Academic journal article The European Journal of Comparative Economics

Inflation Targeting, between Rhetoric and Reality. the Case of Transition Economies

Academic journal article The European Journal of Comparative Economics

Inflation Targeting, between Rhetoric and Reality. the Case of Transition Economies

Article excerpt

1. Introduction

In recent years a number of central banks have adopted IT as a monetary policy regime. There is now a large literature that deals with IT; see among others, Bernanke et al. (1999), Taylor (1999), Truman (2003). The move towards IT started in the 1980's, after the period of high inflation caused by the oil shocks. The inflation adversity that prevailed during that period made monetary institutions to voice their strong commitment to fighting inflation. Recent developments in economic theory strengthened the case for switching towards IT. The basic macroeconomic framework of the New Neoclassical Synthesis (Goodfriend and King, 1997) has provided a theoretical foundation for models employed in monetary policy analysis. These models seem to suggest that a central bank (CB) should pursue an activist policy to target inflation. It has to be said however, that it is too early to judge how well the IT framework is working. The rationale for IT is essentially a long-term one and the inflation targeters' experience is too limited yet in order to provide a definite assessment of its success or failure.

In a comprehensive study, Mishkin and Schmidt-Hebbel (2001) argue that inflation targeting proved to be in general a successful policy. The authors claim that IT reinforced accountability, credibility, resilience to external shocks and helped high inflation countries to reduce inflation to normal levels (most of them were emerging economies). Yet they point that, at the end of the process, inflation in IT countries is not lower than in non-IT countries. Along the same lines Ball and Sheridan (2004) show that, once corrected for the initial conditions, the differences between inflation targeters and non-targeters are minor. Fraga, Goldfajn and Minella (2003) also argue that average inflation in both emerging and developed economies fell after the adoption of IT. Other authors such as Friedman (2004) contend that IT, as practiced in reality in the low inflation countries, actually obscures the communication of the central bank's goals. Moreover, Friedman (2004) argues that this monetary policy framework is not as transparent as claimed by most IT advocates, casting doubts on the benefits brought about by the adoption of IT.

A recent analysis made by the IMF (2) concludes that IT appears to have generated a lower inflation environment in countries that decided to adopt this monetary policy framework. However, it is not clear to what extent the increase in globalisation and a better understanding of how monetary policy works in developed economies helped in the creation of such an environment. Moreover, the analysis makes inferences on the group of IT countries from emerging markets as a whole without distinguishing the subgroup of transition economies. Such a distinction would be useful given that transition economies face special circumstances--expectations in these countries are driven by EU accession and Maastricht criteria impose additional constraints on the implementation of monetary policy.

This paper examines the inflation targeting regime in the context of transition economies. The success of such a regime depends largely on the degree to which certain general requirements are met. As experience in a number of transition economies has shown so far, targeting inflation is not an easy task. The ongoing restructuring process in these economies makes the inflation forecasting process more difficult and introduces an additional source of uncertainty into the system. Moreover, additional constraints imposed either by the Maastricht criteria or the requirement to join the ERM II prior to the euro adoption complicate matters further. By unequivocally choosing inflation as a nominal anchor the central banks could face potential dilemmas if, for example, the exchange rate appreciated too much following capital inflows. The idea of the paper is to present the broad framework in which inflation targeting could operate efficiently and provide an assessment of the extent to which such a regime, when applied to transition economies, could fit into this framework. …

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