II Introduction
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 2 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
  • | 3 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund

Abstract

The exchange rate plays a larger role in monetary policy for inflation-targeting emerging economies than for inflation-targeting advanced economies. Inflation-targeting emerging economies have less flexible exchange rate arrangements and intervene more frequently and less transparently. The exchange rate plays a more important role for a number of reasons, including high pass-through from changes in the exchange rate to inflation, the impact on output of relatively short-term exchange rate movements, balance sheet currency mismatches, underdeveloped financial markets, and lower overall policy credibility.

The exchange rate plays a larger role in monetary policy for inflation-targeting emerging economies than for inflation-targeting advanced economies. Inflation-targeting emerging economies have less flexible exchange rate arrangements and intervene more frequently and less transparently. The exchange rate plays a more important role for a number of reasons, including high pass-through from changes in the exchange rate to inflation, the impact on output of relatively short-term exchange rate movements, balance sheet currency mismatches, underdeveloped financial markets, and lower overall policy credibility.

The enhanced role of the exchange rate poses specific challenges for inflation-targeting emerging economies. Using the exchange rate to smooth output or to address financial and external stability can set up trade-offs between price and output stability that can be difficult to gauge and are not well understood. Furthermore, an active role for the exchange rate may cause confusion about the commitment of the central bank to the inflation target in an environment of weak policy implementation, including when there is no fully integrated central bank decision-making process, a lack of transparency, undeveloped financial markets, and little or no inflation-targeting track record.

Global economic conditions further exacerbate the exchange rate challenges for inflation-targeting emerging economies. The ratcheting up of inflation pressures worldwide during 2007–08 led nearly all inflation-targeting emerging economies to overshoot their inflation targets. Increasingly volatile capital inflows raised exchange rate volatility.1 The global crisis that accelerated in late 2008 poses formidable macroeconomic and financial stability challenges to inflation-targeting emerging economies and thus elevates the importance of having a properly designed monetary and exchange rate policy.

This paper sheds light on the policy and operational role of the exchange rate within the broad monetary framework for inflation-targeting emerging economies. It also examines how emerging economies with flexible exchange rates but without a full-fledged inflation-targeting framework (emerging economies with other anchors) can transition to inflation targeting.2

The bottom line is that, for emerging economies, an explicit but limited role for the exchange rate may improve macroeconomic performance, especially if implemented in a systematic, transparent, and market-friendly manner. For emerging economies with other anchors, the main policy challenge is to develop a more systematic approach to monetary and exchange policy in transitioning to an inflation-targeting framework.

This paper is unusual in that it explicitly brings together analysis of the policy formulation aspect and the implementation aspect of the monetary policy framework, which is important but not always easy to do. It is more challenging for inflation-targeting emerging economies because of the multiplicity and strength of exchange rate channels, the complexity of monetary operations under inflation targeting, and the crucial role of transparency. However, because policymakers must both formulate and implement policy, this paper seeks a more integrated understanding of the role of the exchange rate under inflation targeting.

The integrated approach of this paper is made possible by the use of two complementary analytical approaches. First, case studies and detailed documentation of exchange rate practices are used to identify the motivations for and consequences of exchange rate management and to assess policy implementation. Second, a quantitative model tailored for open-economy inflation-targeting countries is used to assess the macroeconomic motivations for and consequences of an active exchange rate policy. Model simulations provide explicit comparisons of the impact on macroeconomic performance of the most common shocks faced by robust and financially vulnerable economies that have flexible exchange rates and an inflation-targeting framework. In addition, the paper outlines the general implications of the two recent global shocks for inflation-targeting emerging economies.

Country Groups Used in the Analysis1

This paper focuses on two country groups:2

  • Full-fledged inflation-targeting emerging economies: They have a floating exchange rate (independent float or managed float), and they make a clear commitment to an inflation target.

  • Non-inflation-targeting emerging economies: They have a flexible exchange rate (managed float, crawling peg, or crawling band) and do not make a clear commitment to an explicit inflation target.

In addition, two groups of countries are used for comparison: inflation-targeting and other advanced economies, and conventional-pegged-exchange-rate emerging economies.

article image
1 The exchange rate arrangements and country groupings are based on the IMF’s de facto classification system as of mid-2007.2 Countries with less than $17 billion of GDP and $1,345 in per capita GDP as of 2006 are excluded because exchange rate flexibility and inflation targeting are less of an option for them. These thresholds were based on the full-fledged inflation targeter with the lowest GDP (Iceland) and with the lowest per capita income (the Philippines).

Some basic facts demonstrate the key differences among various possible roles for the exchange rate. Box 2.1 describes the key differences between inflation-targeting advanced economies, inflation-targeting emerging economies, and emerging economies with other anchors.

  • Exchange rate arrangement: Almost all inflation-targeting advanced economies have an independent float, whereas both groups of emerging economies have less flexible arrangements (Table 2.1).

  • Exchange rate volatility: Nevertheless, emerging economies have exhibited considerably more volatile monthly exchange rate behavior compared with inflation-targeting advanced economies (Table 2.2).

  • Interest rate reaction function: Research on the interest rate reaction functions of emerging economies suggests that many respond to the exchange rate.3

  • Intervention frequency: The inflation-targeting advanced economies intervene much less frequently than their inflation-targeting emerging economy counterparts (see Table 2.1), according to official documents.

  • Intervention objectives: The most common intervention objective for the inflation-targeting advanced economies is to correct an exchange rate misalignment, whereas smoothing volatility is the most common objective for both groups of emerging economies (see Table 2.1). Furthermore, the emerging economies with other anchors also aim to promote competitiveness and limit the pace of currency appreciation.

Table 2.1.

Exchange Rate Arrangements and Foreign Exchange Intervention Practices (Selected Countries)1

article image
Sources: See Appendix I.

The number of countries is given in parentheses; figures within each category may sum to more than the number of countries owing to multiple practices.

SDDS = Special Data Dissemination Standard, established by the IMF to guide member countries that have or might seek access to international capital markets in the provision of their economic and financial data to the public.

Table 2.2.

Exchange Rate and Reserve Volatility, 1996–2007

(Selected Countries)

article image
Source: IMF staff estimates.

NEER = nominal effective exchange rate (unadjusted, weighted average value of a currency relative to all major currencies).

REER = real effective exchange rate (weighted average of a currency relative to an index or basket of other major currencies).

This research and analysis reflects the strengthened mandate of the IMF to work on exchange rate issues, which is motivated in large part by the challenges faced by emerging economies.4 The role of the exchange rate in the monetary policy framework is always at the core of the IMF’s work on surveillance, and the demand for technical assistance in this area has been especially strong in recent years. The need for enhanced exchange rate surveillance was emphasized in several key IMF policy documents, including the Medium Term Strategy and the 2007 Surveillance Decision.

This Occasional Paper is structured as follows. Section III elaborates the reasons why the exchange rate plays a relatively large role for inflation-targeting emerging economies. Section IV presents a typology of inflation-targeting approaches to the exchange rate, describes the macroeconomic model, and summarizes the simulation results across approaches and shocks. Because macroeconomic models are not well-suited to addressing policy implementation issues, Section V documents the role of foreign exchange market intervention in inflation-targeting policy implementation and makes some positive recommendations for inflation-targeting emerging economies. The myriad aspects of transitioning to an inflation-targeting framework are covered in Section VI. Section VII assesses the implications of recent global shocks for inflation-targeting emerging economies, and Section VIII discusses the four basic questions posed by the role of the exchange rate in the broad monetary framework for inflation-targeting emerging economies. Case studies of the role of the exchange rate in the overall policy framework of selected economies are in Section IX, and Section X documents the foreign exchange market intervention practices of both inflation-targeting emerging economies and emerging economies with other anchors. Appendix II presents in detail the macroeconomic model and results.

1

The policy challenge from high inflation during this period is the subject of Habermeier and others (2009).

2

The term “emerging economies with other anchors” as used here is a misnomer in that it does not encompass emerging economies that have fixed exchange rate arrangements.

3

Mohanty and Klau (2004) estimated interest rate reaction functions for 13 emerging and transition economies and concluded that for 11 of them the coefficient of the real exchange rate was significant. Aizenman, Hutchison, and Noy (2008) estimated reaction functions for 16 emerging market economies and found that the inflation-targeting economies responded to the real exchange rate significantly and by more than the non-inflation-targeting economies. According to Edwards (2006), economies with a history of higher inflation and more real exchange rate variability seem to have a higher coefficient for the real exchange rate in their Taylor rules.

4

Previous work by the IMF on the role of the exchange rate for inflation-targeting emerging economies includes Roger and Stone (2005); Duttagupta, Fernandez, and Karacadag (2004); and Ötker-Robe and Vávra (2007).

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