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Abstract
1- Introduction
2- The link between inflation targeting and natural disasters
3- Empirical strategy and data
4- Inflation targeting and macroeconomic performance
5- Economic mechanisms
6- Sensitivity analysis
7- Conclusions
References
Abstract
We study the characteristics of inflation targeting as a shock absorber, using quarterly data for a large panel of countries. To overcome an endogeneity problem between monetary regimes and the likelihood of crises, we propose to study large natural disasters. We find that inflation targeting improves macroeconomic performance following such exogenous shocks. It lowers inflation, raises output growth, and reduces inflation variability compared to alternative monetary regimes. This performance is mostly due to a different response of monetary policy and fiscal policy under inflation targeting. Finally, we show that only hard, but not soft, targeting reaps the rewards: deeds, not words, matter for successful monetary stabilization.
Introduction
Inflation targeting has become a dominant framework for monetary policy since the 1980s. It is praised not just for its success in bringing down inflation, but also increasing the credibility and accountability of policymakers (Bernanke and Mishkin, 1997; Ball, 2010). Its popularity is reflected in an increasing number of countries adopting inflation targeting (IT). However, the global financial crisis dramatically changed the perception of IT as an optimal framework for achieving macroeconomic stability, especially when the economy is confronting large real or financial shocks. It is argued that IT, by focusing narrowly on inflation, may contribute to a build-up of financial instability (Taylor, 2007; Frankel, 2012), leading central banks to neglect other objectives, such as employment (Stiglitz, 2008), and constraining those monetary authorities dealing with deep recessions (Borio, 2014). As a result, scholars and policymakers call for refining the IT framework to allow for more flexibility (Svensson, 2009).