Annex: Details on the VAR Analysis
Batini, N., and D. Laxton, 2005, “Under What Conditions Can Inflation Targeting be Adopted? The Experience of Emerging Markets,”forthcoming in Monetary Policy Under Inflation Targeting ed. by Schmidt-Hebel and Mishkin , (Santiago: Banco Central de Chile).
Bakradze, G., and A. Billmeier, 2007, “Inflation Targeting in Georgia: Are We There Yet?”mimeo, National Bank of Georgia and International Monetary Fund.
Calvo, G., and C. Reinhart, 2000, “Fear of Floating,”NBER Working Paper No. 7993 (Cambridge, Massachusetts: National Bureau of Economic Research).
Carare, A., A. Schaechter, and M. Stone, 2002, “Establishing Initial Conditions in Support of Inflation Targeting,”IMF Working Paper No. 02/102 (Washington: International Monetary Fund).
Dabla-Norris, E., 2006, “Recent Experiences with Inflation Targeting in Developing and Transition Countries,”mimeo, International Monetary Fund.
Dabla-Norris, E. and H. Floerkemeier, 2006, “Transmission Mechanisms of Monetary Policy in Armenia: Evidence from VAR Analysis,”IMF Working Paper No. 06/248 (Washington: International Monetary Fund).
Duttagupta, R., Gilda Fernandez, Cem Karacadag, 2004, “From Fixed to Float: Operational Aspects of Moving Towards Exchange Rate Flexibility,”IMF Working Paper No. 04/126 (Washington: International Monetary Fund).
Fracasso, A., H. Genberg, and C. Wyplosz, 2003, “How do Central Banks Write? An Evaluation of Inflation Reports by Inflation Targeting Central Banks,”CEPR/Geneva Reports on the World Economy, Special Report No. 2.
Freedman, C., and I. Otker-Robe, 2005, “Conditions for Successful Implementation of Inflation Targeting,” presentation for seminar on Inflation Targeting: Policy and Implementation Issues, Istanbul, Turkey.
Jonas, J., and F. Mishkin, 2005, “Inflation Targeting in Transition Countries: Experiences and Prospects,” in The Inflation Targeting Debate, Studies in Business Cycles, No. 32, Part III, ed. by Bernanke and Woodford (Chicago: University of Chicago Press).
Khan, M., 2003, “Current Issues in the Design and Conduct of Monetary Policy,”IMF Working Paper No. 03/56 (Washington: International Monetary Fund).
Khan, M. and A. Senhadji, 2001, “Inflation and Financial Depth,”IMF Working Paper No. 01/44 (Washington: International Monetary Fund).
Landerretche, O., F. Morandé, and K. Schmidt-Hebel, 2000, “Inflation Targets and Stabilization in Chile,” in Monetary Policy Frameworks in a Global Context, ed. by L. Mahadeva and G. Sterne (London: Routledge).
Laurens, B. and others, 2005, “Monetary Policy Implementation at Different Stages of Market Development,”IMF Occasional Paper No. 244 (Washington: International Monetary Fund).
Leiderman, L., Rodolfo Maino, and Eric Parrado, 2006, “Inflation Targeting in Dollarized Economies,”IMF Working Paper No. 03/12 (Washington: International Monetary Fund).
Masson, P., M. Savastano, and S. Sharma, 1997, “The Scope for Inflation Targeting in Developing Countries,”IMF Working Paper No. 97/130 (Washington: International Monetary Fund).
Roger, S., and M. Stone, 2005, “On Target? The International Experience with Achieving Inflation Targets,”IMF Working Paper No. 05/163 (Washington: International Monetary Fund).
Sargent, T., and Neil Wallace, 1981, “Some Unpleasant Monetarist Arithmetic,”Federal Reserve Bank of Minneapolis Quarterly Review, vol. 5(3), pages 1-17.
Sarr, A., and Tonny Lybek, 2002, “Measuring Liquidity in Financial Markets,”IMF Working Paper No. 02/232 (Washington: International Monetary Fund).
Schmidt-Hebel, K., and M. Tapia, 2002, “Monetary Policy Implementation and Results in 20 Inflation Targeting Countries,”Central Bank of Chile, Working Paper No. 166.
Silver, Mark, 2006, “Core Inflation Measures and Statistical Issues in Choosing Among Them,”IMF Working Paper No. 06/97 (Washington: International Monetary Fund).
Stella, P., 2005, “Central Bank Financial Strength, Transparency, and Policy Credibility,”Staff Papers, International Monetary Fund, Vol. 52(2), pages 335–365.
Stone (2003) defines an inflation targeting “lite” regime as one where the central bank announces a broad inflation objective but owing to its relatively low credibility is not able to maintain inflation as the foremost objective.
This paper is based on the information available as of September 30, 2006.
The NBG considers local currency base money as its primary operating target.
The minor target overshooting in Armenia that has emerged since mid-2006 is mainly explained by supply-side shocks.
The results of the VAR should be interpreted with caution given the inherent weaknesses in the data (see Annex for details on data and variables used).
The CIC is highly correlated with local currency base money in both countries.
Results are reported at a 5 percent significance level.
Using quarterly data from 1996–2006, Bakradze and Billmeier (2007) find a positive exchange rate passthrough that remains significant for 2 to 4 quarters. However, similarly to our results, they find that exchange rate shocks contribute very little to explaining the variance of the CPI once an interest rate is included in the VAR.
See Masson, Savastano, and Sharma (1997); Carare, Schaechter, and Stone (2002); and Khan (2003). Truman (2003); Jonas and Mishkin (2005); and IMF (2005) provide a more nuanced view on the importance of these prerequisites.
Recent rapid credit growth may have contributed to a decrease in the non-performing loans ratios, as lowquality loans become non-performing with a lag.
Laurens and others (2005) note that such weaknesses alter the relative efficiency and speed of monetary transmission through different channels. Weak or incomplete financial markets can also limit the scope for reliance on market-based instruments—such as interest rates—for implementing policy.
While central bank operational independence is a well-established practice among IT central banks, the degree of autonomy from the government in decision making (policy goals and targets) varies considerably. The government typically sets the objectives of monetary policy, which are either laid out in the central bank charter or in government directives or agreements depending on the details of central bank legislation (Dabla-Norris, 2006).
Chile and the Czech Republic are examples of IT countries whose central banks operated successfully despite having negative capital. In the Chilean case, the negative capital was not a constraint because the government was committed to maintaining a budgetary surplus. In recent years, the Czech National Bank (CNB) has also experienced revaluation losses as a result of a strengthening currency. However, the CNB has already established its credibility in inflation targeting and operated in deep and liquid money markets. Also, its exposure to persistent revaluation losses should end with the adoption of the Euro.
The NBG has recently signed a memorandum of understanding with the government on a gradual conversion of these claims into marketable securities, of which 6 percent has already been converted.
Key implications of the so-called “unpleasant monetarist arithmetic” are discussed in Sargent and Wallace (1981) and the recent literature on the fiscal theories of the price level (Sims, 2003). Even in the absence of monetization, if fiscal imbalances are large enough, monetary policy will eventually become subservient to fiscal considerations, and an inflation target will have to be abandoned or seriously modified (Mishkin, 2003).
In Georgia, the central bank, until recently, was able to lend to the government under specific circumstances.
In Peru, for instance, coordination and information exchange take place between government agencies and the central bank in regular high-level policy committees at two levels: (i) at the programming level––the macroeconomic assumptions for the budget, including the annual inflation targets, are set by the ministry of finance in coordination with the central bank; (ii) at the operational level––the fiscal committee meets each month to set government expenditure, foreign exchange purchases, and deposits, with the central bank participating in these meetings.
A few countries, such as Peru, Colombia, and Mexico, used a monetary aggregate-based operating target in the early years of their transition to FFIT, but increasingly emphasized a short-term interest rate as the key operating target.
However, it should be noted that it is difficult to estimate the size of non-precautionary balances.
At end-2005, the six largest banks in Georgia held above 85 percent of the system’s total assets, loans, and deposits, while the five largest banks in Armenia accounted for 55 percent of banking system assets.
South Korea will start adopting headline inflation targets from 2007.
These include (i) a significant divergence of world prices from forecast levels; (ii) large fluctuations in the exchange rate caused by external shocks; (iii) price changes arising from agricultural conditions; and (iv) natural disasters and other emergencies.
For instance, at the National Bank of Hungary (NBH), the central inflation forecast relies on both partial and aggregate econometric equations and expert judgment (nonmodel approaches). The Czech National Bank (CNB) uses several models (e.g., core quarterly projections model and national institute global econometric model) for medium-term forecasts and for policy simulations. At the same time, however, short-term forecasts are prepared using expert judgment and partial econometric models.
The ordering of the exchange rate and monetary aggregate makes little difference in our impulse-response analysis because of the low correlation in residuals of these two variables.
The price puzzle describes the empirical finding that an interest rate tightening is followed by a price increase. Since the price puzzle results from an endogenous monetary policy reaction to external shocks, controlling external variables in VAR estimations generally resolves this problem.