Monetary Regimes and Inflation Targeting

• Author: Enzo Croce and Mohsin S. Khan
• Position: Chief of the Western Hemisphere Division of the IMF Institute/Institute's Director

Inflation targeting-a framework for monetary policy that commits the central bank to achieving low inflation-has enjoyed considerable success among industrial countries in helping to maintain price stability. Developing countries may also benefit from this approach, which enhances transparency and compels policymakers to deepen reforms.

Backed by experience and strong empirical support, academics and policymakers alike agree that high inflation (and its associated high variability) distorts decisions private agents make about investment, saving, and production and ultimately leads to slower economic growth. As a consequence, during the last 15 years or so, a growing number of countries have granted institutional independence to central banks and statutorily committed them to aim monetary policy primarily at achieving some form of price stability.

Rules versus discretion

After years of high inflation, the world entered a period of price stability in the 1990s, not only in the industrial world but also in developing countries. Central banks have helped this favorable trend by moving increasingly toward announcing the future course of key nominal variables as a way to influence inflationary expectations. Such announced intermediate targets (or rules) help improve policy credibility by limiting the central bank's incentive to exploit short-run trade-offs between output movements and inflation, which could otherwise give rise to an inflationary bias. Operationally, the relevance of these intermediate targets is twofold: they prevent domestic or external shocks from leading to permanently higher inflation; and they make the long-term commitment to price stability more concrete. In short, these targets act as nominal anchors, committing central banks to implement consistent policies, while providing a transparent yardstick the public can use to monitor policy implementation.

Targeting the exchange rate or monetary aggregates?

Traditionally, intermediate targeting has involved a preannounced exchange rate rule or targets for a specific monetary aggregate. Under the exchange rate rule, monetary policy is severely limited, because it is directed only at the exchange rate, thus constraining the ability of the central bank to respond to domestic or external shocks. By contrast, for countries with flexible exchange rate arrangements, monetary aggregates become the intermediate target for monetary policy. This type of regime is commonly referred to as monetary targeting. Under this system, the central bank moves its instruments (for instance, interest rates) to control monetary aggregates, which are considered the main determinants of inflation in the long run. Thus, controlling monetary aggregates would be equivalent to stabilizing the inflation rate around the target value. Obviously, the ability of monetary aggregates to function effectively as intermediate targets is based both on the stability of their empirical relationship to the goal variable (the inflation rate) and on their relationship to the instruments of monetary policy.

While most developing countries adopted some form of exchange rate targeting following the breakdown of the Bretton Woods arrangement in the mid-1970s, two-thirds of these countries currently follow more flexible exchange rate arrangements. Nevertheless, a number of developing and transition countries continue to maintain fixed or quasi-fixed exchange rates, and some previously high-inflation economies (for example, Argentina since 1991 and Brazil during 1994-98) have effectively used pegged rates to reduce inflation quickly. However, with the growing integration of world capital markets over the past two decades and the increased volatility of capital flows since the 1992 European Monetary System (EMS) crisis, and especially after the more recent financial crises in Asia and Latin America, the conditions for maintaining a fixed exchange rate system have become much more demanding. As a consequence, developing and transition economies that...