Inflation%20Targeting%20and%20Financial%20Stability%20A%20Perspective%20from%20the%20Developing%20World

Monograph

Inflation Targeting and Financial Stability A Perspective from the Developing World


CODE: IDB-MG-175
AUTHOR(s): Agénor, Pierre-Richard , Pereira da Silva, Luiz A.
PUBLISHED: January 2014
LANGUAGE: English
RELATED TOPICS: Finance
DOWNLOAD FILE IN: English

Abstract:

This study discusses recent experiences with inflation targeting (IT), the challenges that it faces since the global financial crisis, and ways to address them. The discussion is conducted from the perspective of upper middle-income countries. As background for the analysis, the study first provides a review of financial systems in middle-income countries or MICS (with a focus on the role of bank credit), the extent to which exposure to capital flows affects economic stability in these countries, and the link between excessive credit growth and financial crises. Then the study reviews the main features and evidence of the performance of inflation-targeting regimes in middle-income countries. It discusses a number of challenges that IT faces, including fiscal dominance, fear or floating, imperfect credibility, and with respect to an explicit financial stability objective assigned to monetary policy. The issue of complementarity between macroprudential regulation and monetary policy, in the context of an `integrated` IT (or IIT) regime, is taken up next. The nature of monetary policy rules in an IIT regime, and their practical implementation, is also discussed. The analysis suggests that there are robust arguments to support the view that under an integrated inflation-targeting regime, monetary policy should react in a state contingent fashion to a credit gap measure—and possibly to the real exchange rate—in order to address the time-series dimension of systemic risk. However, monetary policy and macroprudential policy are largely complementary instruments. They must be calibrated jointly, in the context of macroeconomic models that account for the type of credit market imperfections observed in middle-income countries and for the fact that macroprudential regimes may substantially affect the monetary transmission mechanism.

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