DOES THE EXCHANGE RATE MATTER FOR MONETARY POLICY UNDER INFLATION TARGETING? EVIDENCE FROM MEXICO, NEW ZEALAND AND CANADA
DOES THE EXCHANGE RATE MATTER FOR MONETARY POLICY UNDER INFLATION TARGETING? EVIDENCE FROM MEXICO, NEW ZEALAND AND CANADA
Files
Publication or External Link
Date
2003-11-13
Authors
Trevino, Juan Pedro
Advisor
Reinhart, Carmen M
Citation
DRUM DOI
Abstract
Recently, many developed and developing countries have adopted inflation targeting as the monetary policy framework. There is large debate regarding the importance of external variables, such as the exchange rate, for monetary policy decisions under this framework, particularly in small open economies. In the first chapter I explore the extent to which the adoption of an explicit inflation target in Mexico can be associated to a de facto change in the behavior of the central bank in terms of how it responds to changes in the exchange rate and other external variables, along with conventional variables considered relevant for monetary policy. The results indicate the presence of a change in the behavior of the central bank in Mexico associated to the adoption of an explicit inflation target in January of 1999. Variables such as policy credibility and the output gap tend to become more important for monetary policy, while the exchange rate becomes relatively less relevant when the inflation target is in operation. As compared to the cases of New Zealand and Canada -two small open economies that have successfully followed this policy prescription- the results suggest that monetary policy implementation in Mexico has become much more like in those countries.
In the second chapter I present a modified version of Drazen and Masson (1994), where instead of assuming exogenous unemployment persistence, an endogenous externality from choosing positive inflation is imposed on unemployment. In face of an adverse shock to unemployment, a policymaker that generates surprise inflation to offset such shock will generate a negative spillover that will translate into future higher unemployment. The result is that this constitutes an additional channel for commitment to zero inflation other than the signaling/reputation channel. This modification may contribute to explain, on the one hand, why a policymaker that is highly committed to lower inflation may still inflate under extreme circumstances, and, on the other, why the central bank in countries like Mexico, where credibility may still be an issue, continue to follow a stringent monetary policy at a cost of "sluggish" economic growth.