Monetary-regime switch from exchange-rate targeting to inflation targeting: with reference to developing economies

Abstract
The objective of this thesis is to investigate whether a switch from exchange-rate targeting (de-facto a fixed exchange rate) to inflation targeting will facilitate a more appropriate monetary policy and a more stable macroeconomic environment in developing economies. To achieve this objective, the thesis starts by developing the argument that the exchange-rate peg, as a nominal variable, might be unimportant for affecting long-run growth performance, but detrimental to short-run output stability, particularly in times of real shocks. By using a dynamic system-GMM panel estimator, the research finds that the exchange-rate regime is not significant in explaining growth, either overall or in developing countries. Next, the Hausman-Taylor panel method is used to investigate whether the exchange-rate regime is important in determining output volatility. To overcome the spurious-regression problem arising from the potentially persistent rolling-standard-deviation based measure of output volatility, a new measure is defined; namely, the difference between the potential and the actual output, which might arise from either economic policies or external disturbances. The empirical evidence suggests that, for the overall sample and for the developing countries, a terms-of-trade shock larger than 7 percentage points under a fixed, and larger than 9 percentage points under limited-flexible and flexible exchange-rate regimes, will give higher output volatility compared to a float. These findings are in line with the expectation that pegs provide early gains in terms of inflation stabilization, but longer pegs begin to develop into a threat for output stabilization in the aftermath of an aggregate-supply shock and as the economy becomes more financially integrated. Given these findings, the thesis suggests the exchange rate be made flexible and a new nominal anchor established. The thesis argues that the direct targeting of inflation is a rational choice in the aftermath of peg exit. To investigate whether monetary-policy responses change and produce a more stable macroeconomic environment under regime switching from exchange-rate targeting to inflation targeting, allowing for the possibility of an endogenous switch, the thesis adopts the framework of a fairly classical Taylor rule, augmented by the exchange rate. Two modelling approaches are used to undertake the empirical research: a panel switching regression; and a Markov-switching VAR. Results from both suggest that inflation targeting represented a real switch in developing countries and is characterized by a more stable economic environment, by more independent monetary-policy conduct, by policy geared to strict observation of inflation and by marginal consideration of the real fluctuations of the economy.