Inflation Targeting and the Pass‐through Rate in East Asian Economies

• Date: 01 June 2014
• DOI: http://doi.org/10.1111/asej.12029
• Author: Woong‐Ki Sohn,Hiroyuki Taguchi
• Published date: 01 June 2014

Inflation Targeting and the Pass-through Rate

in East Asian Economies*

Hiroyuki Taguchi and Woong-Ki Sohn

Received 29 August 2011; accepted 25 February 2014

There has been serious debate regarding whether the inflation targeting (IT) frame-

work for the emerging market economies has been an effective nominal anchor.

Focusing on Korea, Thailand and the Philippines, this article aims to contribute to

the debate by providing empirical evidence on a decline in the ‘pass-through’ effect

with IT adoption. Our main findings are as follows. First, under the IT framework,

Korea has followed an inflation responsive rule in a forward-looking manner, while

Thailand has adopted the rule in a backward-looking manner. Second, only Korea

experiences a reduction in the pass-through effect under IT adoption, thereby

showing a linkage between the forward-looking inflation responsive rule and the

pass-through effect. Finally, a test of the sensitivity of inflation expectations to

external price shocks in Korea supports this linkage.

Keywords: East Asian economies, forward-looking, inflation expectations,

inflation targeting, pass-through, policy reaction function.

JEL classification codes: E52, F31, F41.

doi: 10.1111/asej.12029

I. Introduction

Since the 1990s, inflation targeting (IT) has become popular as a framework for

monetary policy among not only advanced countries but also emerging market

economies. Many countries suffered from high inflation from the latter half of the

1970s, and the necessity arose for monetary authorities to make a solid commit-

ment to lower inflation through curbing expected inflation without sacrificing

output and employment. Therefore, in the early stages of the 1990s, IT frame-

works were adopted by advanced countries such as New Zealand, Canada, the

UK, Sweden and Australia. Several emerging market economies with pegged

exchange rate regimes experienced financial crises with the drastic increase in

international capital flow in the 1990s, and, hence, most switched to floating

exchange rate regimes. With the increasing need for emerging market countries to

search for an alternative nominal anchor, IT has been adopted by Chile, Brazil,

*Taguchi (corresponding author): Faculty of Economics, Saitama University, 255 Shimo-Okubo,

Sakura-ku, Saitama 338-8570, Japan. Email: tagusaya0710@s3.wh.qit.ne.jp. Sohn: Ministry of Strat-

egy and Finance, Government of Korea, Government Complex-Sejong, 477, Galmae-ro, Sejong

Special Self-Governing City 339-012, Korea. We would like to thank Dr Daisuke Ishikawa for helping

us formulate the methodology, and also thank participants for helpful comments at the meeting on 28

July 2010 at the Ministry of Finance.

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South Africa and certain East Asian countries (including Indonesia, Thailand and

the Philippines) since the 1990s and in the 2000s. According to Mishkin (2000),

IT has become as an attractive alternative anchor for emerging market economies

following its successfully adoption by several advanced countries.

The question is how we can evaluate the performance of the IT framework that

has so far been adopted. There appears, by and large, to be a consensus in the

academic literature that the IT adopted in advanced countries has provided a

supportive framework for monetary policy and the macroeconomy. As far as

emerging market countries are concerned, however, there have been less than

sufficient advances in research on IT to date, and no consensus views have been

formed in the literature. In particular, for East Asian countries, which only started

to introduce IT around 10 years ago, there are few academic studies and analyses

on the performance of IT (see Section II below). The greatest issue that emerging

market economies, especially small open ones, are facing in performing IT is the

exchange rate fluctuations in the following two senses. First, a framework of IT

can be realized only when monetary autonomy is secured under a floating

exchange rate regime. Emerging market economies have, however, the problem

of a ‘fear of floating’, as suggested by Calvo and Reinhart (2002), which comes

from a lack of confidence in currency value, especially given that their external

debt is primarily denominated in US dollars. Their efforts to avoid exchange rate

volatility prevent their monetary authorities from concentrating fully on IT.

Second, as Eichengreen (2002) argue, exchange rate fluctuation itself has some

influence on domestic prices through the ‘pass-through’ effect, thereby making it

difficult for the monetary authorities to control inflation and to perform IT. There

is, however, a counterargument against the negative message of the pass-through

effect on IT. Gagnon and Ihrig (2004) argue that an IT framework reduces the

pass-through effect, in the sense that domestic agents are less inclined to change

prices in response to a given exchange rate shock under the strong commitment of

the monetary authority to price stability.

When we try to assess the performance of the IT framework for emerging

market economies, we should recall the reasons why they have adopted such a

framework. According to Mishkin (2000), the motivation was to introduce an

alternative nominal anchor to stabilize inflation after experiencing financial crises

in the 1990s; hence, they switched from pegged to floating currency regimes. The

crucial debate is, then, whether the IT framework for the emerging market

economies has really provided an effective nominal anchor to stabilize inflation

under the condition of exchange rate fluctuations. In this context, focusing on the

pass-through effect, further investigation of whether the pass-through effect has

aggravated IT performance, as Eichengreen (2002) argues, or IT has mitigated the

pass-through effect, as Gagnon and Ihrig (2004) argue, could provide significant

insight into the effectiveness of IT as a nominal anchor.

This article will place the aforementioned debate on the relationship between

IT and the pass-through effect into the context of empirical analyses. Specifically,

we aim to provide empirical evidence on a decline in the pass-through effect in

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Asian Economic Journal © 2014 East Asian Economic Association and Wiley Publishing Asia Pty Ltd