Three Essays on Monetary Policy, Inflation Targeting Rules and Aggregate Shocks: Evidence from Emerging Market Countries

This dissertation investigates macroeconomic performance in emerging-market countries (EMCs) with inflation targeting (IT) regimes. The first chapter examines the role of the exchange rate in IT for a set EMCs, asking whether interest-rate policy responds to exchange-rate fluctuations and if so why. Despite adoption of IT, the exchange rate tends to be a key objective in policy interest-rate reaction functions in EMCs. The often cited possible reasons for this behavior are fear-of-floating (Calvo and Reinhart 2002) and fear-of-inflation (Ball 2000). The central question we explore is whether the weight on the exchange rate reflects efforts to minimize fluctuations in inflation and output (i.e., optimal behavior consistent with IT goals), or otherwise constitutes suboptimal behavior because policy is not focused on IT goals, but on other priorities such as trying to stabilize financial institutions by attenuating exchange-rate swings. Features in EMCs that may complicate use of IT include weak domestic financial institutions and underdeveloped domestic financial markets, thin foreign-exchange markets, high exchange-rate pass-through to inflation and vulnerability to sudden stops in capital inflows. The analysis estimates a set of empirical equations to identify standard targeters and mixed strategy targeters (with significant weight on the exchange rate) and to delineate whether these patterns are consistent with optimal behavior or not. We find the choice of having the exchange rate in the reaction function to reflect optimal policy concerns more than concerns with financial-vulnerability. EMCs have achieved a reduction in average inflation regardless of whether they implement standard or mixed-strategy alternatives.The second chapter asks how the adoption of IT in South Africa has influenced wage- and price-setting behaviors. If credible, IT is expected to durably anchor inflation expectations and change the inflation process by defining how shocks to aggregate demand and aggregate supply affect core price inflation dynamics and growth (Clifton et al. 2001). Agents will prefer longer contracts substantially reducing the responsiveness of the wage-price setting process to inflation shocks. For South Africa, the questions we examine are whether IT has induced a shift in forward- vs. backward-looking influences on wage-price-setting, which has reduced or even eliminated wage-price-indexation (i.e., workers and firms will adjust wages/prices less frequently in response to inflation shocks); and whether IT has resulted in a structural shift in the inflation-cost trade-off (i.e., marginal costs will be less sensitive to inflation shocks). We estimate a hybrid-New Keynesian Phillips curve (NKPC) because the price-rigidity implied in the NKPC has important implications for the role of IT in affecting price dynamics and real unit costs. We report evidence of a significant structural shift consistent with IT encouraging more forward-looking wage-price setting behavior relative to backward. The IT program appears to induce a quantitative improvement in the tradeoff between inflation and real marginal costs.Finally, the third chapter focuses on the role of IT in offsetting exogenous shocks to aggregate demand and supply in South Africa. The key question is whether inflation, output, and the short-term interest rate have become more resilient in the face of amplified aggregate shocks. South Africa is susceptible to unique exogenous shocks as a result of fluctuations in global commodity demand, which presents serious challenges for monetary policy. While direct first-round effects from such shocks have been large, second round effects which manifest through wage markup demands and sharp rises in inflation expectations exert huge pressures on prices and output. We estimate a structural Vector Autoregression (SVAR) system identified via a small open-economy New Keynesian Model. We find evidence that pass-through of shocks to inflation, output and the short-term policy interest rate is resilient in the inflation targeting period and these variables have been stable relative to the size of aggregate shocks.