The Role of the Exchange Rate in Inflation-Targeting Emerging Economies

Occasional Papers, November 24, 2009

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The Role of the Exchange Rate in Inflation-Targeting Emerging Economies

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Bibliographic details

• Authors: Anna Nordstrom, Scott Roger, Mark R. Stone, Seiichi Shimizu, Turgut Kisinbay, Jorge Restrepo
• Published: November 24, 2009
• Series: Occasional Papers
• DOI: https://doi.org/10.5089/9781589067967.084

Summary

• This paper explores the role of exchange rates in emerging economies with inflation-targeting regimes, an issue that has become especially germane during the current episode of financial turmoil and volatile capital flows.
• Under inflation targeting, the interest rate is the main monetary policy tool for influencing activity and inflation, and there is little agreement about the appropriate role of the exchange rate.
• The exchange rate is a more important monetary policy tool for emerging economies that have adopted inflation targeting than it is for inflation-targeting advanced economies.
• Inflation-targeting emerging economies generally have less flexible exchange rate arrangements and intervene more frequently in the foreign exchange market than their advanced economy counterparts.
• The enhanced role of the exchange rate reflects these economies' greater vulnerability to exchange rate shocks and their less developed financial markets.
• A sharper focus on the exchange rate may cause some confusion about the commitment of central banks to achieve the inflation target and may also complicate policy implementation.
• Global inflation pressures, greater exchange rate volatility, and the financial stresses from the global financial turmoil that began in mid-2007 are heightening these tensions.

Key findings

• Exchange rates play a relatively larger role in monetary policy for inflation-targeting emerging economies versus inflation-targeting advanced economies.
• Emerging economies with inflation targeting tend to have:
  • Less flexible exchange rate arrangements.
  • More frequent foreign exchange market intervention.
• Drivers of the enhanced exchange rate role:
  • Greater vulnerability to exchange rate shocks.
  • Less developed financial markets.
• Potential costs and risks:
  • Confusion about central bank commitment to the inflation target.
  • Complication of monetary policy implementation.

Policy implications and challenges

• Monetary authorities in inflation-targeting emerging economies must balance:
  • The need to manage exchange rate volatility given vulnerability to shocks and less developed markets.
  • The imperative to maintain clear commitment to the inflation target to avoid confusing policy signals.
• Heightened external pressures (global inflation, exchange rate volatility, and financial stresses since mid-2007) increase the difficulty of this balancing act.

Context and scope

• Authors: Anna Nordstrom, Scott Roger, Mark R. Stone, Seiichi Shimizu, Turgut Kisinbay, Jorge Restrepo
• Date: November 24, 2009
• Series: Occasional Paper No 2009/004
• Pages: 104
• DOI: https://doi.org/10.5089/9781589067967.084
• ISBN: 9781589067967

International Monetary Fund — The Role of the Exchange Rate in Inflation-Targeting Emerging Economies (Occasional Paper No 2009/004, November 24, 2009).