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I wish to thank Jose Fajgenbaum, Esteban Jadresic, Arto Kovanen, and Martin Parkinson for extensive contributions to an earlier version of this paper, and Trevor Alleyne, Hans Lindberg, Arvind Subramanian, and Lars E.O. Svensson for subsequent comments and discussions. I also thank seminar participants at the Bureau of Economic Research conference in Sandton and University of Stellenbosch for comments, in particular Brian Kahn, Ben Smit, and Geoffrey Woglom. The usual disclaimer applies.
Countries that have adopted inflation targeting include, in chronological order, New Zealand, Canada, United Kingdom, Sweden, Finland, Australia, and Spain. Useful references on their experiences with inflation targeting are Leiderman and Svensson (1995), Debelle (1997), Bernanke and Mishkin (1997), and Mishkin and Posen (1997). An examination of the scope for inflation targeting in developing countries can be found in Masson, Savastano, and Sharma (1997). Since January 1999, Finland and Spain should no longer be regarded as inflation targeting countries, as these countries have joined the European Monetary Union.
The Czech Republic has operated a fully fledged inflation targeting regime since December 1997. Israel, Chile, and Mexico are examples of countries that announce a one-year ahead inflation target as the objective of monetary policy, although other objectives (such as the nominal exchange rate) have also played an important role in the policy formulation (see, e.g., Morandé and Schmidt-Hebbel (1999) for discussions). Poland and Hungary have recently announced multi-year inflation targets with an eye to eventually joining the European Monetary Union.
See, for example, Svensson (1997) for a theoretical discussion of the mechanisms of inflation targeting.
The recent experience of New Zealand may provide an example of the latter; the Reserve Bank of New Zealand’s attempt to keep inflation between 0 and 2 percent in the short-run induced an increase in short-term interest rates and a (real) appreciation of the New Zealand dollar which contributed, at least in part, to a deterioration in competitiveness and the external current account balance. While the larger current account deficit also reflected a fiscal stimulus and a deterioration of the investment account of the balance of payments, this experience illustrates that careful thought is needed in the design of an inflation targeting framework. The inflation target in New Zealand was subsequently increased to 0-3 percent.
Mishkin (1998) provides a comprehensive discussion of international experiences with different monetary policy regimes.
That the average level and volatility of inflation are positively correlated is a well-known empirical regularity, see e.g., Taylor (1981).
The “credibility versus flexibility tradeoff argument has been emphasized by, e.g., Rogoff (1985).
Although some studies indicate that the demand for broad money is relatively sensible once one controls for certain structural breaks (see Hurn (1991), Jonsson (1999), and Moll (1999)), it is difficult to predict the quantitative effects and timing of the trend breaks.
For example, although the nominal effective exchange rate depreciated by 20 percent between March and September 1998, core inflation only increased from 7 percent in March 1998 to 8 percent in March 1999.
Other studies have emphasized the importance of this argument in the case of South Africa, and added that an explicit approval of an inflation targeting framework by the Department of Finance would enhance credibility and confidence in the government’s overall macroeconomic strategy, see CREFSA (1998) and Casteleijn (1999).
New Zealand, Canada, and the Czech Republic are examples of countries that adopted a targeted path for inflation that declined over time.