Can Inflation Targeting Be a Framework for Monetary Policy in Developing Countries?

• Author: Paul R. Masson/Miguel A. Savastano/Sunil Sharma
• Position: Senior Advisor in the IMF's Research Department/Economist in the IMF's Research Department/Senior Economist in the IMF's Research Department
• Pages: 34-37

In a number of industrial countries, the adoption of inflation targeting as a monetary policy framework has enhanced transparency and accountability. Can this framework also be applied to developing countries?

Page 34

EARLIER in the decade, a number of industrial countries adopted a framework for carrying out monetary policy that became known as inflation targeting. They adopted this framework as a response to the difficulties they had encountered in conducting their monetary policy using an exchange rate peg or some monetary aggregate as the main intermediate target. At the same time, they saw the move as a way to improve their record of controlling inflation and to make their monetary policies more transparent and accountable, all measures conducive to improving the credibility of monetary policy. In practice, inflation targeting has also served as a means of explaining to the public the costs of an expansionary monetary policy and the need to preempt any inflationary pressures.

So far only a few industrial countries have practiced inflation targeting-in chronological order, the seven countries are New Zealand, Canada, the United Kingdom, Sweden, Finland, Australia, and Spain. This article examines whether this policy can be applied more widely, particularly in developing countries, which face similar, though often much more difficult problems in designing and conducting monetary policy. Before reaching any conclusions, it is necessary first to consider a conceptual framework in which to understand inflation targeting.

Basic premises

The case for inflation targeting begins with the premise that the main goal of monetary policy in any country must be to attain and preserve a low and stable rate of inflation. Although this premise was the subject of controversy among economists not too long ago, it is widely accepted today because of general agreement on the following four basic propositions:

* An increase in the money supply is neutral in the medium-to-long run. This means that money supply increases have lasting effects only on the price level, not on output or employment.

* High and variable inflation is costly, in terms of either the allocation of resources or long-run growth in output, or both.

* Money is not neutral in the short run. In other words, monetary policy has important transitory effects on a number of real variables, including output and unemployment. There is, however, still an imperfect understanding of the nature and size of these effects, their time frame, and the Page 35 means by which monetary impulses are transmitted to the rest of the economy.

* Monetary policy affects the rate of inflation with lags of uncertain duration and varying strength. These lags make it difficult, if not impossible, for the central bank to control inflation on a period-by- period basis.

Building on these generally agreed principles, a number of economists see inflation targeting as a framework that can improve the design, implementation, and performance of monetary policy compared with the central banks' usual procedures, which tend to lack transparency. It does so by providing a vehicle that is consistent both with recent developments in the theory and practice of monetary policy and with the principles listed above.

Prerequisites

The first requirement for any country considering the adoption of inflation targeting is that the central bank should have a considerable degree of independence. Even though it is not necessary for the central bank to have full legal independence, the monetary authorities must have the freedom to gear the instruments of monetary policy toward some nominal objective.

To meet this requirement, a country must not show any of the symptoms of "fiscal dominance"-in other words, the conduct of monetary policy should not be dictated or constrained by purely fiscal considerations. This implies that public sector borrowing from the central bank and the banking system should be low or nonexistent; the government should have a broad revenue base and should not rely on the revenues from seigniorage generated by excessive currency issuance; domestic financial markets should have enough depth to absorb the placement of public and private debt instruments; and the accumulation of public debt should be...