Mukherjee, Sanchita (2011): Does the level of capital openness explain “fear of floating” amongst the inflation targeting countries?
Download (414Kb) | Preview
Under the assumption of perfect capital mobility, inflation targeting (IT) requires central banks to primarily focus on domestic inflation and to let their exchange rate float freely. This is consistent with the macroeconomic trilemma suggesting monetary independence, perfect capital mobility and a fixed exchange rate regime are mutually incompatible. However, some recent empirical evidence suggests that many developed and developing countries following an IT regime are reacting systematically both to deviations of inflation from its target and to exchange rates. I empirically examine whether the responsiveness of the interest rate to exchange rate fluctuations can be explained in terms of limited capital openness. Applying Arellano-Bond dynamic panel estimation method for 22 IT countries, I find that short-term interest rates do respond to real exchange rate fluctuations. However, the responsiveness of the interest rate to the exchange rate declines significantly as capital market openness increases. The results indicate that capital controls have a significant impact on the exchange rate policy of the IT central banks, as the central banks have relatively less control over the exchange rate movements with greater openness of the capital market.
|Item Type:||MPRA Paper|
|Original Title:||Does the level of capital openness explain “fear of floating” amongst the inflation targeting countries?|
|Keywords:||Macroeconomic Trilemma; Inflation Targeting; Interest Rates; Exchange Rate Policy; Capital Market Openness|
|Subjects:||E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies
E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy
E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics
|Depositing User:||Sanchita Mukherjee|
|Date Deposited:||21. Apr 2011 20:51|
|Last Modified:||16. Feb 2013 00:33|
Aizenman, J., Hutchison, M. and Noy, I. (2008), “Inflation targeting and real exchange rates in emerging markets”, World Development, Forthcoming.
Amato, J. D. and Gerlach, S. (2002), “Inflation targeting in emerging market and transition economies”, European Economic Review, Vol. 46, pp. 781-790.
Anderson, T. and Hsiao, C. (1981), “Estimation of dynamic models with error components”, Journal of the American Statistical Association, Vol. 76, pp. 598-606.
Arellano, M. and Bond, S. (1991), “Some tests of specification for panel data: Monte Carlo evidence and an application to employment equations”, The Review of Economic Studies, Vol. 58, pp. 277-297.
Calvo, G. and Reinhart, C. M. (2002), “Fear of floating”, The Quarterly Journal of Economics, Vol. 117, pp. 379-408.
Castelnuovo, E. (2006), “Describing the Fed’s conduct with Taylor rules: Is interest rate smoothing important?”, The IUP Journal of Monetary Economics Vol. 0, pp. 57-77.
Chinn, M. and Ito, H. (2008), “A new measure of financial openness”, Journal of Comparative Policy Analysis, Vol. 3, pp. 309-322.
Clarida, R., Gali, J. and Gertler, M. (1998), “Monetary policy rules in practice: Some international evidence”, European Economic Review, Vol. 42, pp. 1033-1067.
Clarida, R., Gali, J. and Gertler, M. (2000), “Monetary policy rules and macroeconomic stability: Evidence and some theory”, Quarterly Journal of Economics, Vol. 115, pp. 147-180.
Coelho, B., and Gallagher, K. (2010), “Capital controls and 21st century financial crises: Evidence from Colombia and Thailand", Political Economy Research Institute, University of Massachusetts at Amherst Working Paper 213.
Edwards, S. (2006), “The relationship between exchange rates and inflation targeting revisited”, National Bureau of Economic Research (NBER) Working Paper 12163.
Edwards, S. and Rigobon, R. (2009), “Capital controls on inflows, exchange rate volatility and external vulnerability”, Journal of International Economics, Vol. 78, pp. 256-67.
English, W., Nelson, W. and Sack, B. (2003), “Interpreting the significance of the lagged interest rate in estimated monetary policy rules”, The B.E. Journal of Macroeconomics, Vol. 3, Article 5.
Gerlach-Kristen, P. (2004), “Interest rate smoothing: Monetary policy inertia or unobserved variables?”, The B.E. Journals in Macroeconomics, Vol. 4, Article 3.
Giannoni, M. and Woodford, M. (2003), “Optimal inflation targeting rules”, NBER Working Paper 9939.
Goodfriend, M. (1991), “Interest rate smoothing in the conduct of monetary policy”, Carnegie-RochesterConference Series on Public Policy, pp. 7-30.
Holtz-Eakin, D., Newey, W. and Rosen, H. (1988), “Estimating vector autoregressions with panel data”, Econometrica. Vol. 56, pp. 1371-1395.
Lubik, T. and Schorfheide, F. (2007), “ Do central banks respond to exchange rate movements? A structural investigation”, Journal of Monetary Economics, Vol. 54, pp. 1069-1087.
Mishkin, F. and Schmidt-Hebbel, K. (2001), “One deacde of inflation targeting in the world: What do we know and what do we need to know?”, NBER Working Paper 8397.
Ostry, J. D., Ghosh, A. R., Habermeier, K., Chaon, M., Qureshi, M. S., and Reinhardt. D. B. S. (2010), “Capital inflows: The role of controls”, International Monetary Fund Staff Position Note SPN/10/04.
Parrado, E. (2004), “Inflation targeting and exchange rate rules in an open economy”, IMF Working Paper 04/21, pp. 1-37.
Rose, A. (2007), “A stable international monetary system emerges: Inflation targeting is Bretton Woods reversed”, Journal of International Money and Finance, Vol. 26, pp. 663-681.
Rudebusch. G. D. (2002), “”Term structure evidence on interest rate smoothing and monetary policy inertia”, Journal of Monetary Economics, Vol. 49, pp. 1161-1187.
Svensson, L. E. (2000), “Open economy inflation targeting”, Journal of International Economics, Vol. 50, pp. 155-183.
Svensson, L. E. (2002), “Inflation targeting: Should it be modeled as an instrument rule or a targeting rule?”, European Economic Review, Vol. 46, pp. 771-780.
Taylor, J. B. (2001), “The role of exchange rate in monetary policy rules”, The American Economic Review, Vol. 91, pp. 263-267.
Walsh, C. E, (2009), “Inflation Targeting: What have we learned?”, International Finance, Vol. 12, pp. 195-233.
Woodford, M. (1999), “Optimal monetary policy inertia”, NBER Working Paper 7261.
Xafa, M. (2008), “Monetary stability, exchange rate regimes, and capital controls: What have we learned?”, Cato Journal, Vol. 28.