Exchange Rate Pegging and Inflation:

Transcription

1 The Role of Central Bank Independence June 10, 2012

2 Outline Introduction 1 Introduction Motivation Main Findings Contributions 2 3 Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg 4

3 The Nominal Anchor Theory Motivation Main Findings Contributions What does the theory say? Pegging the exchange rate against the currency of a low-inflation country allows a central bank with low anti-inflation credibility to borrow credibility from the foreign anchor to achieve price stability.

4 The Nominal Anchor Theory Motivation Main Findings Contributions What does the theory say? Pegging the exchange rate against the currency of a low-inflation country allows a central bank with low anti-inflation credibility to borrow credibility from the foreign anchor to achieve price stability. What does the empirical evidence say? It is well established that a fixed exchange rate regime lowers inflation in developing countries.(e.g., Bleaney and Fielding, 2002; Ghosh et al.,1997; Ghosh et al., 2002; Husain et al, 2005; Levy-Yeyati and Sturzenegger, 2001)

5 The Hypotheses Introduction Motivation Main Findings Contributions The Contingent Effect of Central Bank Independence

6 The Hypotheses Introduction Motivation Main Findings Contributions The Contingent Effect of Central Bank Independence The credibility gain and thus the beneficial effect on inflation should diminish as a domestic central banks own inflation-fighting credibility improves.

7 The Hypotheses Introduction Motivation Main Findings Contributions The Contingent Effect of Central Bank Independence The credibility gain and thus the beneficial effect on inflation should diminish as a domestic central banks own inflation-fighting credibility improves. The inflation cost of abandoning a foreign anchor should be smaller in countries where central banks have stronger commitment to low-inflation policy.

8 Motivation Main Findings Contributions Empirical Evidence from Developing Countries Using a sample of 105 developing economies over the period , we find:

9 Motivation Main Findings Contributions Empirical Evidence from Developing Countries Using a sample of 105 developing economies over the period , we find: While a peg is associated with significantly lower inflation,the disinflationary effect of a peg diminishes significantly as a domestic central bank gains more independence.

10 Motivation Main Findings Contributions Empirical Evidence from Developing Countries Using a sample of 105 developing economies over the period , we find: While a peg is associated with significantly lower inflation,the disinflationary effect of a peg diminishes significantly as a domestic central bank gains more independence. While abandoning a peg leads to significantly higher inflation afterwards, the inflation cost decreases significantly as a domestic central bank becomes more independent.

11 What Are Our Contributions? Motivation Main Findings Contributions Make the first attempt in the literature to empirically test for the contingent effect of central bank independence.

12 What Are Our Contributions? Motivation Main Findings Contributions Make the first attempt in the literature to empirically test for the contingent effect of central bank independence. Complement with two strands of existing work on exchange rate regimes: one is the disinflationary effect of a peg and the other is the exiting strategy literature.

13 What Are Our Contributions? Motivation Main Findings Contributions Make the first attempt in the literature to empirically test for the contingent effect of central bank independence. Complement with two strands of existing work on exchange rate regimes: one is the disinflationary effect of a peg and the other is the exiting strategy literature. Have important policy implications for exchange rate regime choices and also the strategy of exiting from a peg.

14 Exchange Rate Regime Classification llzetzki, Reinhart and Rogoff (2009) classification: six broad categories: hard peg, soft peg, managed floating, freely floating, freely falling and dual market. We define a fixed exchange rate regime as either a hard peg or a soft peg.

15 Exchange Rate Regime Classification llzetzki, Reinhart and Rogoff (2009) classification: six broad categories: hard peg, soft peg, managed floating, freely floating, freely falling and dual market. We define a fixed exchange rate regime as either a hard peg or a soft peg. Levy-Yeyati and Sturzenegger (2003) classification: three broad categories: fixed, intermediate and floating. We define a fixed exchange rate regime as observations classified by the authors as fixed.

16 Central Bank s Anti-Inflation Credibility Use central bank independence (CBI) as a proxy of a central banks inflation-fighting credibility.

17 Central Bank s Anti-Inflation Credibility Use central bank independence (CBI) as a proxy of a central banks inflation-fighting credibility. Use a five-year central bank governor turnover rate as a de facto inverse proxy of central bank independence

18 The Empirical Models Introduction Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg Fixed Effect Model: 1 Y it = α+β 1 (fix it indep it )+β 2 (fix it dep it )+γx it +u i +v t +e it

19 The Empirical Models Introduction Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg Fixed Effect Model: 1 Y it = α+β 1 (fix it indep it )+β 2 (fix it dep it )+γx it +u i +v t +e it 2 Y it = α + β 1 fix it + β 2 (fix it turnover it ) + γx it + u i + v t + e it

20 Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg Results from Benchmark Fixed-Effect Models

21 Robustness Checks Introduction Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg

22 Deal with Endogeneity Introduction Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg

23 Allow for Dynamic Effect Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg

24 The Empirical Models Introduction Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg Treatment Effect Model: Y it = α + { β 1 Exit it + β 2 (Exit it turnover it ) + γx it + e it 1 Z it > 0 Exit it = 0 otherwise Z it = αw it + u it

25 Results from Treatment Effect Model Disinflationary Effect of A Peg Inflation Cost of Abandoning a Peg

26 Summary of Results Consistent with the nominal anchor theory, we find strong and robust evidence that central bank independence significantly impacts the nominal anchor function of a fixed exchange rate regime.

27 Summary of Results Consistent with the nominal anchor theory, we find strong and robust evidence that central bank independence significantly impacts the nominal anchor function of a fixed exchange rate regime. The effects of a fixed exchange rate regime on containing inflation and money growth become significantly weaker as central banks become more independent.

28 Summary of Results Consistent with the nominal anchor theory, we find strong and robust evidence that central bank independence significantly impacts the nominal anchor function of a fixed exchange rate regime. The effects of a fixed exchange rate regime on containing inflation and money growth become significantly weaker as central banks become more independent. While an exit event is associated with significantly higher inflation afterwards, the treatment effect decreases significantly with central bank independence.

29 Policy Implications Introduction

30 Policy Implications Introduction The additional benefit of adopting a fixed exchange rate regime on lowering inflation is likely to be negligible for sufficiently independent central banks.

31 Policy Implications Introduction The additional benefit of adopting a fixed exchange rate regime on lowering inflation is likely to be negligible for sufficiently independent central banks. Central bank independence is an important institutional precondition for achieving post-exit price stability.