Asymetric Exchange Rate Policy in Inflation Targeting Developing Countries

Abstract

In the last decades, many developing countries abandoned their existing policy regimes and adopted inflation targeting (IT) by which they aimed to control inflation through the use of policy interest rates. During the period before the crisis, most of these countries experienced large appreciations in their currencies. Given that appreciation helps central banks curb inflationary pressures, we ask whether central banks in developing countries have different policy stances with respect to depreciation and appreciation in order to hit their inflation targets. To that end, we analyze central banks’ interest rate decisions by estimating a nonlinear monetary policy reaction function for a set of IT developing countries using a panel threshold model. Our findings suggest that during the period under investigation (2002-2008), central banks in developing countries implementing IT tolerated appreciation by remaining inactive in case of appreciation, but fought against depreciation pressures beyond some threshold. We are unable to detect a similar asymmetric response for IT advanced countries suggesting that asymmetric policy stance is peculiar to IT developing countries. Although there is a vast literature on asymmetric responses of various central banks to changes in inflation and output, asymmetric stance with regards to exchange rate has not been analyzed yet in a rigorous way especially within the context of IT developing countries. In this sense, our study is the first in the literature and thus is expected to fill an important gap.