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NBER WORKING PAPER SERIES

CAN INFLATION TARGETING WORK

IN EMERGING MARKET COUNTRIES?

Frederic S. Mishkin

Working Paper 10646

www.nber.org/papers/w10646

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue

Cambridge, MA 02138

July 2004

For presentation in a conference in honor of Guillermo Calvo, held on April 15 and 16, 2004 at the

International Monetary Fund in Washington, DC. The views expressed in this paper are exclusively those of

the author and not those of Columbia University or the National Bureau of Economic Research.The views

expressed herein are those of the author(s) and not necessarily those of the National Bureau of Economic

Research.

©2004 by Frederic S. Mishkin. All rights reserved. Short sections of text, not to exceed two paragraphs, may

be quoted without explicit permission provided that full credit, including © notice, is given to the source.

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Can Inflation Targeting Work in Emerging Market Countries?

Frederic S. Mishkin

NBER Working Paper No. 10646

July 2004

JEL No. E5, F3

ABSTRACT

This paper explores issues in emerging market countries to make inflation targeting work for them.

It starts by outlining why emerging market economies are so different from advanced economies and

then discuss why developing strong fiscal, financial and monetary institutions is so critical to the

success of inflation targeting in emerging market countries. Then it discusses two emerging market

countries which illustrate what it takes to make inflation targeting work well, Chile and Brazil. It

then addresses a particularly complicated issue for central banks in emerging market countries who

engage in inflation targeting: how they deal with exchange rate fluctuations. The next topic focuses

on the IMFs role in promoting the success of inflation targeting in emerging market countries. The

conclusion from this analysis is that inflation targeting is more complicated in emerging market

countries and is thus not a panacea. However, inflation targeting done right can be a powerful tool

to help promote macroeconomic stability in these countries.

Frederic S. Mishkin

Graduate School of Business

Uris Hall 619

Columbia University

New York, NY 10027

fsm3@columbia.edu

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1 Although I suspect that Guillermo may be more favorable now, but you will have to ask

him.

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An important theme in Guillermo Calvo’s work has been that emerging market

economies are very different from advanced economies, and this has important implications

that need to be factored in when designing macroeconomic policies. For example, Guillermo

(e.g. see Calvo, 1999a, Calvo, 2001 and Calvo and Mendoza, 2000) has been quite skeptical of

inflation targeting as a monetary policy strategy for emerging market countries.1 He worried that

allowing too much discretion to policymakers in the weak institutional environment of emerging

market countries might lead to poor macroeconomic outcomes. I am known to be an advocate of

inflation targeting, but I think that Guillermo’s concerns about inflation targeting’s efficacy in

emerging market countries need to be taken seriously.

Before starting it is important to make clear what an inflation targeting regime is all

about. It comprises five elements: 1) the public announcement of medium-term numerical

targets for inflation; 2) an institutional commitment to price stability as the primary goal of

monetary policy, to which other goals are subordinated; 3) an information inclusive strategy in

which many variables, and not just monetary aggregates or the exchange rate, are used for

deciding the setting of policy instruments; 4) increased transparency of the monetary policy

strategy through communication with the public and the markets about the plans, objectives,

and decisions of the monetary authorities; and 5) increased accountability of the central bank

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many of them routinely reported numerical inflation targets or objectives as part of the

governments economic plan for the coming year, and yet their monetary policy strategy

should not be characterized as inflation targeting, which requires the other four elements for it

to be sustainable over the medium term.

In this paper, I explore what additional issues need to be addressed in emerging market

countries to make inflation targeting work for them. I start by outlining why emerging market

economies are so different from advanced economies and then discuss why developing strong

fiscal, financial and monetary institutions is so critical to the success of inflation targeting in

emerging market countries. Then I discuss two emerging market countries which illustrate what

it takes to make inflation targeting work well, Chile and Brazil. I then address a particularly

complicated issue for central banks in emerging market countries who engage in inflation

targeting: how they deal with exchange rate fluctuations. The next topic focuses on the IMF’s

role in promoting the success of inflation targeting in emerging market countries. The

conclusion from this analysis is that inflation targeting is more complicated in emerging market

countries and is thus not a panacea. However, inflation targeting done right can be a powerful

tool to help promote macroeconomic stability in these countries.

WHY EMERGING MARKET ECONOMIES DIFFER FROM ADVANCED

differences for emerging market countries that must be taken into account to derive sound theory

and policy advice. These are:

• Weak fiscal institutions.

• Weak financial institutions including government prudential regulation and

supervision.

• Low credibility of monetary institutions.

• Currency substitution and liability dollarization.

• Vulnerability to sudden stops (of capital inflows).

Advanced countries are not immune to problems with their fiscal, financial and monetary

institutions, the first three items in the list above, but there is a major difference in the degree of

the problem in emerging market countries. Weak fiscal, financial and monetary institutions

make emerging market countries very vulnerable to high inflation and currency crises, so that the

real value of money cannot be taken for granted. As a result, emerging market countries face the

threat that domestic residents may switch to a foreign currency leading to currency substitution

(Calvo and Végh, 1996). Currency substitution is likely to be due not only to past inflationary

experience but also to the sheer fact that a currency likes the U.S. dollar is a key unit of account

for international transactions. This phenomenon has induced the monetary authority to allow

banks to offer foreign exchange deposits. In this fashion, a sudden switch away from domestic

and into foreign money need not result in a bank run, since in the presence of foreign exchange

deposits, such a portfolio shift could be implemented by simply changing the denomination of