FIW Working Papers | 2010-11

An Overhaul of a Doctrine: Has Inflation Targeting Opened a New Era in Developing-country Peggers?

The aim of this paper is to empirically examine the effect of a regime switch, from exchange-rate targeting (fixed exchange rate) to inflation targeting, on monetary policy in developing economies, hence adding to evidence on whether inflation targeting along with a managed float provides a better monetary policy compared to exchange-rate targeting. For this purpose, a group of developing countries that have historically experienced such a switch is analysed. This is done by an augmented interest-rate rule a-la Taylor (1993; 2001). Two methodological approaches are used: switching regression and Markov-switching method. Although both approaches have different drawbacks which compensate, still both lead to the conclusion that inflation targeting represented a real switch in developing countries. The period of inflation targeting was characterized by: a more stable economic environment; by more independent monetary-policy conduct; and by strict focus on inflation. Estimates suggest that the switch to a new monetary regime explains these results.