Inflation Targeting: A Three-Decade Perspective 1

Transcription

1 Inflation Targeting: A Three-Decade Perspective 1 Salem Abo-Zaid and Didem Tuzemen 3 First version: July This version: December 9 Abstract This study empirically analyzes the possible benefits of inflation targeting using a sample of developing and developed countries for the time period Our work goes one step further beyond the existing studies in the literature in various important aspects: We study not only the behavior of the inflation rates following the adoption of the inflation targeting regime, but also the effects of this regime on the behavior of the growth rates and the fiscal imbalances. Our analysis reveals that this regime has essential benefits for both the developed and the developing countries. Despite starting from considerably higher and more volatile inflation rates compared to the non-targeting countries, the targeting developing countries are found to manage to bring their inflation rates to lower and more stable levels. These countries also experience higher and more stable growth rates. Despite their initial inferior performance, following the adoption of the regime, their growth rates are similar to those of the non-targeting countries. As for the developed nations, we find evidence for higher economic growth rates and conduct of more disciplined fiscal policy after adopting the regime. The improvements in the budget balances are at least partly attributed to an attempt to achieve the inflation target. 1 We would like to thank Prof. Carmen Reinhart for her invaluable comments. Department of Economics, University of Maryland, College Park, MD. abozaid@econ.umd.edu. 3 Department of Economics, University of Maryland, College Park, MD. tuzemen@econ.umd.edu.

2 I Introduction Since the Early 199 s, several countries followed New Zealand, and started to conduct their monetary policies by means of inflation targeting (IT). Currently, countries rely on IT in conducting their monetary policyies. The basic idea behind the adoption of this regime is to set a specific inflation rate which guides the policy makers. This paper aims to shed light on the debated effects of the IT regime on the macroeconomic performances of both the developed and the developing countries by conducting detailed comparisons between the major economic variables of these countries during the last three decades. In particular, our work goes one step further beyond the existing literature in some important aspects: we discuss not only the behavior of inflation rates following the adoption of the IT regime, but also the effects of this regime on the behavior of the growth rates and the fiscal imbalances. To the best of our knowledge, this paper is the first to consider the effect of the IT regime on the fiscal policy. Our main results suggest that the IT regime has important benefits for both the developing and the developed countries. The inflation rates are considerably lower when countries, especially the developing ones, adopt the IT regime. The growth rates are higher when an inflation target is set. Therefore it is misleading to believe that the IT regime has adverse effects on the economic growth. In fact, our analyses reveal that the opposite is true- this regime has positive effects on economic growth, for both the developed and the developing countries. Also, our results point to a clear convergence in growth rates among the developing IT countries following the adoption of this regime. Finally, fiscal imbalances are found to be significantly improved when the countries follow the IT regime. The sharp declines in the inflation rates experienced by the IT countries in the last two decades are mainly attributed to the adoption of this regime. In particular, several countries, mostly the developing ones, experienced sharp declines in their inflation rates following the adoption of the regime. The fall in the inflation rates have also been accompanied by the reductions in the volatilities of both the inflation rates and the real activity. The contribution of the IT regime to the economic performance is however debatable in the literature. Some studies, most notably Ball and Sheridan( ), claim that the fall in the inflation rates during the past 1- years is not unique for the IT countries since a similar pattern is observed in many nontargeting (NT) countries as well. Thus, they claim that the fall in the inflation rates in the IT countries cannot be credited to the IT regime but it is due to some other common factor, such as the reversion of the Spain and Finland abandoned this regime at 1999 when joining the Euro Area. 1

3 inflation rates to their historical lower means. The doubts on the role of the IT regime in dampening the inflation rates become more significant when the developed countries are considered. Nevertheless, it is possible to claim that IT regime has significant effects on lowering the inflation rates in the developing countries which faced very high inflation rates during the 19 s and the early 199 s. In line with the previous studies, we first present the evidence regarding the inflation rates and the economic growth in both the IT and the NT countries. Existing studies in the literature have been mostly interested in examining the effects of IT on the inflation rates and on the volatilities of inflation and output growth. However, studying only the growth volatility is not sufficient; we believe that it is equally important to examine the evolution of actual growth rates following the adoption of the IT regime. This approach is especially useful when testing the claim that the countries attempting to stabilize the price levels are unable to achieve their goals in a costless fashion. More specifically, it is commonly thought that committing to an inflation target can be harmful for economic growth given that the monetary authority s concern in this case is shifted towards inflation stability and away from economic activity. We challenge this belief by comparing the growth rates in the IT and the NT countries. The possible effect of the IT regime on the fiscal policy is another important issue to address. It has been the belief that higher budget deficits are associated with higher inflation rates as mentioned in Sargent and Wallace (191) and Amato and Gerlach (). In particular, governments inflate in order to both increase their inflation tax revenues and lower the real value of their deficits. However, the adoption of the IT regime, which is typically announced by governments, may reduce these incentives for the government. Having the IT regime in place, governments may now tend to be more fiscally disciplined in order to conduct the monetary policy successfully. That is, governments may put greater efforts to keep their deficits low and thus do their part in achieving the inflation target. If this turns out to be the case, the adoption of the IT regime can be attributed to having a better cooperation between the fiscal and the monetary policies. 7 Therefore, one of our major goals is to examine the possible effects of the IT regime on fiscal imbalances, which has never been studied before. We are also interested in observing the changes in the behavior of the macroeconomic variables particularly before and after the adoption of the IT regime. More specifically, we test whether the sharp declines in the inflation rates in the IT countries precede the adoption of the regime. Since we use data The idea has been empirically challenged too. See Catao and Terrones (). See Mishkin and Schmidt-Hebbel (1). 7 See Amato and Gerlach () for more discussion on the possible theoretical effects of fiscal policy on inflation.

4 for about two decades following the adoption of the IT regime for many countries, we are able to conduct more reliable comparisons between the economic performances of the IT and the NT countries. This paper is organized as follows. Section II presents a detailed literature review. Section III provides an overview of the sample and the data. Section IV displays important characteristics of the IT countries. Section V reports the statistical facts about the macroeconomic variables in both the IT and the NT countries. Section IV presents the econometric methodology and the estimation results. Finally, Section IIV concludes. II Literature Review The debate over the role of the IT regime in stabilizing the inflation and the growth rates across countries has been the subject of a voluminous number of studies. This section briefly presents some of these studies with the focus being on the more recent ones. Among the earlier studies, Svensson (1997) claims that the IT regime helps in reducing inflation variability and further claims that if the regime is flexible it can help in stabilizing output as well. Bernanke et al (1999) outline the role of the IT regime in anchoring public s inflation expectations, which in turn helps in stabilizing inflation. They claim that the regime provides an explicit plan and a direction for monetary policy-making. Mishkin (1999) argues that the IT countries manage to significantly reduce both the current and the expected rate of inflation beyond what would have been in the absence of the IT regime. He further emphasizes that once the IT countries manage to reduce their inflation rates, these rates do stay low and do not bounce up during the periods of economic expansions. Following Mishkin (1999), later studies draw attention to the stabilization effects of the IT regime. King () shows that inflation rates are not only lower for the IT countries, but they are also less volatile and less persistent. Thus, he concludes that shocks to inflation at a given period have short-lasting effects on the inflation rates in the IT countries. Neumann and Hagen () conclude that the IT regime promotes convergence by helping countries with inferior performance in catching up. Johnson () reexamines the role of the IT regime in affecting the inflation expectations by using a sample of IT and NT OECD countries. He shows that the level of the expected inflation in the IT countries falls when controlled for the country effects, year effects, ongoing inflation rates, and business cycles. This result Finding an adequate framework for conducting the monetary policy has been undoubtedly one of the major goals of the policy makers since the early 19 s. 3

5 brings him to conclude that a very important success of the IT regime is the additional reduction in the level of the expected inflation. Above mentioned IT-supporting studies are strongly challenged by the frequently cited and thoughtprovoking paper of Ball and Sheridan (). Using a wide sample of IT and NT OECD countries, they find that the IT regime is irrelevant for bringing down the inflation rates and the volatilities in the developed IT countries. Their main motivation is the fact that the inflation rates decline in the NT countries as well. They further argue that the reason for the fall in the inflation rates is simply the mean reversion. Since the initial levels of the inflation rates have been higher for the IT countries, there is a natural tendency of the inflation rates to return back to their means. Thus they conclude that the IT regime is irrelevant in enhancing economic growth for the OECD countries considered in their sample. Some recent studies support the results of Ball and Sheridan (). Using data from a sample of 7 industrial countries, which adopted the IT regime in the 199 s, Lin and Ye (7) find that inflation targeting has no significant effects on the inflation rates or on the volatilities. Sims () argues that the IT regime may be more harmful than useful, if there is a substantial chance that the central bank cannot control the path of inflation. More recently, Goncalves and Salles () test whether the results of Ball and Sheridan () are valid once the developing countries are considered. Using a sample of 3 countries (of which 13 are IT) over the period 19-, they show that the IT countries experience greater drops not only in the inflation rates, but also in the volatilities of the growth rates. Their results imply that the IT regime may have more significant effects on the macroeconomic performance of the developing countries compared to that of the developed ones, simply because the latter do not suffer from severe inflation or other macroeconomic problems to begin with. III Sample and Data Description III-I The Sample As of today, there are countries adopting the IT Regime. 9 However, our sample covers countries since countries adopted this regime only very recently. 1 Among the targeting countries, 1 are developing and 1 are developed countries. In order to make comparisons on the macroeconomic 9 Refer to Table A1 in the Appendix. 1 Indonesia and Slovak Republic in, Turkey in, and Ghana in 7.

6 variables and economic activities, we compose two control groups, one for the developing and one for the developed countries. The control groups constitute of 1 developed and 17 developing NT countries. 11 When choosing the control groups we make an effort to cover a wide range of countries according to their locations, income levels, and data availabilities. As for the developed countries, that is a challenging task since the number of developed countries is relatively small. When choosing the control group for the developed countries we mostly follow the selection in Goncalves and Salles (). The analysis we carry out covers the period There are three main reasons for choosing this time period. First of all, there is almost full data availability for most of the countries in this time period. Second, several countries adopted the IT regime in the second half of the 199 s, so this time period gives us about a decade of Post-IT observations. Third, given that inflation rates were very high during the 197 s, choosing a long sample of extremely high inflation rates would only bias our results. Although inflation rates were also high in the early 19 s, choosing a sample that goes back to 19 is important when assessing the effects of the IT regime for the early targeters, such as New Zealand, Israel and the UK. Along the study, we also check for the robustness of our results by considering a shorter Pre-IT period that starts in 197, which is the year when the inflation rates declined sharply in many developing countries. We follow Ball and Sheridan () and Goncalves and Salles () in determining the adoption year of the NT countries. For each control group, the adoption year is the average year of IT adoption among the corresponding IT countries. Hence, the adoption years are 199 and 199 for the developed and the developing countries, respectively. III-II The Data Our data covers different variables of interest, namely the inflation rates, GDP growth rates, and government fiscal imbalances. The inflation rate is measured by the annual change in the Consumer Price Index (CPI). The GDP growth is the yearly growth rate in real GDP. Following Alesina and Tabellini (), fiscal policy is measured by the annual budget imbalances as a share of GDP. Note that, as pointed out by Ilzetzki and Vegh (), this might not in general be the adequate measure of fiscal policy since it embeds the government revenue side. 13 Yet, for our purposes, this is a good measure of 11 Refer to Table A in the Appendix 1 We do not include data for in our sample since the severe economic crisis may heavily bias the results without adding any new insights. 13 A better measure of fiscal policy is the tax rates, but the relevant data is unfortunately unavailable.

7 fiscal policy because of two reasons. First, as mentioned before, studies in the literature typically link the government deficits, not only the government expenditures, to inflation. Second, it has been the case that countries, mainly the developing ones, use inflation in order to raise revenues in the form of inflation tax. Hence, looking at the revenue side of the government budget is equally important when inflation is considered. We use the budget balances since it takes into account the two sides of the government budget. Our main data comes from the IMF s World Economic Outlook (WEO) database. 1 This database, however, does not report fiscal data for the developing countries. Therefore, when composing the fiscal data, we use the database of Kaminsky, Reinhart and Vegh () as well as the fiscal data reported on the websites of central banks of countries, and the OECD database. 1 IV Inflation Targeting: An Overview of the IT Countries In this subsection we present some basic facts about the IT countries. Figure 1 summarizes the data for IT countries: 1 years of adoptions, and the average inflation rates in the last two years preceding the adoption of the IT regime. 17 The figure reveals some very important and interesting facts. First of all, starting with the adoption of the regime by New Zealand in 199, the shift towards IT has been continuous along the past 17 years. Second, the average inflation rates in the eve of the adoption vary a lot among countries. For example, several countries, mainly the developed ones, decide to implement this regime although their inflation rates have been already low. Sweden, Thailand, Austria and Finland are some examples. Other countries, such as Peru, Israel and Chile, adopt the regime while experiencing high inflation rates. Third, the group of the IT countries is geographically diversified: There are countries from Europe, North America, and Latin America as well as Asia, Middle East and Africa. Fourth, the IT countries show a significant diversification when levels of economic development are considered Peru is not shown here for illustration purposes. Its average inflation rate in the years preceding the adoption of IT was about 1%. 17 Mishkin and Hebbel (1) report only the average inflation rate in the last quarter before of the IT adoption. We believe that this is a relatively short period and hence we look at the average inflation rates in the last years. A longer period not only decreases the sample bias but also provides more information on the motivations to shift to this regime (typically it takes a longer time period for the policy makers to conclude for the need for a new regime).

8 Given the considerable variations across the IT countries, one wonders why these countries would choose to adopt this regime. We agree with the common conclusion in the literature that the main reason for the developing countries - which are characterized with high levels of inflation and low levels of economic development - to adopt the IT regime is to bring the inflation rates down after years of extremely high rates. In addition, countries with low inflation rates, particularly the developed ones, may be willing to adopt the IT regime in order to set an institutional rule that helps them in keeping the inflation rates low, especially in the periods of upward pressures on prices. 1 Figure 1: Average for IT Countries: CHL Average Inflation Rate (in percents) 1 1 NZ ISR UK CAN SWE FIN SPA COL MEX POL HUN CZE KOR SA PHI ICE BRA THA NOR TUR SVK IDN GHA AUS SWI In the following section, we show that we find support for the above claims. We focus on the macroeconomic variables separately for the developing and the developed countries. 1 In other words, during the periods of high inflation rates, the Central Bank in an IT country can conduct a contractionary policy without worrying about the reaction of the public or the government. In the absence of such a clear target, the Central Bank may need to follow a less contractionary policy. Thus, having an institutionally approved regime helps the Central Bank to justify its actions. 7

9 V Data Facts and Statistical Results V-I In this subsection, we study the levels and volatilities as well as the timing of the changes in the inflation rates. To be able to determine the effects of the IT regime on the inflation rates, we compare our findings for the targeting countries with those for the corresponding control group. We first report results for the developing and the developed countries separately, and then compare the results for the two groups. The evolution of the inflation rates in all countries are shown in Figures A1-A. Table 1 and Table summarize the statistical information for the developing countries. Important observations follow. First, prior to adopting the IT regime, the inflation rates are significantly higher for the IT countries compared to those for the NT countries, especially between 197 and the adoption years. Second, although the inflation rates drop dramatically for all countries, 19 the average inflation rate for the IT countries falls below that for the NT countries. Table 1: Average and Standard Deviations of, 19-7, Developing IT countries Brazil Chile Colombia Czech Republic Hungary Israel Mexico Peru Philippines Poland South Africa Thailand Average Adoption I- Average (in percentages) Pre IT IT Post IT II- Average Standard Deviations of (in percentages) Pre IT IT Post IT III- Average Coefficient of Variation of (in percentages) Pre IT IT Post IT Typically the changes are from double-digit or triple-digit figures to single-digit figures.

10 Table : Average and Standard Deviations of, 19-7, Developing NT Countries Argentina Bolivia Bulgaria China Costa Rica Côte d'ivoire Dominican Republic Ecuador Egypt El Salvador India Malaysia Morocco Panama Tunisia Uruguay Venezuela Average I- Average (in percentages) Pre IT IT Post IT II- Average Standard Deviations of (in percentages) Pre IT IT Post IT III- Average Coefficient of Variation of (in percentages) Pre IT IT Post IT Note that the average Pre-IT inflation rate for the IT countries may be biased because of the extremely high inflation rates of Brazil and Peru. When the information for these two countries is excluded from the data, the average inflation rates of the group become considerably lower (3.3%,.% and.1% for Pre- IT, 197-IT and Post-IT periods, respectively). Similarly, the average inflation rate for the control group may be biased due to the high inflation rates of Argentina, Bolivia, and Bulgaria. Excluding these countries from our sample leads to the average inflation rates of 1.1% for the sub-period, 1.% for the sub-period, and 7.% for the final sub-period. The exclusion of the outlier observations has almost no effect on the Post-IT average inflation rates of the either group, but it considerably affects the initial average inflation rates of both groups. Although the developing IT countries start from considerably higher inflation rates - almost twice as large compared to those of the control group - their inflation rates drop much faster and they end up, on average, with lower inflation rates. In this regard, notice that the Latin American IT countries, such as Excluding data for Poland changes these average inflation rates to.3%,.% and.3%, respectively. 9

11 Brazil and Peru, manage to bring their inflation rates down to single-digit rates while the NT ones, such as Ecuador and Venezuela, still have considerably higher inflation rates despite the fact that their initial inflation rates have been significantly lower than those of both Brazil and Peru. Therefore, even when a similar group of countries is considered, the IT countries go further in lowering their inflation rates. 1 This is in favor of the claim that the adoption of the IT regime has a significant impact on the behavior of the inflation rates for the developing countries; mainly by moving the rates to lower levels despite the inferior performance of these countries prior to the adoption of the regime. Third important result arises when the convergence of inflation rates is considered for the developing IT countries. Despite the differences in the initial inflation levels and the levels throughout the adoption years, most of these countries successfully move their inflation rates towards a lower level of %. Perhaps the most notable examples are Brazil and Peru, which manage, within a relatively short time, to cut their inflation rates to the same levels as other countries. Such convergence is not observed when the control group is considered. For example Ecuador and Venezuela continue to have inflation rates of more than twice of the group average even after The average volatility of the inflation rates drops to a lower mean for the developing IT countries compared to that for the developing NT countries (3.% vs..%). Notice that we cannot determine a clear pattern for the volatilities before the adoption of the IT regime: the average volatility for the NT countries is higher during the 19-IT adoption period, but it is lower during the shorter period of 197- IT adoption. However, excluding the data for the outlier countries from each group lets us note that the average volatility for the IT countries is considerably higher before the adoption of the IT regime, but it is significantly lower afterwards. In particular, the volatilities for the IT countries drop from 3.1% (19- IT sub-period) and 3.% (197-IT sub-period) to only.% for the period following the adoption. At the same time, the volatilities for the NT countries drop from 11.3% and 1.% to.%. In other words, although the initial average volatility for the IT countries is almost three times that for the NT countries, the final volatility is only about one half. The last result should be interpreted with caution. Typically, the standard deviations tend to be higher when the levels, hence the means, are higher. It might be the case that the volatilities for the IT countries are higher simply because these countries had higher inflation rates before the adoption of the regime. To check for the robustness of our results, we express the volatilities in terms of the Coefficient of Variation 1 Also, notice that Costa Rica, Uruguay and Argentina have higher POST-IT inflation rates than those in any of the Latin American IT countries. 1

12 (CV). This transformation embodies the level effect and hence provides a better measurement for the volatilities. The results are reported in panels III of both Table 1 and Table. The average CV for the developing IT countries is slightly lower than that for the control group. Moreover, while the average CV for the IT countries drops by 3%, there is a much smaller drop of about % in the average CV for the control group. 3 These observations confirm that developing IT countries have been successful in both lowering and also stabilizing their inflation rates further beyond the rates for the NT countries. How about the timing of the declines in the inflation rates? For some countries, inflation rates decline right after the adoption of the IT regime. The most notable cases are those of the Czech Republic, Mexico, and Hungary. The inflation rates of these countries drop in the first year of the adoption. In Colombia, the inflation rate declines sharply in the year of adoption after moderate declines in the preceding years. We now discuss our results for the developed countries, which are tabulated in Table 3 and Table. For these countries, the inflation rates decline significantly following the adoption of the IT regime. In particular, the average inflation rate for the IT countries after the adoption of the regime is.3%, which is less than one third of its Pre-IT level of 7.7%. Excluding Iceland - which, relative to the average, had extremely high inflation rates both before and after the adoption - gives a clearer picture: the average inflation rate drops from.% to.1%. Table confirms what has been claimed by several studies: the inflation rates decline substantially in the developed NT countries as well. It is interesting to note that since 199, the average inflation rate for the developed NT countries has been about %, which is very similar to the average inflation rate for the developed IT countries. In fact, excluding Japan - which had a deep deflation during the 9 s- from the sample, leads us to find that the average inflation rate has been.% since 199. Thus, although they begin with higher initial rates - an average of 7.7% compared to.% - the IT countries, do manage to bring their inflation rates to the same levels observed in the NT countries. CV is defined as the standard deviation to mean ratio. 3 Excluding the outlier countries has no significant effect on the results. 11

13 Table 3: Average and Standard Deviations of, 19-7, Developed IT Countries Australia Canada Finland Iceland Korea New Zealand Norway Spain Sweden Switzerland United Kingdom Average Adoption I- Average (in percentages) Pre IT IT Post IT II- Average Standard Deviations of (in percentages) Pre IT IT Post IT Table : Average and Standard Deviations of, 19-7, Developed NT Countries Austria Belgium France Germany Italy Japan Netherlands United States Denmark Portugal Average I- Average (in percentages) Pre IT IT Post IT II- Average Standard Deviations of (in percentages) Pre IT IT Post IT As shown in Panel II of Table, there is a considerable decline in the inflation volatility for the developed countries. The average standard deviation drops by more than 7% compared to its Pre-IT level, thus validating the belief that the inflation rates not only decline in the last two decades but also becomes more stable. Finally, the inflation rates of some of the developed IT countries drop immediately after the adoption of the regime. This pattern can be easily observed for the case of Canada, Switzerland, Korea 1

14 and New Zealand. For these countries the inflation rates change direction instantly, decreasing after periods of persistent increase. V-II Output Growth As previously mentioned, the adoption of the IT regime by a country is thought to be harmful for the economic growth as the central bank conducts a relatively more tightening policy in order to achieve the targeted level of inflation. In this subsection we question this claim by comparing the economic growth patterns of the IT and the NT countries. The evolution of the output growth rates in all countries are shown in Figures A-A. Table summarizes our results for the developing countries, while Figure 3 presents output growth rates for each country along the investigated period. Some observations are worth-noting. First, with the exclusion Colombia and Thailand from the sample, the average growth rate for these countries becomes considerably higher for the Post-IT period, compared to the Pre-IT level. In particular, the cross country average almost doubles, increasing from.% to.%. Adding Thailand to the sample does not alter the results. More specifically, the Post-IT average remains the same while the Pre-IT level increases to.%. Second, the growth rates in some countries, such as Columbia, Czech Republic, and Philippines, change course immediately after the adoption of the IT regime and show upward trends. Third, the change in the average growth rate is considerably lower; corresponding to a change from 3.% to.3%, as seen Table and Figure. Excluding China - which had a significantly higher average growth rate compared to the average of its group - the change in the average growth rate for the developing NT countries turns out to be an increase from 3.1% to 3.9, which is only one half the size of the increase in the average growth rate for the developing IT countries. In addition, despite starting off with similar average standard deviation values, the IT countries end up with a lower average volatility compared to that for the NT countries. Our results for the shorter sample, covering the period of 197-7, are in line with those for the longer Pre-IT period. As for the developing IT countries, the average growth rate increases significantly while The decline in the growth rate for Thailand is not surprising given the severe crisis this country faced in the late 199 s. These results are highly comparable to the results in Gonvales and Salles (): they report that the volatility of economic growth drops from.1% to.%. 13

15 the average standard deviation gets cut by more than a half. The developing NT countries experience only a small increase in the average growth rate and a moderate decline in the average growth volatility. Table : Average Growth Rates and Standard Deviations of Growth Rates, 19-7, Developing IT Countries Brazil Chile Colombia Czech Republic Hungary Mexico Peru Philippines Poland South Africa Thailand Israel Average Adoption I- Average Growth Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Growth Rates (in percentages) Pre IT IT Post IT In light of the above analysis, we would like to comment on the common belief that a commitment to the IT regime has inferior effects on the economic growth. Given that the IT countries exhibit higher growth rates after the adoption compared to the Pre-IT adoption period, and the fact that their growth rates catch up with those of the NT countries, we do not observe any negative effects of the IT regime on growth. Moreover, when the increase in the average growth rate corresponding to a change from.% to.% - is considered, it is possible to conclude that the IT regime has a positive effect on growth. Excluding China from the sample, we repeat the analysis. We find that the average growth rate for the developing IT countries is even slightly higher compared to that for the developing NT countries, which is a big contradiction to the misleading belief about the possible negative effects of the IT regime. These changes confirm our discussion that the choice of the longer sample has no qualitative effects on the results and can only moderately affect the quantitative results. 1

16 Table : Average Growth Rates and Standard Deviations of Growth Rates, 19-7, Developing NT Countries Argentina Bolivia Bulgaria China Costa Rica C te d'ivoire Dominican Republic Ecuador Egypt El Salvador India Malaysia Morocco Panama Tunisia Uruguay Venezuela Average I- Average Growth Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Growth Rates (in percentages) Pre IT IT Post IT Figure points to another interesting result. Most of the developing IT countries had very similar growth rates after the adoption of the IT regime. The picture is very different for the developing NT countries since the differences among these countries remained large even though some degree of convergence is still observable, as seen in Figure 3. This comparison between the developing IT and NT countries suggests that for the IT countries, sharing the same monetary regime render them to display some similarities not only in the behavior of the inflation rates, but also in the real economic performances. This conclusion is in line with the predictions of Neumann and Hagen (). Figure : Average growth rates, before the adoption (left panel) and after the adoption (right panel) of the IT regime. The horizontal line denotes the cross-country average. Developing IT Countries 1

17 Figure 3: Average growth rates, before the adoption (left panel) and after the adoption (right panel) of the IT regime. The horizontal line denotes the cross-country average. Developing NT Countries Next, we report the main results for the developed countries in Table 7 and Table. The cross country average growth rate for the developed IT countries slightly increases from.% to 3.1%. When both Spain and Finland are excluded from the sample, the Post-IT average growth rate becomes almost identical to the Pre-IT average. This pattern differs from the one observed in the developed NT countries. For this group, the average growth rate actually declines from.% to.1%. 7 Once again, our striking result follows. Given that the average growth rate increases for the developed IT countries and it slightly declines (or remains unchanged) for the developed NT countries, it is misleading to believe that the IT regime has an adverse effect on the economic growth. On the contrary, the regime has a positive effect on growth, which is more pronounced in the case of the developing countries. For both the developed IT and NT countries, a declining pattern is observed when the growth volatilities are considered. The average volatility of output growth drops significantly for some of the developed IT countries, such as Australia and the United Kingdom. There is a slight decline for some, such as Sweden, and no change for others, such as New Zealand. Only for Korea, we observe an increase in the volatility of growth, which can be explained with the huge collapse in 199. When Korea is excluded from the sample, the average volatility of the output growth for the group is found to drop by nearly 3%, going from.3 to 1.. Despite the decrease in the average volatility for the developed IT countries, economic 7 Here, we should note that Japan had a long decade of deflation, which can be a source of bias. When Japan is excluded from the group, we see that the growth rate remains unchanged. See Figure. 1

18 growth is still more volatile for the IT countries compared that of the NT countries. This result is mainly due to the fact that the IT countries experience higher volatilities before the adoption of the regime. Table 7: Average Growth Rates and Standard Deviations of Growth Rates, 19-7, Developed IT Countries Country Australia Canada Finland Iceland Korea New Zealand Norway Spain Sweden Switzerland United Kingdom Average Adoption I- Average Growth Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Growth Rates (in percentages) Pre IT IT Post IT Table : Average Growth Rates and Standard Deviations of Growth Rates, 19-7, Developed NT Countries Austria Belgium France Germany Italy Japan Netherlands United States Denmark Portugal Average I- Average Growth Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Growth Rates (in percentages) Pre IT IT Post IT We close this subsection by re-stressing that we do not find any evidence that would support the belief that a commitment to an inflation target comes at the cost of a lower economic growth and/or higher growth variability. We actually find the reverse to be true. The IT countries, particularly the developing 17

19 ones, enjoy higher output growth and lower output volatility compared to the NT countries. Our results not only support those of Gonvales and Salles (), but also take a step further to show that the positive effects of adopting the IT regime are both on the levels as well as on the volatilities. V-III s In this subsection we investigate the possible effects of the IT regime on the fiscal imbalances. Our study is the first one to consider the fiscal effects of the IT regime. Previous studies have been silent on the fiscal side; therefore the analysis conducted here is aimed to fill a very important gap in the literature. Yet, we need to note the fact that there are some data limitations when the fiscal policy is considered. As mentioned earlier, we measure the fiscal policy by the annual budget imbalances as a share of GDP. Although the data on the budget imbalances are available for all of the developed countries in our sample, this is not the case for some of the developing countries. Therefore, we use shorter time periods for the analysis of some these developing countries. The evolutions of the fiscal imbalances in all countries are shown in Figures A9-A1. Table 9 and Table 1 display the results for the developing countries and these results are considerably different from those for the developed countries. Starting from the same average levels of the budget deficits, both the IT and the NT countries experience declines in their deficits, albeit moderately. The decreases in the budget deficits for the developing NT countries seem to be higher than that for the developing IT countries. Note, however, that the results may be biased because of Egypt being included in the control group and the Philippines being in included in the IT group. Excluding these two countries gives the following result: the average deficit for the developing IT countries drops from.1% to 3. %, while the average deficit for the developing NT countries drops from 3.% to 3.%. Hence, the changes in the average budget deficits of the two groups are very similar. 9 Following the adoption of the IT regime, several IT countries have their deficits around the group s average, thus even though the IT regime does not lead to considerable improvements in deficits; it does help them to have similar fiscal policies. 9 Also, excluding Hungary from the IT group and India from the NT group shows that the average deficit of the IT group drops from.% to 3.% while the average deficit of the NT group drops from 3.% to 3.%. 1

20 Table 9: Average Government Deficit-GDP Ratios and Standard Deviations of Government Deficit- GDP Ratios, 19-7, Developing IT Countries Brazil Chile Colombia Czech Republic Hungary Mexico Peru Philippines Poland South Africa Thailand Israel Average Adoption Panel I- Average Fiscal Deficit Rates (in percentages) Pre IT IT Post IT Panel II- Average Standard Deviations of Fiscal Deficit Rates(in percentages) Pre IT IT Post IT Table 1: Average Government Deficit-GDP Ratios and Standard Deviations of Government Deficit- GDP Ratios, 19-7, Developing NT Countries Argentina Bolivia China Costa Rica C te d'ivoire Dominican Republic Ecuador Egypt El Salvador India Malaysia Morocco Panama Tunisia Uruguay Venezuela Average Panel I- Average Fiscal Deficit Rates (in percentages) Pre IT IT Post IT Panel II- Average Standard Deviations of Fiscal Deficit Rates (in percentages) Pre IT IT Post IT Following the adoption of the IT regime, fiscal imbalances become more stable as reflected in panel II of Table 1. The average volatility gets cut by almost two thirds. A similar pattern is observed for the NT group, but in this case the decline in the volatility is considerably lower. In order to check for the robustness of this result we exclude Israel (IT) and Egypt (NT) from the sample since both countries exhibit very high volatilities. The initial average for the developing IT countries falls only slightly (to 19

21 3.%) with no change in the Post-IT average. As for the developing NT countries, it drops from 3.1% to.%. Thus, with the major outliers excluded, the previous result is unchanged. Note, however, that excluding the 199 observation for Panama gives a considerably higher drop in the average volatility, which goes from 3.% to 1.%. Finally, note that despite the fact that the IT countries start off with different standard deviations - ranging from.% to.% - these values after adopting the IT regime are very similar. This pattern is not observed for the NT group. Next, we turn to the developed countries. Figure A9 and Figure A1 show sharp decreases in the budget deficits for both the developed IT and NT countries. The IT countries have considerably lower deficits compared to the NT countries. In fact, most of the IT countries did succeed to turn their deficits into surpluses in the last decade. The best examples are Australia, Canada, New Zealand, and Korea. In this regard, the United Kingdom and Switzerland stand as the major exceptions. Except for Denmark, 3 the developed NT countries still display considerable high levels of budget deficits. More interestingly, for several developed IT countries, the change to surpluses occurred immediately after adopting the IT regime. Canada, Australia, Spain, Finland and Sweden are just some examples. 31 Although the budget deficits show a declining trend for the developed NT countries as well, there are still high fluctuations. The trends for Germany, France, Portugal, and United States illustrate this fact clearly. Summing up, these countries managed to cut their deficits by about %, but they could not turn them into surpluses and hence the actual budget deficits are fluctuating around a new lower average. Changes in the fiscal levels and volatilities of fiscal imbalances for the developed IT and NT countries are reported in Table 11 and Table 1. The average Pre-IT budget deficit for the IT countries is 1.%, and for the Post-IT era it becomes a moderate surplus of.%. Exclusion of Norway, which has a budget surplus of more than %, gives a significantly higher Pre-IT average budget deficit of about.%, and a negative Post-IT balance of about 1%. Two other countries are needed to be handled with caution: Finland and Spain. The improvements in their budget imbalances start with the adoption of the IT regime and continue even after they abandon the regime. The Post-IT average includes Spain (for 3 years of adopting the IT regime) and Finland (for years). It is biased towards higher levels of deficits because these two countries experienced deficits when adopting the regime. Once they are excluded from the sample, we actually find that the average budget deficit moves from about.% to only.3%, which indicates that 3 Denmark showed a consistent budget surplus in the past years. 31 Notice that for Finland and Spain, the sharp improvement in the budget balance became moderate after abandoning this regime in favor of joining the EMU.

22 the countries in this group enjoy almost balanced budget. Alternatively, if we assume that the two countries did not abandon the regime, the average moves from.% to.3%, which gives almost the same results as in the case when they were excluded from the sample. Table 11: Average Government Deficit-GDP Ratios and Standard Deviations of Government Deficit- GDP Ratios, 19-7, Developed IT Countries Australia Canada Finland Iceland Korea New Zealand Norway Spain Sweden Switzerland United Kingdom Average Adoption I- Average Fiscal Deficit Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Fiscal Deficit (in percentages) Pre IT IT Post IT Table 1: Average Government Deficit-GDP Ratios and Standard Deviations of Government Deficit- GDP Ratios, 19-7, Developed NT Countries Country Austria Belgium France Germany Italy Japan Netherlands United States Denmark Portugal Average I- Average Fiscal Deficit Rates (in percentages) Pre IT IT Post IT II- Average Standard Deviations of Fiscal Deficit (in percentages) Pre IT IT Post IT When the developed NT countries are considered, the average budget deficit gets cut by almost a half, decreasing from.% to.%. The high initial average for this group of countries is highly biased due to the existence of Italy and Belgium in the sample, since these countries experiences deficits of around 1

23 1%. With the exclusion of these two countries, the Pre-IT average becomes considerably low, 3.3%, with no change in the Post-IT average of.%. The results regarding the standard deviations of the budget balances differ highly across the developed IT and NT countries. More specifically, the average standard deviation for the IT countries remains higher than that for the NT countries. Moreover, it can be inferred that the volatility of the imbalances increases slightly for the IT countries whereas it declines moderately for NT countries. Yet, this result is not robust to the exclusion of the outliers in the two samples. For example, once Belgium and Denmark 3 are excluded from the developed NT countries group, the Pre-IT average volatility becomes slightly lower. Moreover, our figures show that several developed IT countries have continuous reversals in their deficits, which causes the actual levels to significantly differ from their mean. This fact undoubtedly leads to high variations. On the other hand, for many developed NT countries, the fluctuations are smaller, and hence volatilities are much lower. 33 We repeat the exercise by considering only the deviations from the moving averages. This method delivers an interesting result: the average standard deviations for the two groups of countries increase only slightly, more specifically from 1. to. for IT countries, and from 1. to 1. for NT countries. The changes for the two groups are very similar. 3 We close this subsection by summarizing our main results. The developed IT countries succeed to improve their fiscal imbalances considerably, with several of them ending up with surpluses. Although there is a cost of a slight increase in the volatility, the success of turning the deficits into surpluses is notably important. On the other hand, the improvements for the NT countries are not sufficient to balance their budgets. We believe that this important difference between the IT and the NT countries is due to the adoption of the IT regime, which brings superior discipline in budget managing. As for the developing countries, the changes in the budget deficits of both the IT and the NT countries are similar. However, contrarily to the experience of the developed IT countries, the developing IT countries end up with considerably more stable fiscal budgets. 3 Standard deviations of the imbalances for these countries are about twice as big as the average standard deviation for the whole group. 33 In other words, the NT countries now have lower means, an the actual values vary around these means. On the contrary, the IT countries exhibit a trend in their series thus making simple averages inadequate measures. 3 We also consider the means for the two groups of countries. With this method, we find that the average budget deficit rate for the IT countries drops down to.1% from about 1.%, and that for the NT countries drops down to.% from.%.