A simple model of some possible long-run adverse effects of inflation targeting

ABSTRACT

In Latin America, Brazil, Chile, Colombia, Mexico and Peru, have been using Inflation Targeting for at least two decades, and although there were significant improvements in social indicators, macroeconomic results have been mixed. In particular, the real exchange rate has been much more volatile and growth was significantly slower in Brazil and Mexico. In accordance with these facts, we sketch a simple New Consensus open economy model with hysteresis and we show that a policy that targets inflation disregarding the effects on the real exchange rate may have negative long-run effects.

KEYWORDS:

• Inflation targeting
• hysteresis
• open economy models

JEL Codes:

• E31
• E52
• E58

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 We stick to the Latin American convention, so the exchange rate is defined as units of domestic currency per dollar. Depreciations means that the exchange rate goes up, while appreciation means that the exchange rate goes down.

2 The sizeable increase in the stock of foreign exchange reserves is a generalized phenomenon. Considering the period 1999–2016, they increased tenfold in Brazil, almost 3 times in Chile, and 6 in Colombia, Mexico and Peru. They range from 15.5% of GDP in Mexico to 32.3% of GDP in Peru (see NU. CEPAL, 2016).

3 Some have also argued that a higher real exchange rate also cuts real wages in terms of tradable goods, which increases profitability and can stimulate savings and investments (Levy-Yeyati & Stuzenegger, 2007), although there are some concerns regarding the empirical and theoretical support of this view (Montiel & Serven, 2008).

4 Two views seems to dominate the debate. Some authors believe that the central bank should not do fine tuning using monetary policy, while others believe that a short-term interest rate is a valuable tool, provided that it is complemented with additional policies (Rochon & Setterfield, 2007, for an overview of the debate). Moreover, some authors have even claimed that Post Keynesian economics is fully compatible with Inflation Targeting (Lima & Setterfield, 2008; Mota dos Santos, 2011).

5 The NC model comes in many forms, and a relatively simple version of the model exist in well-known textbooks (Carlin & Soskice, 2006). This version is a variant of the Aggregate Demand – Aggregate Supply model. The NC model assumes that monetary policy is conducting using a short-term interest rate as the main tool, and that an active monetary policy rule can ensure that the rate of inflation is well anchored by the central bank (i.e. the economy will converge to a unique equilibrium, often through a unique equilibrium path).

6 This implicitly disregards the balance of payments constrain, by assuming that it is possible to taper the international capital market for any amount of funds. In a context of lax international financial conditions and booming commodity prices, this assumption is harmless, as long as the current account remains in surplus or if there is a moderate deficit (as it was the case in the five FITs until very recently). Notice this is also the main assumption of similar models (see Drumond & Porcile, 2012; Drumond & De Jesus, 2016).

7 Because most Latin American countries are price-takers in world markets, it also make sense to distinguish between the tradable and the non-tradable sectors (as in the so-called ‘Dependent Economy Model’). This implies that the real exchange rate $Q$ should be redefined as the (log) of the relative price of the tradables to non-tradable goods. As long as the bulk of employment is generated in the non-tradable sector, which is often the case when a large share of exports are natural resource intensive commodities, the reduced form of the model will not be very different, so equation (1) could capture the demand for non-tradable goods (see Libman, 2018a). In that case, the parameter $a_2$ should be interpreted as the effect of the real exchange rate on the demand for non-tradable goods, and it is possible to have $a_2<0$ if depreciations are short-run contractionary, for example because a higher level of the real exchange rate will reduce the real wage. For the remaining of the paper, we stick to the case where $a_2>0$, but we discuss this issue in section 3.

8 From equations (9) and (10), it follows that the locus that define $\dot{Q}=0$ and $\dot{\pi }=0$ will shift towards the left if $\overline{Y}$ falls. Implicit differentiation of these locus given $\pi$ shows that $\left(\mathrm{\partial }Q/\mathrm{\partial }\overline{Y}\right)<0$ on both cases.

9 In the appendix, we sketch an additional justification based on an adiabatic approximation considering that the real exchange rate is a fast adjusting variable.

10 An improvement in the terms of trade can be captured using a similar reasoning, provided that we capture it mainly via an increase in $b_0$ (triggered by an increase in $a_0$).

11 This idea can be traced back to Keynes Clearing Union plan, when he considered that the surplus countries need to share the burden of the adjustment (1941). While deficit countries are constrained with the balance of payments, and thus they should either let their currencies float or pursue deflationary policies, surplus countries can easily avoid exchange rate appreciation or expansionary policies. Recently, the text of Carlin and Soskice made the exact same point (2006, pp. 366–368). Some authors have supported the idea that the real exchange rate may no revert some predefined equilibrium level, so the real exchange rate may depend on its past evolution. In other words, the real exchange rate is a unit root and its behavior exhibit ‘hysteresis’ (Rapach, 2001; Jenkins, 1999).

Additional information

Notes on contributors

Emiliano Libman

Emiliano Libman holds a Phd in economics from UMASS Amherst. Emiliano Libman is a professor of Economics at the Department of Economics from the University of Buenos Aires and the Bussiness School of the University of General San Martín, and a research fellow at CIMaD.