Inflation targeting and private domestic investment in developing countries

Abstract

Does inflation targeting foster private domestic investment in developing countries? A few studies have attempted to examine this issue, with mixed results. Here we argue that by anchoring public expectations firmly, the inflation targeting framework should enhance monetary policy credibility and macroeconomic stability, thereby promoting investment incentives. Using data from 62 countries over the period 1990–2019 and applying propensity score matching methods, we find that inflation targeting significantly increases domestic investment. However, inflation deviations from the target reduce the favorable effect of inflation targeting on investment. Furthermore, the positive effect of inflation targeting on investment is amplified in emerging economies and in countries with sound fiscal discipline. Finally, we explore the underlying mechanisms and show that macroeconomic stability, i.e., the reduction in inflation and its volatility, interest rate, exchange rate, and output volatility, is the main channel through which the monetary framework promotes domestic investment.