Inflation targeting and exchange rate volatility in emerging markets

Abstract

The paper investigates the relevance of the exchange rate on the reaction function of the central banks of 24 emerging market economies for the period 2000Q1 to 2015Q2. This is done by first employing fixed-effects ordinary least squares and then system generalized method of the moments techniques. Under fixed effects, the exchange rate is found to be an important determinant in the reaction function of emerging market economies. Allowing for the endogeneity of inflation, output gap, and exchange rate, the exchange rate remains a positive and significant determinant, but less quantitatively relevant across inflation-targeting countries. When the sample is partitioned into targeting and nontargeting countries, the exchange rate remains relevant in the reaction function of the latter group. The results remain robust to splitting the sample at the time of the financial crisis of 2007–09 and suggest that, after the crisis, the central banks of emerging market economies responded only to inflation movements in the interest rate reaction function.