Does Inflation Targeting Matter in Developing Countries? A New Approach
Developing countries that target inflation tend to have economies less open to trade, more developed (a higher share of industry and services to GDP), more independent central banks and more diversified exports compared with developing countries that do not target inflation. Controlling for these variables, the probability of inflation targeting (IT) adoption is not associated with GDP/capita, fiscal dominance and average inflation rates. Developing countries that had low inflation rates before IT adoption also had lower fiscal dominance and higher financial depth. After IT adoption, all developing countries experienced decreases in inflation rates, but targeters had larger decreases in inflation rates. After controlling for factors historically associated with low inflation rates (such as fiscal dominance and financial depth), as well as initial inflation rates (to control for reversion to the mean), central bank independence and degree of openness to trade, I found that the choice of inflation targeting helped decrease inflation rates in developing IT-ers.
The Asian crisis of the 1990s brought into question the adequacy of soft pegs for developing countries. The alternatives to soft pegs suggested by the literature are fixed exchange rates and inflation targeting. Using a multinomial logit model of monetary policy choice between hard pegs, inflation targeting, and neither, I find that inflation targeters are less open to trade, more developed, have more diversified exports and have more independent central banks than the countries in the control group, while hard pegs are more developed and their central banks have less actual independence than those in the reference group. Fiscal dominance, central bank governors' turnover rate and restrictions on financing the deficit by the central bank do not play a role in the choice of monetary policy.