INFLATION TARGETING IN EMERGING COUNTRIES: THE EXCHANGE RATE ISSUES A Dissertation by JAVIER ARTURO REYES ALTAMIRANO Submitted to the Office of Graduate Studies of Texas A&M University in partial fulfillment to the requirements for the degree of DOCTOR OF PHILOSOPHY August 2003 Major Subject: Economics INFLATION TARGETING IN EMERGING COUNTRIES: THE EXCHANGE RATE ISSUES A Dissertation by JAVIER ARTURO REYES ALTAMIRANO Submitted to Texas A&M University in partial fulfillment to the requirements for the degree of DOCTOR OF PHILOSOPHY Approved as to style and content by: ____________________________ ____________________________ Leonardo Auernheimer Thomas R. Saving (Chair of Committee) (Member) ____________________________ ____________________________ Dennis W. Jansen Brian Balyeat (Member) (Member) ____________________________ Leonardo Auernheimer (Head of Department) August 2003 Major Subject: Economics iii ABSTRACT Inflation Targeting in Emerging Countries: The Exchange Rate Issues. (August 2003) Javier Arturo Reyes Altamirano, B.A., Instituto Tecnologico y de Estudios Superiores de Monterrey, Campus Estado de México Chair of Advisory Committee: Dr. Leonardo Auernheimer The current discussion of Inflation Targeting (IT) in emerging economies deals with the effects that nominal exchange rate movements have on the overall inflation rate. The literature has focused in the analysis of the advantages and disadvantages that IT has with respect to other monetary policy regimes and the relevancy of the nominal exchange rate pass-through effect into inflation. So far none of them have dealt with the differences arising from the policy instruments used to fight off inflationary pressure under an IT regime. The literature on IT for emerging economies can be separated in two categories. In the first category the monetary authority uses interest rate policy as the instrument variable to implement and control the inflation target. The second category illustrates when the monetary authorities use international reserves as the instrument to influence the nominal exchange rate in such a way that the depreciation rate is consistent with the overall inflation target. This dissertation presents a model in which both policy instruments are available to the monetary authority. This model is used to address two questions: i) Is IT better than a monetary rule regime? and ii) Is it better to intervene directly in the foreign exchange market rather than use interest rate policy to control exchange rate pressure on inflation, or are they equivalent? The results show that there are important differences between these choices and the answers to these questions are shock dependent. These differences iv arise because the intervention needed under IT is accompanied by important output costs or benefits depending on the direction of the shock being analyzed. Regarding the pass-through effect, some studies have shown that the pass- through effect from currency depreciation into inflation has been decreasing and therefore is becoming less of an issue for these countries. The literature has offered different explanations for these declines but so far they have not been directly linked to the adoption of IT. This dissertation shows that lower pass-through levels can be a natural result of fear of floating observed in emerging countries that adopted IT and therefore exchange rate effects on inflation are still relevant. v To Maritza and my Parents vi ACKNOWLEDGEMENTS First of all I would like to thank my professors back at ITESM, they are the ones who introduced me to Economics and are partly responsible for my acceptance to Texas A&M. Especially, I would like to thank Professors Marcela Villegas, Benjamin Garcia and Gerardo Dubcovsky. During the first three years of the Ph.D. program in Texas A&M, I was heavily influenced by my professors including Heather Anderson, Richard Anderson, Badi Baltagi, James Griffin, Timothy Gronberg, William Neilson, Norman Swanson, and Curtis Taylor. I am sure that much of the knowledge they passed on to me is reflected on this dissertation. I would like to express my eternal gratitude to Professor Leonardo Auernheimer who has been more than my advisor, inside the classroom he has been my mentor and guide for my economic thinking, while outside he has been a friend to me and my family. I also thank the other members of my committee: Professors Brian Balyeat, Dennis W. Jansen and Thomas R. Saving, who helped me in one way or another throughout the completion of this dissertation. Paula Hernandez-Verme is not on my committee, but she went out of her way to find time to discuss my research, and for this, I am thankful. Over the past five years I have been in countless discussions with my fellow graduate students, and I thank them all, especially Chris Ball, Pablo Gonzalez, Sittisak Leelahannon, Karla Rossette, Victor Saenz and Harold Zavarce. My gratitude also goes to Professor Hae-shin Hwang and the Department of Economics for giving me the opportunity to come to Texas A&M. Finally, I thank Maritza for her unconditional support over the past ten years and my parents and brothers for their continuing support after twenty-eight years. vii TABLE OF CONTENTS CHAPTER Page I INTRODUCTION………………………………………………………... 1 II EMPIRICAL ANALYSIS OF THE EXCHANGE RATE PASS-THROUGH EFFECT INTO INFLATION AND FEAR OF FLOATING IN BRAZIL, CHILE, AND MEXICO………………… 9 A. Introduction………………………………………………….. 9 B. Brief Review of Inflation Targeting Adoption and Evolution …………………………………………………….. 10 1. Inflation Targeting Adoption ……………………………. 10 2. Experience with Inflation Targeting……………………... 12 C. Empirical Analysis of the Pass-Through Effect……………... 14 D. Empirical Analysis of Fear of Floating………………………. 28 E. Conclusion…………………………………………………… 33 III THE COMPREHENSIVE MODEL FOR INFLATION TARGETING AND A MONETARY RULE…………………………… 35 A. Introduction……………………………………………………… 35 B. The Model……………………………………………………….. 35 C. Characterizing Equilibrium……………………………………… 44 D. Inflation Targeting Policy Instruments………………………….. 47 IV INFLATION TARGETING, MONETARY RULE AND PASS-THROUGH EFFECT ANALYSIS USING THE COMPREHENSIVE MODEL……………………...…………………… 48 A. Introduction…………………………….…..……………………. 48 B. World Interest Rate (rt) Shock……………….………………….. 48 1. Under a Monetary Rule Case…….…….………………….. 49 2. Under Inflation Targeting………….……..………………... 50 2.A. With International Reserves…..……….……………. 52 2.B. With Interest Rate Policy……..………..……………. 53 viii CHAPTER Page C. Money Demand Shock…………………………………….……… 55 1. Under a Monetary Rule……………………………….…….. 56 2. Under Inflation Targeting…………………………….……... 57 2.A. With International Reserves………………….………. 57 2.B. With Interest Rate Policy…………………………….. 59 D. Summarizing the Results and Welfare Analysis…………………. 60 E. Comment on the Parameters of the Model……………………….. 63 F. Correlation between Inflation and Domestic Currency Depreciation, Pass-through Effect and Fear of Floating under Inflation Targeting.……………………………………………….. 64 1. The Framework for the Analysis…………………………… 64 2. Nominal Exchange Rate Movements and the Correlation between Inflation and Domestic Currency Depreciation under Inflation Targeting……………………....…………… 66 3. Nominal Exchange Rate Pass-Through Effect into Inflation under Inflation Targeting…………………………. 68 V CONCLUSIONS……………………………………………...………….. 72 REFERENCES………………………………………………………………….... 75 APPENDIX 1…………………………………………………………………….. 79 APPENDIX 2…………………………………………………………………….. 91 APPENDIX 3…………………………………………………………………….. 92 VITA……………………………………………………………………………… 97 ix LIST OF TABLES TABLE Page I Correlation Analysis between Annual Inflation and Depreciation Rates……………………………………………………….. 25 II Estimated Nominal Exchange Rate Pass-Through into Inflation ……..…. 26 III Variability Analysis of the Nominal Exchange Rate, International Reserves and the Nominal Interest Rate………………………………….. 31 IV Simulated Correlation between Inflation and Depreciation Rates for a Regime Switch from a Fixed Exchange Rate Regime to an Inflation Targeting Regime……………………………………………………….... 68 x LIST OF FIGURES FIGURE Page 1 Realized Annual Inflation Rates and Inflation Targets for Brazil, Chile, and Mexico………………………………………………………. 12 2 Correlation Analysis between the Annual Inflation and Depreciation Rates for Brazil (1993:01-2002:12), Chile (1991:01-2002:12), and Mexico (1986:01-2002:12) with a Four Year Initial Window………….. 15 3 Estimated Coefficients for the Depreciation Rate in Equation (1) for Brazil (1993:01-2002:12), Chile (1991:01-2002:12), and Mexico (1986:01-2002:12) with a Five Years Initial Window…………. 18 4 Estimated Coefficients for the Depreciation Rate in Equation (2) for Brazil (1993:01-2002:12), Chile (1991:01-2002:12), and Mexico (1986:01-2002:12) with a Five Years Initial Window…………. 22 5 Impulse Response Function of CPI and Percentage of Variance of CPI Explained by the Nominal Exchange Rate (After a One Standard Deviation Innovation in the Nominal Exchange Rate)………………….. 25 6 Percentage of Interest Rate and International Reserves Variance Explained by the Domestic Currency Depreciation (After a One Standard Deviation Innovation in the Depreciation Rate)………………. 30 7 Phase Diagram of the Comprehensive Model…………………………… 46 8 Representation of an Increase in the World Interest Rate……………….. 49 9 An Increase in the World Interest Rate: Results for the Monetary Rule and the Inflation Targeting Regime with International Reserves….. 51 10 An Increase in the World Interest Rate: Results for the Monetary Rule, the Inflation Targeting Regime with International Reserves, and