THE ROLE OF INFLATION TARGETING ON EXCHANGE RATE VOLATILITY: AN EVIDENCE FROM PROPENSITY SCORE MATCHING APPROACH

Year 2022, , 56 - 81, 31.12.2022

Güntülü Özlem Yüksel , İsmail Onur Baycan

https://doi.org/10.11611/yead.1196743

Abstract

This study examines the treatment effects of inflation targeting on exchange rate volatility across a large panel of 91 (36 inflation targeting) countries over the 1985-2019 period on annual basis. We apply propensity score matching methods to developed, developing, and high-income inflation targeting countries and non-inflation targeting countries. Our results reveal that, on average, adopting the inflation targeting policy exerts lower exchange rate volatility in all sample and developing economies. However, subgroups results demonstrate that inflation targeting regimes may lead to higher exchange rate volatility in developed and high-income economies. The outcome from different degrees of flexibility of exchange rates subgroups points out that the inflation targeting regime has significant and lower exchange rate volatility under free-floating regimes however this policy stance has no discernible effect on floating regimes. Additionally, adopted inflation targeting countries are affected by less damage on exchange rate volatility than those adopting exchange rate targeting regimes.

Keywords

Propensity score matching, Exchange rate volatility, Inflation targeting

References

• Alagidede, P. and Ibrahim, M. (2017). "On the Causes and Effects of Exchange Rate Volatility on Economic Growth: Evidence from Ghana". Journal of African Business, 18:2, 169-193.
• Berganza, J. C. and Broto, C. (2012). "Flexible Inflation Targets, Forex Interventions and Exchange Rate Volatility in Emerging Countries". Journal of International Money and Finance, 31, 428-444.
• Bleaney, M. and Tian, M. (2012). "Currency Networks, Bilateral Exchange Rate Volatility and the Role of the US Dollar". Open Economies Review, 23, 785-803.
• Bruno, V., Kim, S., and Shin, H. S. (2018). "Exchange Rates and the Working Capital Channel of Trade Fluctuations". BIS Working Papers, No:694, 1-6.
• Calderon, C. and Kubota, M. (2018). "Does Higher Openness Cause More Real Exchange Rate Volatility". Journal of International Economics, 176-204.
• Caliendo, M. and Kopeining, S. (2008). " Some Practical Guidance for the Implementation of Propensity Score Matching". Journal of Economic Surveys, Vol.22, No.1, 31-72.
• Calvo, G. A. and Reinhart, C.M. (2002). "Fear of Floating". The Quarterly Journal of Economics, Vol.177, No.2, 379-408.
• Carare, A. and Stone, M.R. (2003). "Inflation Targeting Regimes". IMF Working Paper, WP/03/9, 1-36.
• Coulibaly, D. and Kempf, D. (2010). "Does Inflation Targeting Decrease Exchange Rate Pass-through in Emerging Countries?". Banque de France Working Paper No. 303, 1-25.
• Dehejia, R. H. and Wahba, S. (1998). "Propensity Score Matching Methods for Non-Experimental Causal Studies". NBER Working Paper Series, No.6829, 1-22.
• Ebeke, C. and Azangue, F. (2015). "Inflation Targeting and Exchange Rate Regimes in Emerging Markets". IMF Working Paper, WP/12/228, 1-35.
• Edwards, S. (2006). "The Relationship Between Exchange Rates and Inflation Targeting Revisited". NBER Working Paper Series, No. 12163, 1-45.
• Gagnon, J. E. and Ihrig, J. (2004). "Monetary Policy and Exchange Rate Pass-through". International Journal of Finance and Economics, 315-338.
• Gourinchas, P. and Obstfeld, M. (2011). "Stories of the Twentieth Century for the Twenty-First". NBER Working Paper, No. 17252, 1-68.
• Grydaki, M. and Fountas, S. (2010). " What Explains Nominal Exchange Rate Volatility? Evidence from the Latin American Countries". Discussion Paper Series 2010_10, Department of Economics, University of Macedonia, 1-28.
• Heckman, J. J. and Robb, R. (1985). "Alternative Methods for Evaluating the Impact of Interventions: An Overview". Journal of Econometrics, 30(1-2), 239-267.
• Heckman, J. J., Ichimura, H., and Todd, P. E. (1997). "Matching as an Econometric Evaluation Estimator: Evidence from Evaluating a JobTraining Programme". The Review of Economic Studies, Vol.64 No.4, 605-654.
• IMF. (2018). "Annual Report on Exchange Arrangements and Exchange Restrictions". International Monetary Fund.
• Insah, B. and Chiaraah, A. (2013). "Sources of Real Exchange Rate Volatility in the Ghanaian Economy". Journal Economics and International Finance, Vol. 5(6), 232-238.
• Jasova, M., Moessner, R., and Takats, E. (2016). "Exchange Rate Pass-Through: What Has Changes Since the Crisis?". BIS Working Papers, No:583, 1-31.
• Kabundi, A. and Mlachila, M. (2019). "The Role of Monetary Policy Credibility in Explaining the Decline in Exchange Rate Pass-through in South Africa". Economic Modelling, 79, 173-185.
• Karahan, Ö. (2017). "Exchange Rate Pass-Through in Turkey Before and After the Adoption of Inflation Targeting Regime". Financial Assets and Investing, 8(2), 37-48.
• Lechner, M. (1999). "Program Heterogeneity and Propensity Score Matching: An Application to the Evaluation of Active Labor Market Policies". The Review of Economics and Statistics, 84, 205-220.
• Lin, S. (2010). "On the International Effects of Inflation Targeting". Review of Economics and Statistics, 1-18.
• Lin, S. and Ye, H. (2012). "What to Target ? Inflation or Exchange Rate". Southern Economic Journal, 78(4), 1202-1221.
• Lucotte, Y. (2012). "Adoption of Inflation Targeting and Tax Revenue Performance in Emerging Market Economies: An Empirical Investigation". Economic Systems, 36, 609-628.
• Mirchandani, A. (2013). "Analysis of Macroeconomic Determinants of Exchange Rate Volatility in India". International Journal of Economics and Financial Issues, Vol.3, No.1, 172-179.
• Mishkin, F. (2008). "Exchange Rate Pass-Through and Monetary Policy". NBER Working Paper Series, No.13889, 1-19.
• Mundell, R. A. (1961). "A Theory of Optimum Currency Areas". The American Economic Review, Vol.51, No.4, 657-665.
• Oaikhenan, H. E. and Aigheyisi, O.S. (2015). "Factors Explaining Exchange Rate Volatility in Nigeria: Theory and Empirical Evidence". Economic and Financial Review, 53(2), 47-77.
• Ouyang, A.Y, Rajan, R. S., and Li, J. (2016). "Exchange Rate Regimes and Real Exchange Rate Volatility: Does Inflation Targeting Help or Hurt?". Japan and the World Economy , (39), 62-72.
• Pontines, V. (2013). "Inflation Targeting and Exchange Rate Volatility: A Treatment Effect Regression Approach". International Economic Journal, 27:1, 25-39.
• Rose, A. K. (2007). "A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed". Journal of International Money and Finance, 26, 663-681.
• Rosenbaum, P. R. (2002). "Sensitivity to Hidden Bias In Observational Studies". New York, NY.: Springer.
• Rosenbaum, P. R. and Rubin, D. (1983). "The Central Role of the Propensity Score in Observational Studies for Causal Effects". Biometrika, (70), 41-55.
• Taguchi, H. and Sohn, W. (2014). "Inflation Targeting and the Pass-through Rate in East Asian Economies". Asian Economic Journal, Vol.28 No.2, 139-159