingly, the variable that is chosen as the key policy target becomes less volatile and becomes more relevant in terms of transmitting monetary signals.

Figure 5.6aPeru: response to one SD innovation ±2 SE, 1993:01-1998:12

Source: Authors’ calculations.

Figure 5.6bPeru: response to one SD innovation ±2 SE, 1999:01-2005:07

Interest rate pass-through

As a complementary exercise, we focus our attention on the transmission from policy rates to banking rates for Peru, using the previous samples. We find that in the first sample, the interbank rate Granger causes the policy rate while the opposite does not hold. Instead, the one-way causality is missing between these rates in the second sample (Table 5.3). This suggests that the central bank has gained credibility in influencing market rates.

Table 5.3Peru, Granger causality: BCRP rate vs. banking interest rates
Null hypothesisObservationsF-statisticProbability
Period: 1993:01-2004:12
Interbank rate does not Granger cause BCRP rate1007.940.00
BCRP rate does not Granger cause interbank rate1.680.19
Active rate does not Granger cause BCRP rate1420.800.45
BCRP rate does not Granger cause active rate9.000.00
Passive rate does not Granger cause BCRP rate1425.270.01
BCRP rate does not Granger cause passive rate7.340.00
Passive rate does not Granger cause active rate1423.450.03
Active rate does not Granger cause passive rate1.020.36
Period: 1999:01-2004:12
Interbank rate does not Granger cause BCRP rate638.430.00
BCRP rate does not Granger cause interbank rate2.910.06
Active rate does not Granger cause BCRP rate724.580.01
BCRP rate does not Granger cause active rate2.990.06
Passive rate does not Granger cause BCRP rate7211.170.00
BCRP rate does not Granger cause passive rate8.200.00
Passive rate does not Granger cause active rate727.260.00
Active rate does not Granger cause passive rate2.050.14
Source: Authors’ calculations.
Source: Authors’ calculations.

Financial stress

Reflecting balance sheet effects, higher dollarization should trigger a closer association between exchange rate fluctuations and non-performing loans. Figures 5.7a and 5.7b display the evolution of the real exchange rate and non-performing loans in Chile and Peru, respectively. From the figures we can observe that there is some relationship between the two series in both countries. However, it is not possible to tell whether there is a causal relationship. Using a bivariate VAR model and two different sub-samples (1994:03-2004:12 and 1999:01-2004:12), we find evidence of Granger causality from the real bilateral exchange rate to NPLs in Peru, but not in Chile (see Figures 5.8a and 5.8b). This is consistent with the former country being more dollarized than the latter. In Peru, real exchange rate shocks have a significant impact on NPLs from the fifth month and persist for around one quarter, with no significant differences between the two sub-samples.

Figure 5.7aChile: real effective exchange rate (year on year) and NPLs, 1993-2004

Sources: BCCH, BCRP, SBIF, SBS, and authors’ calculations.

Figure 5.7bPeru: real effective exchange rate (year on year) and NPLs, 1993-2004

Figure 5.8aChile: response of NPLs to one SD REER innovation

Source: Authors’ calculations.

Figure 5.8bPeru: response of NPLs to one SD REER innovation

5.5 Reaction functions

We now turn to examine in more detail to what extent dollarization has affected in recent years the formulation of monetary policy in the four Latin American countries in our sample. The baseline reaction functions comprise those typically used for open economies. The short-term nominal interest rate (i) reacts to: (i) the actual inflation rate gap (π); (ii) the output gap (γ); (iii) the US Federal Fund rate (FF), to account for interest rate parity; (iv) net international reserves (NIK), to gauge the reaction to reserve losses; and (v) the real effective exchange rate (REER), to take into consideration competitiveness targeting. Thus, the specification is the following:

where Δ is the first difference operator. In the case of Bolivia, the dependent variable is the rate of crawl (Crawl), rather than the interest rate, reflecting the fact that the exchange rate is not allowed to float.10 The results (see Table 5.4) are based on the GMM technique which provides better results when simultaneity and endogeneity become a problem.11

Table 5.4Reaction functions (based on GMM), 1993-20051
Using the interest rate as operational instrument

r-statistics appear in parentheses. Optimal weighting matrix obtained from first-step two-stage least squares parameter estimates. Instruments: lagged values of inflation, estimates of output gap and changes in real exchange rates.

Using the rate of crawl as operational instrument

r-statistics appear in parentheses. Optimal weighting matrix obtained from first-step two-stage least squares parameter estimates. Instruments: lagged values of inflation, estimates of output gap and changes in real exchange rates.

r-statistics appear in parentheses. Optimal weighting matrix obtained from first-step two-stage least squares parameter estimates. Instruments: lagged values of inflation, estimates of output gap and changes in real exchange rates.

Several interesting results emerge.12 First, the strong significance and signs of the inflation coefficient indicates that all central banks, even Bolivia, try to control it. While an increase in inflation leads to higher interest rates in Chile, Colombia and Peru, in Bolivia it leads to a slowing down of the rate of crawl.

Second, the coefficients associated with the output gap are weakly significant for Colombia and Peru. However, in the latter case it is wrongly signed, possibly reflecting the dominance of confidence shocks that simultaneously raise the risk premium and depress output through a decline in aggregate demand. Interestingly enough, the output coefficient is strongly significant in the case of Bolivia, confirming that the monetary authorities have used monetary policy for countercyclical purposes, as indeed has been the case during the last few years.

Third, the coefficients associated with changes in the real exchange rate are significant for Bolivia and Colombia. In view of its expansionary impact, an exchange rate depreciation leads to a decline in interest rates in Colombia and a slowing down of the rate of crawl in Bolivia.

Fourth, both the Peruvian and the Bolivian monetary authorities react to changes in their international reserves. A reserve loss leads to counteracting increases in the policy interest rate in Peru and the rate of crawl in Bolivia. This suggests that both countries use their international reserves as front-line buffers against shocks and adjust their monetary policy to replenish their reserves once they have been used.

All in all, the evidence therefore supports classifying Chile as an FFIT country, where inflation control is the only key target for monetary policy. While inflation control is also the main policy target in Colombia, concerns about the real exchange rate also appear to be relevant, suggesting that there might exist some element of competitiveness targeting as well. In the case of Peru and Bolivia, the fact that they mould their monetary policy, to some extent, around a more active use of their international reserves is consistent with a concern for limiting the potentially damaging impact of large exchange rate fluctuations in a highly dollarized environment. In the case of Peru, which does allow its exchange rate to float, this would suggest classifying it as an IIT country. In the case of Bolivia, the importance of international reserves and the real exchange rate in monetary policy, together with the fact that it operates through a crawl, make it a natural FFCT candidate. It is important to note, however, that inflation also appears to have been an important concern for the Bolivian monetary authorities. It is also rather remarkable that Bolivia appears to be the country with the most countercyclical monetary policy.

5.6 Concluding remarks

Since our main conclusions from this research were summarized in the Introduction, we now turn to some avenues for future work and some policy implications.

As far as the analytical framework is concerned, the challenge for future work is to develop simple models of IT that fully incorporate some of the special features that arise under financial dollarization, such as contractionary devaluations due to balance sheet effects and the wide use of direct foreign exchange market intervention. From a policy perspective, one would need to consider models in which the monetary authority has two instruments to respond to various fluctuations: the policy interest rate and direct foreign exchange market intervention. Accordingly, when facing, for example a sudden stop, the authorities may spread the burden of the monetary adjustment between interest rate hikes and selling foreign currencies. As far as we know, these trade-offs have not been discussed in previous IT work.

We believe there are important ways for improving the transparency of monetary policy in dollarized IT economies. Given the key role of financial system fragility in these economies, and the wide use of foreign exchange market intervention as a policy instrument, it would seem reasonable to expect central banks to communicate to the public their assessments, evidence and policy strategy in these areas. A quick look at existing inflation reports indicates that there is scope for improvement here.

Another policy theme has to do with de-dollarization as a means of improving the efficacy of monetary policy. In most emerging market economies, de-dollarization typically occurs as an endogenous phenomenon, along with a marked reduction in the rate of inflation and not as a result of active and direct policies with that objective. Yet, the experience of countries such as Chile and Israel suggests that policy-makers can also have a direct role in this process by contributing to the development and deepening of domestic financial markets. For example, the growing presence of medium- and long-term bonds denominated in domestic currency is a remarkable phenomenon. Other useful policy (institution-building) steps have to do with helping develop markets in financial instruments to hedge foreign exchange risk. These can be expected to attenuate the Tear of floating’ phenomenon. These are key policy issues that need to be addressed in future work.


We thank Alain Ize, Eduardo Levy Yeyati, Klaus Schmidt-Hebbel and participants at the April 2005 Lima conference for their valuable comments. We also appreciate the editing comments provided by Graham Colin-Jones. The usual disclaimer applies.

For recent references on the issue, see Mishkin and Schmidt-Hebbel (2005) and Batini and Laxton (2005).

See, for example, the papers that started this discussion: Calvo and Reinhart (2002) and Stein et al. (1999).

Our special thanks to Alain Ize who provided this useful categorization during the review process.

See also Armas and Grippa, Chapter 6 of this volume.

Ize and Levy Yeyati (2003) show that financial dollarization should be related to the ratio of the volatilities of inflation and real exchange rate.

The variables considered in the baseline model are (in the same order in the VAR): world oil price, foreign interest rate, seasonally adjusted GDP, inflation, domestic (policy) interest rate, money and the nominal exchange rate.

This specific policy setting was empirically proposed and implemented by Parrado (2004).

The tests show that there are no problems of autocorrelation and that the equation setup explains around 90 per cent of actual movements of interest rates.


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