Four Essays on Monetary Regimes: Inflation Targeting and a Fixed Exchange Rate system in Emerging Market Economies

Recent evidence has shown that monetary policy has a neutral real effect in the long run. Exploiting the short-run trade-off between inflation and unemployment creates an inflation bias which can be eliminated at a high economic and social cost. Hence, the only variable that could be controlled by the monetary authority in the long run is the inflation rate. This indicates that the monetary policy's role should be placed on achieving the goal of price stability. This thesis considers two monetary regimes with a quantitative target for the goal of price stability. It consists of four separate yet related empirical studies on inflation targeting and a fixed exchange rate system. First, we assess the institutional preconditions for adopting inflation targeting: central bank independence and transparency, in Jordan, where the credibility of low inflation is imported from abroad. These institutional requirements are assessed based on the experience of two inflation targeters that act as a benchmark of the study: New Zealand and the UK, in their first year of implementing the framework. The chapter addresses the institutional challenges of adopting inflation targeting when a country faces a macroeconomic trilemma of exchange rate stabilisation. The assessment of central bank independence, using the index of Mathew (2003), indicates that the central bank of Jordan is not independent as stated by the central bank's personal legislations. The central bank is also not fiscally independent; non-securitised and securitised lending is offered at no cost to cover the expenditure of the central government as well as the public corporations. The assessment of central bank transparency using the index of Eijffinger and Geraats (2006) shows that although providing the market with more transparent policies will not be infeasible, given the enhancement in the level of central bank independence, the central bank should clarify the policy changes and any inclination of preferences and release all relevant macroeconomic data to the public. Comparing the overall results to the two inflation targeters, the study recommends the need to grant the central bank more personal independence and induce more fiscal discipline which entails non-moneterisation of the government deficit in order to build a domestic reputation for the goal of price stability. Second, the interest rate pass through is examined within its intermediate lag of action to shed light on the credibility of monetary policy in Jordan, where the reputation of low inflation is imported through a fixed exchange rate system to the U.S dollar. The Johansen approach is performed to estimate the long-run degree of pass-through along with the speed of adjustment to disequilibrium. The parsimonious conditional dynamic model of Hendry and Doornik (1994) is employed to connect the short-run and long-run effect, and to estimate the mean lag of adjustment under (a)symmetric market response. The results are compared to that of two inflation targeting countries at time proceeding building the credibility of price stability domestically: New Zealand and the UK. This is to show how far Jordan is from building a domestic reputation for the goal of price stability. The empirical findings suggest that the interest rate pass-through in Jordan is weak and slow and the symmetric mean lags in the loan and deposit market are highly sticky. In addition, a deviation from symmetry is found in the loan market, where the mean lag is sticker to decreasing, which indicates the existence of non-competitive pricing behaviour in the market. Comparing the results to the two inflation targeters, the study suggests that Jordan needs to move to a more resilient exchange rate arrangement, provided the need for an intensive reform in economic constitutions and institutions. Third, we examine the credibility of the current experience of a pegged exchange rate system to the US dollar in eleven emerging market economies: Bahamas, Bahrain, Barbados, Belize, Egypt, Jordan, Oman, Kuwait, Lebanon, Qatar and Venezuela, over the annual span from 1996 to 2012. Based on the first generation-demand mismanagement models, the second generation of currency crises and the empirical works on the European Monetary System crisis, two proxies reflecting the market agents' realignment expectations are employed: the interest rate differential and the exchange rate market pressure index. The two proxies are regressed on a set of macro-fundamentals derived from the theory and empirical work of currency crises and gathered from the IMF-IFS and the World Bank Indicators. The analysis is based on unbalanced panel data models: fixed effects and first difference GMM. We construct different setups to consider the small sample size at hand and the nexus between current account and money stock as in the notion implied by the monetary approach to balance of payments, in which a balance of payments deficit results from excessive domestic credit creation. When interest rate differential is used as a proxy for the credibility, both panel models provide evidence that inflation differential is the main driving force for generating realignment expectations, and explains why anchoring interest rates in not feasible for soft fixed exchange rate targeting countries. This result is consistent with the empirical findings on the credibility of the European Monetary System before the collapse. However, when the exchange rate market pressure index is used as a proxy for the credibility, none of the fundamentals appear significant in explaining the realignment expectations. When we examine the credibility in the countries which have not experienced a shift in monetary regime during the study period: Bahamas, Bahrain, Barbados, Belize, Jordan, Oman, the estimation of the fixed effects model suggests that inflation differential is a vital factor of the credibility. The deterioration in current account and the reserve adequacy also appear to be important indicators for expecting realignment from the parity condition in these countries. Fourth, we investigate the relationship between inflation and inflation uncertainty under inflation targeting and a fixed exchange rate system and examine the role of both regimes in lowering inflation rate and inflation uncertainty. We utilise monthly data on consumer price index obtained from the IMF-IFS for the period 01:1980-06:2014 and construct different GARCH in mean models. The findings suggest that the hypotheses of Cukierman and Meltzer (1986) and Friedman (1977) and Ball et al. (1990) are valid under the two monetary regimes, that is, inflation uncertainty increases inflation and inflation generates inflation uncertainty, respectively. The results provide evidence that both regimes could reduce inflation uncertainty; however, it could be argued that the impact of exchange rate targeting on inflation uncertainty holds as long as the possibility to renege on the fixed parity commitment is not perceived by the market. The results also indicate that inflation targeters have been successful at reducing the inflation rate and inflation persistence more than fixed exchange rate targeting countries, where the regime has no impact on lowering average inflation and inflation inertia.