Inflation Targeting and Impossible Trinity

I had written some days ago on impossible trinity. It covered a speech from BIS Deputy GM who explains the mechanics and presented evidence on the same. He says most Asian Pacific nations have been targeting exchange rates.  The currencies have hardly appreciated over the years despite capital inflows being a problem with most. Further, couple of countries have inflation targets as well but still seem to be targeting exchange rates as well.

Now, this was just about Asian- Pacific countries. How about others? Impossible Trinity says one you allow for free capital flows, a country can go for either exchange rates stability or price stability but not both.

Now, some countries have adopted exchange rate stability (by following some exchange rate regime) and some have adopted price stability (by following inflation targeting (IT)). So which is better so far?

This paper from Andrew Rose does answer the question in his own way. The title is also quite stimulating – “A Stable International Monetary System Emerges: Inflation Targeting is Bretton Woods, Reversed”. Infact,if you look at it the title reveals the findings right away. Inflation targeting is doing quite well so far. The abstract:

A stable international monetary system has emerged since the early 1990s. A large number of industrial and a growing number of developing countries now have domestic inflation targets administered by independent and transparent central banks. These countries place few restrictions on capital mobility and allow their exchange rates to float. The domestic focus of monetary policy in these countries does not have any obvious international cost. Inflation targeters have lower exchange rate volatility and less frequent “sudden stops” of capital flows than similar countries that do not target inflation. Inflation targeting countries also do not have current accounts or international reserves that look different from other countries. This system was not planned and does not rely on international coordination. There is no role for a center country, the IMF, or gold. It is durable; in contrast to other monetary regimes, no country has been forced to abandon an inflation-targeting regime. Succinctly, it is the diametric opposite of the post-war system; Bretton Woods, reversed.

Now why Bretton Woods (BW) reversed. BW advocated fixed exchange rates (backed by USD) and following an IT means floating exchange rates. As latter is quite successful, it is BW reversed.

This is a short paper (31 pages) compared to his peers and has a lot of food for thought. The paper focuses on IT and exchange rate stability is just an add-on. It is largely empirical but explains  the process and findings in English.

The evidence that took me most by surprise was that countries that have IT have lower exchange rate volatility than others.

This paper is different as earlier papers looked at whether countries that have adopted IT have actually managed to lower inflation or not? So, they compared countries that have adopted IT vs those that have not. Some found positive evidence, some found the evidence questionable. So as a result, IT despite being pretty popular has its criticisers as well.

This paper looks at the evidence from the foundations of Impossible Trinity i.e. exchange rate and capital flows. And yes, the evidence is IT so far looks a good strategy.

A nice paper. Very neatly written. If you can absorb the statistics a bit, it is an excellent read.

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2 Responses to “Inflation Targeting and Impossible Trinity”

  1. Mundell vs Friedman on exchange rates « Mostly Economics Says:

    […] rates. His most famous work is what we call today as impossible trinity (see my few posts on this here and […]

  2. shibin Says:

    intresting and easy to understand

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