The collapse of the Bretton Woods system, the sharp increase in worldwide inflation in the 1970s, and a series of supply shocks led to a search for alternative monetary frameworks. Although many countries experimented with monetary targeting during the 1980s, the results proved to be unsatisfactory (Goodfriend, 2007). There was a need for a better framework to anchor expectations, especially in countries with a history of high inflation. An explicit commitment to a quantitative inflation objective was proposed as a way to bring about and sustain low and stable inflation. Starting with New Zealand and Canada, an increasing number of advanced countries adopted inflation targeting as their monetary framework. Several emerging economies followed suit in the late 1990s (Freedman and Laxton, 2009a). However, for emerging economies, implementation of inflation targeting posed challenges that are different from those in advanced economies.
Key among them are building institutional capacity and overcoming a multitude of policy challenges.
While institutional capacity was largely in place in many developed countries, more work was necessary in emerging economies before inflation targeting could be adopted. An early debate focused on the set of preconditions necessary for successful adoption of inflation targeting. Although initially it was thought that a long and demanding list of strict preconditions should be met, this was later qualified with the successful adoption of inflation targeting in a number of emerging economies (IMF, 2006). Using survey and econometric evidence, Batini and Laxton (2007) show that no inflation targeter-not even industrial economies- had the strict preconditions in place before adopting inflation targeting. The key to successful adoption is the authorities' commitment to the price stability objective and the ability to bring institutional change required to achieve the objective.
In order to prepare the institutional structure for inflation targeting, a number of choices have to be made. These include the choice of the target index and its level; the medium-term targets in the case of disinflation; the long-term definition of price stability; necessary institutional arrangements to establish and enhance transparency; and development of a communications strategy. Heenan, Peters, and Roger (2006) and Freedman and Laxton (2009b) discuss the trade-offs between various organizational choices and provide a cross-country perspective. Inflation targeters use a short-term policy interest rate to provide an anchor for inflation and inflation expectations. In many emerging economies the shift towards a reliance on money...