Inflation Targeting, Exchange Rate and Financial Globalization

Abstract

In this paper we investigate the impact of financial globalization on the behavior of inflation targeting emerging market economies with respect to exchange rate – do central banks respond to exchange rate movements or not. We use quarterly data for six emerging market inflation targeting economies from the date of their inflation targeting adoption to 2009 Q4. The study uses small open economy new Keynesian model a la Gali and Monacelli (2005), and employs multi-equation GMM technique to investigate the relationship. We find that the response of central bank to the exchange rate in case of Brazil, Chile, Mexico and Thailand is statistically significant while insignificant for Korea and Czech Republic. Theoretically, it should not be so as even under flexible inflation targeting central bank responds to inflation deviation and output gap ; we think that the peculiar characteristics of emerging markets, like fear of floating, weak financial system and low level of central bank credibility make exchange rate important for these economies.