msc thesis 2010 2011
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MSc Economics thesis 2010-2011
Department of Economics, University of Bristol
MANHAL M ALI
ii
APPRAISING INFLATION TARGETING: PANEL EVIDENCE FROM
DEVELOPED ECONOMIES
NAME OF AUTHOR: MANHAL M ALI
A THESIS SUBMITTED TO THE UNIVERSITY OF BRISTOL IN ACCORDANCE WITH THE
REQUIREMENTS OF THE DEGREE OF MSc ECONOMICS IN THE FACUALTY OF SOCIAL
SCIENCES AND LAW
DEPARTMENT OF ECONOMICS, UNIVERSITY OF BRISTOL
SEPTEMBER, 2011
iii
Abstract
By using dynamic panel GMM techniques this paper finds that in general that inflation
targeting (IT) regime has not led to improvement or was positively effective in terms of
macroeconomic performance in terms of inflation, output growth, inflation volatility
and output volatility. Hence reinforcing, in summary IT was mainly ineffective. There is
some evidence IT had positive impact on inflation, inflation volatility and output growth
but it is not robust and not general. At best there is no indication that IT had adverse
effects on economic stabilization or volatility. There is also no conclusive evidence that
IT has worsened or led to more favourable tradeoffs between inflation and economic
activity. The general results of this paper also align with results of some previous
researches in this field.
iv
WORD COUNT
Number of pages: 60
Number of words: 14,992 (including title, abstract and pages 1 to 44 only).
v
ACKNOWLEDGMENTS
I have benefited from the discussions that I had with my thesis supervisors Dr. Helene
Turon and Professor Fabien Postel-Vinay and suggestions that I have received from
them. My sincere recognition goes to them. I would like to specially thank Dr. Helene
Turon and my academic supervisor Professor Simon Burgess for their kind support to
help me carry out this thesis. I would also like to thank Professor Jon Temple for kindly
making one of his papers available to me in order to read on applied work using panel
GMM. I gratefully acknowledge the help I have received from thesis help desk regarding
the use of Stata software from Jake Bradley, a senior PhD student at the Department of
Economics, University of Bristol.
Lastly, I would like to dedicate this work to my parents who were extremely supportive
all the way from the beginning. It would have not been possible without them.
vi
AUTHOR’S DECLARATION
I declare that the work in this dissertation/thesis was carried out in accordance with
the regulations of the University of Bristol. The work is original except where indicated
by special reference in the text and no part of the thesis has been submitted by other
degree.
Any views expressed in the thesis are those of the author and in no way represent those
of the University of Bristol.
The thesis has not been presented to any other University for examination either in the
United Kingdom or overseas.
SIGNED: DATE:
vii
TABLE OF CONTENTS
1. INTRODUCTION ................................................................................................................................................ 1
2. INFLATION TARGETING IN THEORY ...................................................................................................... 2
3. PREVIOUS STUDIES ........................................................................................................................................ 6
4. DATA ....................................................................................................................................................................... 9
5. METHODOLOGY .............................................................................................................................................. 17
6. RESULTS ............................................................................................................................................................ 21
6.1. PRELIMANARY RESULTS ............................................................................................................... 21
6.2. 1985-2002 ........................................................................................................................................... 28
6.3. ROBUSTNESS ANALYSIS .................................................................................................................... 31
6.4. INFLATION-OUTPUT TRADEOFF .................................................................................................... 37
7. LIMITATIONS AND EXTENSIONS ......................................................................................................... 41
8. CONCLUSION ................................................................................................................................................... 43
REFERENCES ....................................................................................................................................................... 45
LIST OF FIGURES
4.1. AVERAGE INFLATION ....................................................................................................................... 14
4.2. INFLATION VOLATILITY................................................................................................................... 15
4.3. AVERAGE OUTPUT GROWTH .......................................................................................................... 16
4.4. OUTPUT VOLATILITY ........................................................................................................................ 16
LIST OF TABLES
4.1. COUNTRIES INCLUDED IN THE SAMPLE .......................................................................................... 9
4.2. INFLATION STATISTICS FOR INFLATION TARGETING COUNTRIES......................................... 10
4.3. INFLATION STATISTICS FOR NON-INFLATION TARGETING COUNTRIES ............................... 11
4.4. OUTPUT STATISTICS FOR INFLATION TARGETING COUNTRIES .............................................. 12
4.5. OUTPUT STATISTICS FOR NON-INFLATION TARGETING COUNTRIES .................................... 13
6.1. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION AND GROWTH (1980-
2009) ............................................................................................................................................................ 22
viii
6.2. ESTIMATES OF INFLATION TARGETING EFFECTS ON MACROECONOMIC VOLATILITY
(1980-2009)................................................................................................................................................ 24
6.3. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION AND GROWTH (1985-
2002) ............................................................................................................................................................ 29
6.4. ESTIMATES OF THE INFLATION TARGETING EFFECTS ON MACROECONOMIC VOLATILITY
(1985-2002)................................................................................................................................................ 30
6.5. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION AND GROWTH,
ROBUSTNESS CHECKS............................................................................................................................... 33
6.6. ESTIMATES OF INFLATION TARGETING EFFECTS ON MACROECONOMIC VOLATILITY,
ROBUSTNESS CHECKS............................................................................................................................... 35
6.7. ESTIMATES OF INFLATION TARGETING EFFECTS ON COEFFICIENT OF VARIATIONS OF
INFLATION AND OUTPUT GROWTH, ROBUSTNESS CHECKS ............................................................. 36
6.8. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF
(1980-2009)................................................................................................................................................ 38
6.9. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF
(1985-2002)................................................................................................................................................ 39
6.10. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF,
ROBUSTNESS CHECKS............................................................................................................................... 40
1
1. INTRODUCTION
One of the central objectives of the central banks worldwide is to promote
macroeconomic stability by stabilizing and lowering inflation. Several economies,
industrial and emerging markets implemented various monetary policy regimes to
achieve this objective. A regime that has received significant attention recently is
Inflation Targeting. It was first pioneered and adopted by New Zealand in 1990. In
recent years there has been increasing number of countries that adopted inflation
targeting to help to stabilize inflation and promote economic stability. But has inflation
targeting been successful as a monetary policy regime to achieve the aforementioned
objective and in terms of general macroeconomic performance? Certainly from the data
both developed and emerging economies saw reductions in inflation rates since
adopting this monetary regime. But countries that did not adopt this regime also
experienced fall in inflation rates. So did inflation targeting lead to fall in inflation rates
from point of view of formal statistical analysis? Did inflation targeting produced
smaller costs in terms of output, was IT favourable to the real economy and managed to
reduce volatility?
Since its introduction there has been a surge in research on inflation targeting
concerning its effectiveness. So far, the empirical results on this topic are mixed and
inconclusive. Results vary according to the methods used and samples selected.
Nevertheless this area still remains active an area of research and is debated in
academia and central banks worldwide. The objective of this paper is to enter this
debate and to answer the questions posed at the beginning i.e. whether inflation
targeting countries benefited in terms of key macroeconomic performance, using
dynamic panel techniques for the case of developed economies.
This paper uses the dynamic panel GMM techniques i.e. Difference GMM (D-GMM)
due to Holtz-Eakin et al. (1988) and Arellano and Bond (1991) and System GMM (S-
GMM) due to Arellano and Bover (1995) and Blundell and Bond (1998) to assess
whether inflation targeting was effective or improved the macroeconomic performance
of developed economies. In general there is no evidence that inflation targeting
mattered or in other words inflation targeting was not found to be positively effective.
2
The paper is divided into eight sections. After this introduction, section two looks
briefly at the theory. Section three present reviews previous literature along with the
contribution of this paper. Section four is concerned with the data and descriptive
analysis. Section five presents the methodology. Section six presents the econometric
results. Section seven considers extensions and limitations. Section eight concludes.
2. INFLATION TARGETING IN THEORY
Inflation targeting (henceforth IT) is a monetary policy framework where the sole
objective of the central bank adopting it is to promote price stability by committing
itself to achieve an explicit target or range for inflation rate by using interest rates or
other monetary options. The objective function facing a central bank operating under IT
regime is given in equation (2.1):
(2.1)
Equation (2.1) is the loss function that central bank minimizes were is the
inflation rate and is the output gap, at time t. The parameter is the weight that the
society places on output stabilization relative to inflation stabilization and is the
target inflation rate. As long as , specifying IT in terms of the social loss function
assumes that the central bank is concerned with both output and inflation stabilization
– if then IT regime is said to be flexible.
Since policy has a lagged effect, an assumption is made that central bank must set ,
nominal interest rate at time t, prior to observing any information at time t. This implies
that central bank cannot act to shocks at time t contemporaneously. Information about
shocks at time t will affect the choice of , and . The central bank’s objective
is to then minimize (2.2) by choosing :
(2.2)
where the subscript on the expectations operator is now t-1 to reflect that information
available to central bank when it sets its policy, where the constraints are given by IS
and New Keynesian Phillips curve given in equations (2.3) and (2.4) respectively:
3
(2.3)
(2.4)
where the cost shock et-1 follows an AR (1) process. The first order condition under
discretion1 for central bank’s choice of is given by:
(2.5)
Rearranging this first-order condition yields2:
(2.6)
Hence if the central bank forecasts that inflation in period t will exceed the target
rate then it should adjust monetary policy to ensure that the forecast of the output gap
is negative from (2.6).
IT consists of the following important elements: (1) Public announcement of a
medium term target for inflation which is usually quite low (usually specified as a few
range of percentage points). (2) Institutional commitment to price stability as the chief
long run monetary policy goal. (3) Increased transparency through communication with
public and markets about the monetary policy objectives. (4) Increased accountability
of the central bank for attaining its inflation objectives. Batini and Laxton (2007)
mentions the pre conditions that are needed to be met before IT can be adopted.
One main advantage of IT due to its credibility and transparency elements is that it
solves the inflation bias problem due to dynamic inconsistency theory of inflation
(Kydland and Prescott, 1977) thus leading to lower inflation rates. Again due to the
policy being transparent and credible it is understood by the public and therefore it can
anchor the expected inflations and can “lock in” expectations of low inflation which
helps to contain the possible inflationary impact of macroeconomic shocks. Also in the
spirit of Barro and Gordon’s (1983) reputation model, central banks can establish a
1 Under discretion the policy maker or the central bank chooses inflation taking expectations of inflation as
given and solves the optimisation problem every period (Walsh, 2010). 2 See Walsh (2010) for details on the micro-foundations of the IS and New Keynesian Phillips curve and first
order conditions. (2.5) can be derived by differentiation of the discretionary monetary policy problem with
respect to and and then combining them into one equation. See page 361 of Walsh (2010).
4
reputation of being tough against inflation in the context of infinitely repeated games
where subgame perfect Nash equilibrium exists with inflation lower than discretionary
inflation.
By anchoring expected inflations towards the target range, IT can reduce the impact
of shocks to the economy thereby leading to greater economic stability (Mishkin, 1999).
Another way of seeing this is that in the loss function (2.2) above, given , central
bank’s implementing as the target also brings about reduced output variability i.e.
central bank also cares about output stabilization. Since inflation target is a medium
term objective where the central bank’s target inflation over a certain horizon and given
that inflation cannot be controlled instantaneously, short term deviations from the
target are acceptable and do not necessarily translate into losses in credibility. This
increased flexibility also leads to lower output variability. By maintaining low inflation
and inflation volatility, IT also helps to promote output growth (Mishkin, 1999). Also
two channels in which IT can lead to output growth is through productivity enhancing
and finance growth nexus (Mollick et al. 2011). That is transparency, credibility and
certainty associated with IT can lead to better financial sector developments, more
domestic and foreign investments which in turn help to promote growth.
However IT has its disadvantages and hence beneficial claims made by its advocates
are rebutted. Critics argue that due to increased weight on inflation it offers little
discretion and this rigidity unnecessarily restrains growth and increases output
volatility. Also since targets can be changed and since it offers too little discretion, IT
cannot anchor expected inflations. For inflation to be successful the central bank must
demonstrate its commitment to low and stable inflation through tangible actions. In the
initial periods after adoption, to establish this reputational equilibrium of being tough
against inflation will require aggressive measures and extra conservatism which will
harm output growth. Generally IT constrains discretion inappropriately; it is too
constrictive (see loss function (2.2)) in terms of ex ante commitment to a particular
inflation number and a particular horizon over to which to return inflation to target
(Batini and Laxton, 2007). Growth can be restrained if it obliges the central bank to hit
the target very restrictively. Furthermore there are measurements and implementation
issues, for instance which measure of inflation should the central bank aim to target
(Bernanke et al., 1999; Mishkin and Posen, 1997). IT sceptics worry that pursuing rigid
5
and low inflation target rates for example 1% can lead economies to hit the zero lower
bound-real interest rates become negative as nominal rates cannot be zero. In such
situations it can be challenging and prolonging to stimulate the economy especially at
the same time economy is concerned with also high inflation. Hence rigid and very low
target inflation targeting may lead to liquidity trap- a situation where nominal interest
rate is zero and monetary policy is powerless (Romer, 2006). Critics argue that IT
matters less for inflation and its stability and thus it is merely a “conservative window
dressing”. They argue it is the central bank’s greater emphasis and aversion towards
inflation that is important and not IT per se.
The credibility effects can lead to better tradeoffs because policy changes can affect
expected as well as actual inflation – a central bank which agents believe will be
inflation hawk in the future will not have to contract output by as much today to achieve
a given disinflation – Phillips curve becomes steeper. Furthermore, a credible
disinflation policy widely believed by agents or general public will cause inflation
expectation to decline rapidly and thereby shift down the Phillips curve without a large
output loss and hence resulting in smaller output losses and society having to pay lower
sacrifice ratio. This is sometimes referred as ‘credibility bonus.’ It is commonly argued
that enhanced communication and accountability of the central bank under IT should
make announced inflation objectives more credible and hence disinflations less costly.
However there are problems with this result. If higher credibility leads to greater
nominal wage – price rigidity for instance by perpetuating labour contracts, then this
can offset direct effects of improved credibility. For instance when a credible monetary
regime produces low inflation environment, firms does not change their prices
frequently and are less afraid to catch up if costs rise. And as the central banks become
more inflation averse, labour unions may choose less wage indexation and perpetuate
their wage contracts implying greater wage-price rigidity and hence flatter Phillips
curve (Clifton et al., 2001). Hutchison and Walsh (1998) mention that lower average
inflation by establishing credibility can increase nominal rigidity and worsen the
tradeoff – Phillips curve becomes flatter – the net effect is ambiguous.
In the following sections, the paper applies panel data analysis to test the above
theoretical claims made by proponents and critics of IT.
6
3. PREVIOUS STUDIES
Since the introduction and adoption of IT in the 1990’s, there has been growing active
research on whether implementation of this new monetary regime has been beneficial
in terms of macroeconomic performance. So far the empirical studies are mixed and
inconclusive, thus lacking consensus among researchers regarding the effectiveness of
IT.
One key seminal contribution to this literature is due to Ball and Sheridan (2005)
who analyse economic performance of IT using OECD economies. Using cross sectional
difference-in-difference estimation, Ball and Sheridan (2005) find no evidence that
adoption of this regime leads to improvement in economic performance i.e. inflation,
growth and volatilities. Using similar procedure Christensen and Hansen (2007) for
OECD economies from 1970 to 2005 found countries that have switched either to
exchange rate regime or IT experienced improvements in inflation, output and
volatilities but former regime lead to better performance. Mollick et al. (2011) for the
period 1986 to 2004 using static panel data techniques finds that adoption of IT leads to
higher output per capita for both developing and industrial economies. However under
dynamic specifications the evidence is rather weak. Wu (2004) and Willard (2006)
assessed the performance of IT for industrial economies using Difference – GMM (D-
GMM). Wu (2004) using quarterly data from 1985 to 2002 finds that IT has been
effective in reducing inflation rates in the industrial countries. However revising the
findings, Willard (2006) finds no such evidence. Mishkin and Schmidt-Hebbel (2007)
using panel and instrumental variable (IV) estimation procedure with time and country
fixed effects, suggest that IT has been favourable to macroeconomic performance for
both industrial and emerging economies. However despite these results they find no
evidence that IT countries produced better monetary policy outcomes relative to non-IT
countries. Biondi and Toneto (2008) for 51 countries from 1995 to 2004 uses D-GMM
and S-GMM including time effects and Feasible Generalized Least squares with time and
random country effects. Biondi and Toneto (2008) find no benefits to output growth
due to IT adoption among developing economies however it was successful in reducing
inflation rates. The findings are opposite for developed economies but smaller in
magnitude. According to Mishkin (2004) institutional differences make inflation
targeting much more difficult operate in emerging economies than in developed
7
economies. However others argue practicing IT leads to better macroeconomic
outcomes in developing economies (Bernanke et al., 1999; Svensson, 1997). Goncalves
and Salles (2008) using the methodology of difference-in-difference for the case of
emerging economies from 1980 to 2005 finds that IT is effective in terms of average
inflation, growth and output volatility. However Brito and Bystedt (2010) from 1980 to
2006 using S-GMM and other dynamic panel techniques using both common time and
country fixed effects for the case of emerging economies finds no empirical evidence
that IT matters in terms of behaviour of inflation, output growth, volatilities and found
that IT did not lead to favourable output inflation tradeoffs.
Using different methodologies, Lin and Ye (2007) using propensity score matching
methods for seven industrial countries from 1985 to 1999 find no evidence that IT had
impacts on inflation and on its volatility. Walsh (2009) using a similar methodology
finds no evidence that IT was effective in reducing inflation and economic volatility
among developed economies however results are more favourable for developing
economies. Nevertheless Vega and Winkelried (2005) also using propensity score
matching methods for a sample of developed and emerging economies find robust
evidence that IT has helped reduce inflation and its volatility. Peturrson (2004) using
Seemingly Unrelated Regression finds that inflation has fallen after IT adoption
however it is statistically insignificant when lagged inflation is used as an additional
control but remain significant for some countries. Affect of IT on output growth is
significant or borderline significant but find that output and inflation volatility had
fallen after the adoption of this regime. Goncalves and Carvalho (2007) for OECD
economies using Heckman’s procedure find that IT countries suffered smaller output
loses during disinflation. However revising their findings, Brito (2009) again for OECD
economies using panel GMM techniques finds no such evidence of a favourable tradeoff
between inflation and output.
As seen from above, results vary according to methodologies and data sets. However
panel data has the advantage that it leads to more observations than cross sectional
data. Also by exploiting the time and country dimensions, it can isolate improvements
due to IT monetary regime from other sources that might be overlapping in a cross
sectional framework. By introducing country fixed effects panel data can address the
issue of omitted variable bias inherent in above studies for example Ball and Sheridan
8
(2005) and lead to improvement on inference on the causal impact of IT on
macroeconomic indicators of interest. According to Biondi and Toneto (2008) panel
data is more informative, provides more efficient estimates of parameters, allowing the
study of dynamics and control for unobserved heterogeneity of individual countries.
Most of the findings above fail to take into account the short run relationship between
inflation variability and real economic activity as implied by the Accelerationist Phillips
curve because as Mankiw (2001) mentions that inflation-output tradeoff is inexorable.
Therefore not acknowledging this tradeoff casts doubt on some of the findings
regarding IT as an effective monetary policy strategy for economic performance. As
Brito and Bystedt (2010) mentions, inflation reduction in isolation simply implies that
IT central banks are more risk averse towards inflation than non-IT counterparts. As far
as the difference-in-difference estimation procedure is concerned, Bertrand et al.
(2004) mention that it may erroneously produce causal relationship between IT
adoption and macroeconomic indicator and it also ignores vital time series information
in the data. This approach does not take into account the endogenous choice of IT
adopted by countries with different observable and unobservable characteristics (Uhlig,
2004). Although the propensity score methods deal with self selection problems, its
cross sectional nature does not control for time effects, unobserved country
heterogeneity and persistence. Given that it ignores past information the IV within
group estimation procedure of Mishkin and Schmidt-Hebbel (2007) is not efficient. The
random effect analysis used by Biondi and Toneto (2008) is not suitable as individual
specific effects can be correlated with the explanatory variables and do not consider the
impact IT regime on volatilities. The S-GMM is opted over D-GMM used by Wu (2004)
and Willard (2006) because of efficiency gains reason and S-GMM estimator is better
instrumented to capture the effects of high persistent variables (Arellano and Bover,
1995; Blundell and Bond 1998). Brito and Bystedt (2010) uses two-step S-GMM
estimator but only for the case of emerging economies. As mentioned above
institutional differences and weaknesses, preconditions (for instance technical
capability of the central bank, absence of fiscal dominance and sound financial markets)
and relatively late adoption imply that IT will have less favourable and desired
macroeconomic impacts in emerging economies.
9
The aim of this paper is to re-assess the impact of IT on macroeconomic
performance by taking into account some of the shortcomings and discrepancy in the
above findings. Hence the aim and the contribution of this paper to the existing studies
is to study the impact of IT on inflation and output growth, on their volatilities and on
the inflation-output tradeoffs for developed economies from 1980 to 2009 using S-GMM
due to Arellano and Bover (1995) and Blundell and Bond (1998), also conducting
extensive robustness analysis.
4. DATA
The data consists of an unbalanced panel of 39 developed economies3 from the period
1980 to 2009. Table 4.1 lists the economies included in the data.
Table 4.1: Countries included in the sample4
Inflation Targeting Year of adoption Inflation target rate Non Inflation
countries
Targeting countries
Australia 1993 2-3% Austria Netherlands
Canada 1991 1-3% Belgium Portugal
Chile 1991 2-4% Denmark Singapore
Czech Republic 1997
3%(±1%)
Cyprus Slovakia
Hungary 2001 3% (±1%) Estonia Slovenia
Iceland 2001 2.5%(±1.5%) Finland Spain
Israel 1992 1-3% France Switzerland
South Korea 1998 3%(±1%) Germany Taiwan
Mexico 1999 3%(±1%) Greece USA
New Zealand 1990 1-3% Hong Kong SAR Norway 2001 2.5%(±1%) Ireland Poland 1998 2.5%(±1%) Italy Sweden 1993 2%(±1%) Japan Turkey 2006 6.5%(±2%) Luxembourg UK 1992 2%(±1%) Malta
The data consists of 15 economies that are IT and 24 that are non-IT. The data for the
countries inflation and real GDP growth rates were taken from IMF’s World Economic
3 According to IMF 34 economies in the sample are classified as advanced economies. Chile, Hungary, Israel,
Mexico and Turkey being members of OECD are regarded as developed countries. 4 Adoption dates taken from Roger (2010) and Goncalves and Salles (2008).
10
outlook database and World Bank’s World Development Indicators. The GDP series for
Estonia, Slovakia and Slovenia starts from 1981, 1985 and 1991 respectively whereas
for inflation it starts from 1992 for Slovakia and Slovenia and 1990 for Estonia.
In table 4.2 all countries that have adopted IT according to adoption dates in table
4.1 ex-post experienced lower average inflation rates and inflation volatility as
measured by standard deviation (SD) of inflation rates. Inflation rate is measured as
percentage change in Consumer Price Index (CPI) where base year is country specific.
Table 4.2: Inflation statistics for Inflation Targeting (IT) Countries
Entire Sample Pre-IT Post-IT
Mean SD Mean SD Mean SD
Australia 4.69 3.21 7.36 3.02 2.71 1.31
Canada 3.61 2.96 6.35 3.12 1.82 0.74
Chile 12.21 9.56 21.79 7.32 5.82 4.05
Czech Republic 6.35 10.59 8.3 13.67 3.39 2.83
Hungary 12.42 8.59 15.29 8.75 5.29 1.55
Iceland 16.56 20.44 20.94 23.09 6.3 3.89
Israel 43.01 83.55 99.49 112.12 4.96 4.28
Mexico 31.56 35 46.21 37.47 5.22 1.7
New Zealand 5.55 5.38 11.87 4.81 2.2 1.01
Norway 4.29 3.41 5.28 3.6 1.84 1.07
Poland 49.4 112.28 79.33 138.3 3.85 2.83
South Korea 5.75 5.72 7.39 6.8 2.9 1.04
Sweden 4.07 3.62 7.12 3.61 1.67 0.73
Turkey 50.51 29.64 56.93 26.4 8.48 2.11
UK 4.05 3.52 7.03 3.91 1.93 0.69
IT15*† 16.94 22.5 24.55 26.4 3.56 1.98
Note:
*The average of statistics above †Excludes Turkey since it adopted in 2006 which is late compared to other IT countries
The average inflation rates for IT countries fell from 24.55% in the pre targeting period
to 3.56% in end of post targeting period, an average by 20.99%. The volatility of
inflation measured by the standard deviation of inflation rates also dipped from 26.4%
to 1.98%. According to table 4.2, IT has been beneficial to the inflation outcomes of all IT
countries and an important reason why central banks seem happy with their choice.
11
Table 4.3 reports inflation statistics for non-IT countries also for the periods prior and
after 1990.
Table 4.3: Inflation Statistics for Non-Inflation Targeting countries
Entire Sample Pre-1990 Post-1990
Mean SD Mean SD Mean SD
Austria 2.6 1.61 3.8 2.06 1.96 0.9
Belgium 3.02 2.26 4.9 2.91 2 0.95
Cyprus 4.06 2.74 5.77 3.74 3.14 1.59
Denmark 3.51 2.85 6.33 3.46 2.04 0.59
Estonia 77.57 238.32 80.74 244.4
Finland 3.74 3.22 7.28 3.04 1.82 1.06
France 3.71 3.64 7.34 4.38 1.81 0.78
Germany 2.32 1.64 2.9 2.2 1.99 1.26
Greece 11.45 8.28 19.5 4.07 6.41 5.18
Hong Kong SAR 4.71 4.83 7.43 2.86 2.99 4.96
Ireland 4.87 5.14 9.26 6.96 2.63 1.47
Italy 5.95 5.43 11.43 6.3 3.06 1.44
Japan 1.16 1.92 2.53 2.29 0.34 1.16
Luxembourg 3.46 3.19 5.78 4.68 2.22 0.89
Malta 2.64 2.29 2.27 3.82 2.8 1.01
Netherlands 2.48 1.76 2.84 2.8 2.29 0.99
Portugal 8.35 7.9 16.67 7.86 3.7 2.7
Singapore 2.07 2.3 2.77 3.27 1.62 1.6
Slovakia 7.66 5.21 7.66 5.21
Slovenia 19.72 47.4 19.72 47.4
Spain 5.85 4.09 10.25 3.94 3.49 1.6
Switzerland 2.19 1.88 3.27 1.78 1.45 1.51
Taiwan 2.83 4.35 4.64 7.03 1.81 1.66
USA 3.71 2.58 5.55 3.62 2.65 0.98
Non-IT24* 7.9 15.2 6.79† 3.96† 2.49 1.63
Note:
*The average of statistics above † Excludes Estonia, Slovakia and Slovenia.
As these countries did not adopt IT, there is natural breaking point into pre and post
periods and hence the choice of the year 1990 is arbitrary, but rather it serves to
illustrate how the era of IT has largely been an era of low and stable inflation for both IT
and non-IT countries as table 4.3 illustrates. From table 4.3 all non-IT countries also
experienced low and stable inflation except for Malta which only experienced fall in
12
inflation volatility. Hence it is evident that these countries have less incentive to pursue
IT as inflation rates were fairly low and stable. A simple difference-in-difference
comparison suggests some impact of IT as inflation fell from 28.41% to 8.96% between
the pre-1990 period and end of post-1990 period, a fall of 19.45% for IT countries
compared to 7.9% to 2.49%, a decrease of 5.41%.
As it has been noted earlier, greater emphasis of inflation stabilization and explicit
targeting will conflict with other macroeconomic goals i.e. real economy objectives and
lead to greater output volatility as can be seen from the loss function (2.2). Intermediate
monetary economics especially in short run generally suggest a tradeoff between
inflation and output stabilization. Hence in accordance with this, IT which puts more
weight on inflation stabilization should lead to greater output volatility. Tables 4.4 and
4.5 illustrate the average growth rates and output volatilities measured by the standard
deviation of growth rates for IT and non-IT countries from 1980 to 2009.
Table 4.4: Output growth statistics for Inflation Targeting (IT) Countries
Entire Sample Pre-IT Post-IT
Mean SD Mean SD Mean SD
Australia 3.26 1.71 2.82 2.33 3.57 0.99
Canada 2.53 2.22 2.78 2.44 2.63 1.88
Chile 4.56 4.77 3.58 6.67 4.97 3.33
Czech Republic 1.81 3.68 1.28 4.02 2.85 3.13
Hungary 1.27 3.66 0.958 3.75 1.79 3.72
Iceland 2.92 3.51 2.9 3.1 2.84 4.8
Israel 4.21 2.51 3.85 1.88 4.3 2.89
Mexico 2.55 3.78 2.91 4.04 1.75 3.51
New Zealand 2.33 2.23 1.94 1.99 2.65 2.37
Norway 2.75 1.79 3.19 1.75 1.68 1.62
Poland 2.25 4.62 1.03 5.5 4 1.9
South Korea 6.57 4.18 8.22 3.34 4.98 2.99
Sweden 2.08 2.39 1.87 1.87 2.55 2.54
Turkey 4.01 4.47 4.33 4.39 0.21 4.69
UK 2.14 2.2 2.02 2.44 2.34 2.09
IT15*† 3.02 3.18 2.81 3.23 3.06 2.7
Note:
*The average of statistics above †Excludes Turkey
13
Table 4.5: Output growth Statistics for Non-Inflation Targeting countries
Entire Sample Pre-1990 Post-1990
Mean SD Mean SD Mean SD
Austria 2.04 1.59 1.82 1.16 2.05 1.77
Belgium 2.02 1.63 2.16 1.6 1.89 1.72
Cyprus 4.72 2.74 6.13 1.99 3.84 2.79
Denmark 1.72 2.17 1.9 2.22 1.63 2.25
Estonia 1.9 7.55 2.74 1.58 1.98 9.09
Finland 2.43 3.3 3.55 1.3 1.94 3.94
France 1.88 1.43 2.35 1.19 1.6 1.52
Germany 1.7 1.97 1.87 1.48 1.37 2.03
Greece 2 2.32 0.78 2.3 2.75 2.09
Hong Kong SAR 5.07 4.13 7.44 4.25 3.88 3.7
Ireland 4.29 4.04 2.4 1.76 5.1 4.62
Italy 1.33 1.86 2.06 1.74 0.91 1.89
Japan 2.16 2.67 4.4 1.46 0.81 2.23
Luxembourg 4.43 3.13 4.94 3.46 4.11 3.09
Malta 3.78 2.79 4.01 3.02 3.49 2.73
Netherlands 2.16 1.95 1.81 1.94 2.24 2
Portugal 2.7 2.59 3.69 2.84 1.9 2
Singapore 6.76 4.05 7.81 4.15 6.04 4
Slovakia 2.46 5.49 2.67 1.21 2.68 6.19
Slovenia 2.44 4.59 2.44 4.59
Spain 2.7 2.07 2.72 2.05 2.64 2.18
Switzerland 1.73 1.76 2.38 1.89 1.29 1.59
Taiwan 5.82 3.02 7.7 2.64 4.78 2.84
USA 2.68 2.08 3.05 2.54 2.5 1.9
Non-IT24* 2.96 2.96 3.49 2.16 2.67† 2.96†
Note:
*The average of statistics above † Excludes Slovenia
Among the IT countries, five countries (Canada, Mexico, Norway, South Korea, Iceland
and Turkey) faced a fall in output growth after IT adoption whereas four countries
(Iceland, Israel, New Zealand and Sweden) experienced an increase in output volatility.
In table 4.5, generally non-IT countries experienced fall in output growth. On average,
output volatility has increased from 2.16% to 2.96% between the pre 1990 and end of
post 1990 period. On the evidence presented in table 4.4, IT in general has not been
associated with increase in output volatility and has been favourable to output growth,
albeit moderately. However as Walsh (2009) mentions the fall in output volatility may
14
be associated with good luck view of ‘Great Moderation’ period. Nevertheless, among
non-IT countries except USA, Switzerland, Singapore, Portugal, Malta, Hong Kong and
Greece experienced increased output volatility. Tables 4.3 to 4.5 suggest that both IT
and non-IT countries’ central banks placed increased importance on stable and low
inflation over the period 1980 to 2009.
Figure 4.1 and 4.2 depicts the average inflation rates and inflation volatility against
time for both IT and non-IT economies.
The gap between average inflation rates and inflation volatility between IT and non-IT
economies is more pronounced before early 1990’s. The gap between these two
measures diminishes during the targeting periods i.e. 1990’s and onwards hence
implying monotonic convergence. This reinforces the finding that after the period 1990,
there was a greater aversion among central banks among IT and non-IT economies
towards inflation. Pertaining to inflation, the results so far emphasize that inflation
volatility has fallen with inflation rates for both IT and non-IT countries post 1990.
Figures 4.3 and 4.4 depict the average growth rates and output volatilities averaged
over the sample period for both IT and non-IT economies. From figure 4.3, both IT and
0
10
20
30
40
50
60
70
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Ra
te
Year
Figure 4.1: Average Inflation
Non Inflation Targeting countries
Inflation Targeting countries
15
non-IT economies enjoyed periods of favourable growth in 1990’s where 11 countries
in the sample adopted IT however both groups faced slump in the early 2000 and
towards the end of the sample. These were the periods where developed economies
suffered recessionary effects due to external shocks. Importantly the average growth
rates of IT countries were closely followed by the average growth rates of non-IT
countries thus suggesting growth behaviour was the same for these groups. Figure 4.4
suggests that both group of countries faced a fall in average output volatilities during
the inflation targeting periods i.e. year 1990 and onwards. However since early 1990’s
till the end of the sample output volatility for non-IT economies were confined within
2% to 3%. Hence figure 4.4 suggests that both IT and non-IT countries faced favourable
tradeoffs in terms of inflation and output volatility.
Looking at the data in this way is informative and suggestive, however it is not
conclusive. The above descriptive analyses do not constitute an evidence of causal
relationship between IT and better economic outcomes, is bivariate and it does not
account for changes in other variables that may affect the macroeconomic indicator of
interest. From the above information summarized, IT is associated with lowering of
inflation for all IT countries, but central banks also achieved lower inflation without any
explicit targeting. During the 1990’s many countries experienced lower and stable
inflation rates due to changes in the structural characteristics in labour markets. Ihrig
0
50
100
150
200
250
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Sta
nd
ard
De
via
tio
n o
f In
fla
tio
n r
ate
Year
Figure 4.2: Inflation Volatility
Non Inflation Targeting countries
Inflation Targeting Countries
16
and Marquez (2004) finds that among 19 industrialized countries persistent labour
market slack was the main factor exerting downward pressure for inflation in addition
to acceleration in productivity effects for USA. Labour market reforms helped to push
down inflation dramatically in Ireland, Norway and New Zealand.
-6
-4
-2
0
2
4
6
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Ra
te
Year
Figure 4.3: Average output growth
Non Inflation Targeting countries
Inflation Targeting Countries
0
1
2
3
4
5
6
7
1980 1983 1986 1989 1992 1995 1998 2001 2004 2007
Sta
nd
ard
De
via
tio
n o
f o
utp
ut
gro
wth
Year
Figure 4.4: Output Volatility
Non Inflation Targeting countries
Inflation Targeting countries
17
Furthermore the decline in output volatility over the most of the course of last two
decades was due to what is called as the ‘Great Moderation Period’ (Stock and Watson
,2003) and not due to IT itself. Hence this warrants a formal statistical investigation on
the importance of IT on macroeconomic outcomes.
5. METHODOLOGY
For estimating long and short run elasticities researchers often use a form of a
geometric lag model called the partial adjustment model. The following partial
adjustment model is utilized:
(5.1)
where is inflation rate, growth rate, inflation or output growth volatility. The
subscript indexes country; is the time period. The term
is included to capture persistence and mean reverting dynamics and as a consequence
there are time observations for the dependent variable. The main interest is IT
dummy variable which will be equal to 1 if country i adopted IT in period t and 0
otherwise. Therefore is the treatment variable which measures the average effect of
IT across all IT economies. Vector includes other covariates, some possibly
endogenous. The time or period dummies control for common time or period effects
and capture common shocks to all countries. allows for cross country fixed effects
and is the disturbances. It is assumed throughout that are serially uncorrelated.
For concreteness, will be sometimes be mentioned as average inflation and similarly
for other macroeconomic indicators. is log transformed using .
The inflation rate is log transformed to prevent the results from being biased by small
number of countries with high inflation. Another motivation to use this log transform is
that simple log transform to down weight very large readings, over weights readings
that are very close to zero where the log such readings are large negative numbers.
The model (5.1) implies that ordinary least squares (OLS) and fixed effects (FE)
would render biased and inconsistent estimates (Baltagi, 2005; Bond, 2002; Nickell,
1981). The consistency of the FE estimation depends on T being large. However, in
simulation studies, Judson and Owen (1999) found a bias equal to 20% of the coefficient
18
of interest even when T = 30. Standard results for omitted variables indicate that at
least in large samples, the FE estimator and OLS are biased downwards and upwards
respectively (Bond, 2002).
Given the possibility of reverse causation on inflation (or other macroeconomic
indicators) on IT, or a third omitted time variant factor causing both IT adoption and
inflation reduction and that both OLS and FE yields biased and inconsistent estimates
provides the motivation to use D-GMM estimation for the model (5.1) that controls for
both simultaneity and omitted variable bias. The D-GMM estimation strategy is due to
Holtz-Eakin et al. (1988) and Arellano and Bond (1991). Under the assumptions that (i)
disturbances are serially uncorrelated, (ii) weakly exogenous explanatory variables
and a mild condition that (iii) initial conditions are predetermined (i.e. not correlated
with future disturbances), D-GMM approach consists of differencing (5.1) to expunge
the country fixed effects and to apply the following moment conditions on
instruments :
(5.2)
where Using these moment conditions, Arellano and Bond
(1991) proposes a two-step GMM estimation. In the first step the error terms are
assumed to be homoskedastic and independent across countries and over time. In the
second step, the residuals obtained in the first step are then used to construct a
consistent estimate of the variance-covariance matrix for the second-step estimation,
therefore relaxing the assumptions of independence and homoskedasticity. Thus the
two-step estimation is asymptotically more efficient than one-step even when the
errors are homoskedastic. To correct for the downward bias of two-step standard
errors, the Windmeijer’s (2005) finite sample correction procedure is used to the two-
step estimator variance-covariance matrix. Hence this paper uses only two-step
estimation.
While GMM approaches are more suited to micro data where N is large relative to T,
it can cause problems in macro data where T is large relative to the number of
countries, N, because the number of instruments, function of T, climbs towards the
number of countries, N. As Roodman (2009) mentions this instrument proliferation
19
problem can bias the results by over-fitting the instrumented variables. To deal with
this problem the data is summarized over many 3 year periods as in Islam (1995) and
Acemoglu et al. (2008). Averaging the data over intervals means that results are less
likely to be driven by co-movements at very short horizons, lessens the impact of
measurement error and simplifies the specification of the dynamics of the model
(Hwang and Temple, 2005). It is also a good concession between giving enough time for
slow response of macroeconomic variables and isolating the IT treatment effects from
events occurring in close proximity. This allows entering information contained in a
long time series into smaller time periods while holding down the number of
instruments. As mentioned in Roodman (2009), to overcome instrument proliferation
problem and hence over fitting, the dimensionality of the matrix of instruments is
reduced by collapsing its columns. Columns of the instrument matrix embodying the
moment conditions in (5.2) for all t and s are collapsed into a single moment condition
as for all s, as in Calderon et al. (2002).
A potential drawback of D-GMM is that it leads to low precision and finite sample
biases when the time series is a highly persistent process; lagged levels of variables are
poor instruments for first differences (Blundell and Bond, 1998; Bond et al., 2001).
Since it is reasonable that inflation and IT dummy variable are persistent processes
their past values convey little information about future changes and hence provide poor
instruments for the transformed equation in differences. To increase efficiency an
alternative approach, the S-GMM, was suggested by Arellano and Bover (1995) and
Blundell and Bond (1998). To increase efficiency, Blundell and Bond (1998) suggest
also using the moment conditions5:
(5.3)
where the fixed effects are expunged from the instruments using orthogonal deviations
as used by Arellano and Bover (1995) and mentioned in Roodman (2006), and using
these moment conditions with (5.2) in S-GMM approach. Hence S-GMM approach
5 Only the most recent lagged differences are used as instruments. Using other lagged differences in
instruments results in redundant moment conditions given the moment conditions exploited in (5.2) (see
Arellano and Bover, 1995). In other words, lagged two periods or more are redundant instruments,
because corresponding moment conditions are linear combinations of those already in use in (5.2).
20
augments the D-GMM approach by using lagged values as instruments for regression in
differences with lagged differences as instruments for regression in levels. That is S-
GMM estimation combines in a system the regression in differences with regression in
levels. The above moment conditions are valid if changes in any instrument are
uncorrelated with the fixed effect i.e. for all z and t. In other words
there should be no correlation between changes in right hand side variables in (5.1)
with the fixed effects, but there may be correlation in levels. Sufficient conditions for
this are that (iii) which is the initial condition and (iv) conditional on
common time effects, the first moments of and are invariant of time or
and . As mentioned above it is assumed that
disturbances are serially uncorrelated. The assumption on the initial condition given
in (iii) holds when the initial condition satisfies mean stationary assumption6. Loosely
speaking countries in the sample are in steady state in this sense that deviations from
long term values after controlling for covariates are not systematically related to fixed
effects. This prescribes that IT adoption is not correlated to the inflation fixed effects,
however IT regime can have time invariant relation i.e. , where a for
all t and IT adoption to be related to changes in inflation, and
similarly for . To prevent the problem of instrument proliferation and biasing the
results the columns of matrix of instruments for S-GMM is collapsed as mentioned
earlier.
Blundell and Bond (1998) show using Monte Carlo studies for the case of AR(1)
specification that S-GMM can lead to dramatic reductions in finite sample bias and
efficiency gains for small T and persistent series. The results are also corroborated by
Hahn (1999), Blundell and Bond (2000) and Blundell et al. (2002). Soto (2009) using
Monte Carlo simulations found that provided that some persistence is found in the data,
S-GMM outperforms D-GMM when N is small i.e. S-GMM has a lower bias and a higher
efficiency. This is especially important for macro data or in empirical growth literature
when N, the number of countries is small and size of T is moderate.
To test the validity and consistency of the GMM, specification tests are employed as
mentioned in Arellano and Bond (1991). The consistency of the GMM estimators
6 See Blundell and Bond (1998) for details on this assumption.
21
presented above relies that there is no second-order serial correlation in the first
differenced disturbances, . But by construction might be first-order serially
correlated even if is not. The additional moment conditions are over identifying
restrictions and to test their validity, tests of over indentifying restrictions are used. To
test the validity of additional restrictions for D-GMM and S-GMM, Hansen’s (1982) J test
is used and to test the additional moment conditions that are used for regression in
levels in S-GMM, difference in Hansen C test is used. This tests statistic tests for the
validity of subsets of instruments used for equation in levels whereas the Hansen J test,
tests the overall validity of instruments. To overcome the weaknesses of tests of over
identifying restrictions due to instrument proliferation the size of the matrix of
instruments is collapsed as mention above. Sargan and difference in Sargan tests are not
vulnerable to instrument proliferation but they require homoskedastic errors for
consistency which is rarely assumed (Roodman, 2009). If Hansen J and C test statistic
rejects the null of validity of moment conditions and additional moment conditions as in
(5.2) and in (5.3) then this implies endogeneity of some the instruments used. If the
above tests fail to reject the null, then this lends support to the model, validity of
moment conditions and its specification.
6. RESULTS
6.1. PRELIMINARY RESULTS
Tables 6.1 and 6.2 present various estimates of the following equation:
(6.1)
where is the macroeconomic indicator of interest. and are common time effect
and the country fixed effects respectively. The main interest is the IT dummy variable
which is equal to 1 if country i is an inflation targeter in period t and 0 otherwise.
To prevent bias in the favour of the IT dummy, high inflation dummy is partially
controlled using the dummy which is equal to 1 if average inflation is greater
than 0.20 per year (in natural logarithm) in period t and 0 otherwise. As in the spirit of
Ball and Sheridan (2005) is output growth or output volatility to find if IT had any
effects on the real economy. It is sensible to keep when assessing the impacts of
22
IT on real economy as Bruno and Easterly (1998) and Barro (1996) have recognized
differences in growth pattern during high inflationary periods.
Table 6.1: Estimates of Inflation targeting effects on inflation and output growth (1980-2009)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.1.A- Inflation equation
Inflation targeting dummy 0.67 -0.28 -3.54 -3.72 1.77 0.85
(0.12) (0.92) (0.66) (0.73) (0.17) (0.24)
Lagged inflation 0.21 0.1 -0.01 -0.01 -0.08 -0.09
(0.01) (0.28) (0.97) (0.92) (0.62) (0.58)
High inflation dummy 36.7 37.6 57.9 61.5 71.5 72.8
(0.00) (0.00) (0.00) (0.00) (0.00) (0.00)
AR(1) test 0.09 0.12 0.06 0.06
AR(2) test 0.13 0.18 0.12 0.13
Hansen J test 0.51` 0.18 0.09 0.07
Difference-in-Hansen 0.59 0.81
Observations 340 340 301 301 340 340
Instrument columns 29 28 33 32
R-squared 0.59 0.44
6.1.B Output growth equation
Inflation targeting dummy 0.18 -0.01 -1.10 -1.32 0.71 0.57
(0.43) (0.99) (0.69) (0.66) (0.02) (0.11)
Lagged output growth 0.41 0.14 0.25 0.24 0.30 0.30
(0.00) (0.01) (0.03) (0.03) (0.00) (0.00)
High inflation dummy -1.49 -3.28 -2.60 -2.82 -1.38 -1.42
(0.10) (0.00) (0.29) (0.27) (0.20) (0.22)
AR(1) test 0.00 0.00 0.00 0.00
AR(2) test 0.42 0.48 0.41 0.41
Hansen J test 0.20 0.16 0.28 0.23
Difference-in-Hansen 0.83 0.81
Observations 343 343 304 304 343 343
Instrument columns 29 28 33 32
R-squared 0.38 0.38 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
23
Column (1) of tables 6.1 and 6.2 presents pooled OLS results with time effects where
standard errors are clustered by country. The time effect captures the worldwide trend
events and productivity changes common to all countries. Results show that IT has been
ineffective in reducing inflation and inflation volatility (tables 6.1.A and 6.2.A) which are
two main goals of the central bank. On contrary IT is shown to have positive effects on
output growth and growth volatility with an estimated per year impact of 0.18% and -
0.08% respectively (tables 6.1.B and 6.2.B) but the results are insignificant. Hence OLS
presents that IT has been unsuccessful in reducing inflation and inflation volatility.
Rather the positive sign indicates that it produced adverse effects on these two
variables which are key policy variables for central bank but the effects are insignificant.
Column (2) of tables 6.1 and 6.2 present the Within Group (WG) or FE estimates where
estimation indicates that IT has favourable impact on inflation with adverse costs in
terms of output growth (tables 6.1.A and 6.1.B) and was ineffective in stabilization of
inflation and output (tables 6.2.A and 6.2.B) but results are largely insignificant.
However as mentioned above both estimations are biased and inconsistent and WG
suffers from dynamic panel bias (Nickell, 1981) where the direction of the bias for OLS
and WG is upwards and downwards respectively. Thus if there is a candidate consistent
estimator, it is expected that it will lie between OLS and WG estimates.
The two-step D-GMM estimates presented in columns (3) and (4) of tables 6.1 and
6.2 fixes the dynamic panel bias and takes into account the undisputable endogeneity
of . For t≥3 column (3) uses the instruments ( ) for
j=0,1,…,t-3 (for predetermined IT) and column (4) uses ( )
for j=0,1,…,t-3 where IT is treated as endogenous. As mentioned earlier the matrix of
instruments is collapsed to prevent over fitting problem. D-GMM estimates in columns
(3) and (4) indicate that IT has positive impacts on inflation but coming at the cost of
lower output growth (tables 6.1.A and 6.1.B). There is no indication IT has been
successful in lowering macroeconomic volatilities (tables 6.2.A and 6.2.B). However
none of the results are significant. The GMM specification tests7 also do not indicate a
problem of serial correlation of residuals using the AR(1) and AR(2) test statistics in
tables 6.1 and 6.2. As mentioned earlier that consistency of the GMM estimates crucially
7 For details of the specification tests see Arellano and Bond (1991), Hayashi (2000) and Roodman (2006)
24
depends on i.e. no second-order serial correlation for the
disturbances in the first
Table 6.2: Estimates of Inflation targeting effects on macroeconomic volatility (1980-2009)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.2.A- Inflation volatility equation
Inflation targeting dummy 0.44 2.15 4.97 3.88 -0.54 1.30
(0.12) (0.55) (0.48) (0.66) (0.62) (0.16)
Lagged inflation volatility 0.201 0.05 0.168 0.166 -0.068 -0.066
(0.05) (0.64) (0.33) (0.35) (0.82) (0.83)
High inflation dummy 22.2 30.5 28.6 28.9 48.8 49.5
(0.02) (0.02) (0.08) (0.08) (0.06) (0.05)
AR(1) test 0.199 0.20 0.22 0.23
AR(2) test 0.24 0.25 0.16 0.17
Hansen J test 0.02 0.02 0.02 0.01
Difference-in-Hansen 0.00 0.00
Observations 340 340 301 301 340 340
Instrument columns 29 28 33 32
R-squared 0.3 0.25
6.2.B Output growth volatility equation
Inflation targeting dummy -0.08 0.21 1.73 1.72 0.06 0.05
(0.68) (0.41) (0.24) (0.26) (0.78) (0.86)
Lagged output growth volatility 0.23 0.02 0.13 0.13 0.13 0.33
(0.00) (0.68) (0.06) (0.07) (0.05) (0.05)
High inflation dummy 1.92 1.89 2.40 2.4 1.46 1.51
(0.00) (0.00) (0.13) (0.15) (0.02) (0.02)
AR(1) test 0.00 0.00 0.00 0.00
AR(2) test 0.87 0.88 0.96 0.95
Hansen J test 0.72 0.70 0.29 0.24
Difference-in-Hansen 0.14 0.12
Observations 342 342 303 303 342 342
Instrument columns 29 28 33 32
R-squared 0.38 0.38 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
25
differenced equation which tests for serial correlation for disturbances in levels
(Roodman, 2006). The Hansen J test which tests the overall validity of the instruments
is also not rejected in tables 6.1.A, 6.1.B and 6.2.B. However D-GMM results are
disappointing. It is well documented for example in Blundell and Bond (1998) that D-
GMM suffers from weak instrument problems due to series being highly persistent or
closely following a random walk process and hence D-GMM performs poorly (leads to
finite sample bias) in terms of precision. Therefore past levels of variables provide weak
instruments (becomes less informative) for equation in differences for D-GMM. Output
is a persistent process and as mentioned earlier so are inflation and IT dummy
variables.
To increase efficiency a more appropriate approach of S-GMM due to Arellano and
Bover (1995) and Blundell and Bond (1998) is used which exploits additional moment
restrictions as mentioned above. Columns (5) and (6) produce the two-step S-GMM
estimates. For t≥3 column (5) of tables 6.1 and 6.2 use the following instruments
( ) for j=0,1,…,t-3 for equations in differences and the
instruments ( ) for the equation in levels where IT is
predetermined. In column (6) of tables 6.1 and 6.2, IT variable is treated as endogenous
to address possible reverse causality from inflation and/or output growth to IT.
Alternatively to take into account a third country specific time varying factor that
simultaneously determines both the macroeconomic performance and the monetary
policy. Then for t≥3, the following instruments ( ) for
j=0,1,…,t-3 for equations in differences and the instruments ( )
for the equation in levels are used.
S-GMM estimates confirm the weak instruments problem of D-GMM estimates in
tables 6.1.A, 6.1.B, 6.2.A and 6.2.B. For instance relative to D-GMM estimates in columns
(3) and (4) for inflation equation in 6.1.A, the IT coefficient becomes positive and
weakly significant at 20% to 25% for S-GMM estimates in columns (5) and (6)
indicating that IT did not produce favourable effects on inflation – IT economies were
not successful in reducing the inflation rates relative non-IT economies. In column (5) in
6.1.A IT imposes a negative impact of 1.77% per year on inflation rate.
26
Columns (5) and (6) in contrast to D-GMM estimates in (3) and (4) of table 6.1.B also
confirms the weak instrument problem (output is persistent process as indicated by
lagged output growth coefficient i.e. 1-0.25=0.75 as in column (3) table 6.1.B or 1-
0.24=0.76 as in column (4)) as S-GMM estimates show that IT produced higher output
growth relative non-IT economies and results are marginally significant. Thus inferring
the S-GMM estimate when IT is endogenous from column (6) in table 6.1.B for instance,
IT had a positive impact on output growth of magnitude 0.57% per year at 15%
significance. This hints that central bank’s have been more flexible with IT policy and
placed relatively greater weight towards growth.
S-GMM estimates indicate that IT was not effective at stabilizing inflation and output
but the results are largely insignificant (tables 6.2.A and 6.2.B). Again as for output
growth in table 6.1.B there is weak instrument problem for D-GMM estimates in table
6.2 especially for output volatility in 6.2.B. As pointed out by Spilimbergo (2009),
another way to identify the persistence of the series and detect/diagnose weak
instrument problem is to consider the differences in coefficient estimates of OLS, WG
and unbiased GMM estimator. In column (1) table 6.2.B for example, OLS provides an
estimate of -0.08% per year impact of IT on output volatility and in column (2) WG
provides 0.21% whereas an unbiased GMM estimate in column (6) of table 6.2.B yields
0.05%. This technique along with comparing S-GMM estimates relative to D-GMM
estimates and/or computing , as done for output growth in the preceding
paragraph revels the persistence of the series and the nature of the weak instrument
problem. The S-GMM estimate in column (6) where IT is treated as endogenous in tables
6.1.A and 6.2.A reveals the simultaneity existent between inflation, inflation volatility
and IT regime as indicated by large changes in magnitude and direction of the
coefficient estimates, thus indicating IT is influenced by the average inflation and
inflation volatility error, cov . The S-GMM estimates of output and output
volatility in tables 6.1.B and 6.2.B do not change much in magnitude and in direction
thus suggesting that main cause of endogeneity bias is reverse causality from inflation
and its volatility to IT.
The specification tests do not reject the S-GMM estimates for output and output
volatility (tables 6.1.B and 6.2.B). Another evidence of consistency is that both lagged
output and output volatility GMM estimates are between the OLS and WG estimates. On
27
a worrying note Hansen J test is weakly insignificant for the average inflation equation
for the S-GMM estimates in columns (5) and (6) of table 6.1.A. However the test statistic
rejects the validity of the overall instruments for the inflation volatility equation in 6.2.A
for both D-GMM and S-GMM specifications. Furthermore the difference in Hansen C test,
which tests the validity of the additional moment conditions used in S-GMM,
or the exogeneity of the extra lagged instruments in levels is rejected
for inflation volatility equation at 1% in table 6.2.A in columns (5) and (6). Hence the
efficiency gain from S-GMM is not free; we need extra assumptions and the violation
which leads to bias. The weak exogeneity of some of instruments as indicated by Hansen
J test in table 6.1.A for inflation raises some concerns and doubt regarding the S-GMM
estimates. However D-GMM estimates in columns (3) and (4) remain consistent and
indicates that IT has -3.72% per year impact on inflation rate taking into account the
endogeneity of IT8 with estimated long run effect of -3.68% ( ), however it is
insignificant. In columns (5) and (6) of table 6.1.B, S-GMM estimates show IT had
significant or marginal significant effect on output growth where the impact per year
lying in 0.57% to 0.71% range. If the lagged coefficient α which controls for mean
reversion or regression to mean is significant and between 0 and 1 and IT dummy
coefficient β is insignificant then it implies that countries that had higher inflation saw a
greater decline in inflation than already low inflation countries. Similar analogy also
applies to output and volatilities. In contrast to simple regression to mean evidence
found in Ball in Sheridan (2005) for inflation, table 6.1.A for inflation does not indicate
this is the case. Thus the significant or marginal significant IT impact on output growth
is not due to simple regression to mean but for output growth volatility it is (columns
(5) and (6), tables 6.1.B and 6.2.B).
The high inflation dummy also provides interesting results – it significantly affects
inflation and promotes greater volatilities in the economy hence suggesting that in high
inflation periods macroeconomic indicators have different long run means. Also as
expected high inflation has a negative impact on growth confirming the findings that
countries going through high inflation grew less (Bruno and Easterly, 1998) but results
are not significant.
8 Uhlig (2004) mentions that choice of IT has been an endogenous one by the countries that has adopted it.
28
6.2. 1985-2002
To examine the sensitivity of the above results to different sample period, the period
1985-2002 is chosen9. In columns (5) and (6) of table 6.3.A the difference in Hansen C
test rejects the validity of additional moment conditions for S-GMM estimates for the
inflation equation. The test statistic weakly rejects (at 10%) the extra instruments in
levels for the S-GMM when IT is treated as predetermined variable but when IT is
endogenous it is rejected at 5%. However the D-GMM estimates in columns (3) and (4)
are still valid according to the specification tests and are consistent but it is not efficient.
D-GMM estimates are still valid if one is unwilling to accept the condition of Blundell
and Bond (1998) that . Hence on the face of it, IT has been successful in
reducing inflation at marginal significance level (10% or 15%) where it has -7.97% to -
8.34% per year impact on the inflation rate beyond simple regression to mean i.e. even
after taking into account lagged inflation. There may be indication of endogeneity as the
coefficient estimate in (4) is more negative.
The D-GMM estimates in columns (3) and (4) of table 6.3.B indicate that IT has been
adverse for output growth for the 1985-2002 period imposing a significant negative
cost of -7.97% to -8.42% per year impact. Nevertheless as in table 6.1.B, the S-GMM
estimates reveal weak instrument problem of D-GMM results in table 6.3.B for output
equation. S-GMM estimates indicate that IT did not have any significant impact on
output growth for IT economies. The S-GMM results in columns (5) and (6) of table
6.3.B also reveals the importance of taking into account the endogeneity of IT as the
magnitude of IT per year impact on output growth estimate changes from 0.24% to
0.09% in table 6.3.B for the output growth equation. Hence the S-GMM estimates in
columns (5) and (6) are preferred results and they are fairly robust to sample periods in
a sense that IT is not found to have any adverse impact of output growth and
furthermore the specification tests do not reject the validity of the instruments used and
consistency. But now there is some evidence of simple regression to mean effect. Lagged
output growth estimates in table 6.3.B also lie between OLS and WG estimates – further
evidence of consistency.
9 This period was also used by Wu (2004) and Willard (2006).
29
Table 6.3: Estimates of Inflation targeting effects on inflation and output growth (1985-2002)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.3.A Inflation equation
Inflation targeting dummy 1.06 -0.50 -7.97 -8.34 -4.97 -1.33
(0.35) (0.86) (0.08) (0.15) (0.55) (0.41)
Lagged inflation -0.04 -0.26 0.22 0.23 0.29 0.36
(0.82) (0.10) (0.03) (0.00) (0.32) (0.43)
High inflation dummy 50.70 44.40 3.25 2.70 -10.70 -21.50
(0.00) (0.04) (0.81) (0.83) (0.81) (0.75)
AR(1) test 0.14 0.16 0.46 0.53
AR(2) test 0.18 0.70 0.68
Hansen J test 0.92 0.86 0.33 0.15
Difference-in-Hansen 0.07 0.02
Observations 190 190 151 151 190 190
Instrument columns 15 14 19 18
R-squared 0.52 0.53
6.3.B Output growth equation
Inflation targeting dummy 0.05 0.04 -8.42 -7.85 0.24 0.09
(0.88) (0.96) (0.05) (0.03) (0.55) (0.86)
Lagged output growth 0.40 -0.01 0.15 0.17 0.40 0.30
(0.00) (0.84) (0.51) (0.35) (0.02) (0.14)
High inflation dummy -1.69 -4.39 -15.70 -12.6 0.20 0.26
(0.03) (0.00) (0.12) (0.13) (0.98) (0.97)
AR(1) test 0.12 0.08 0.02 0.05
AR(2) test 0.64 0.49 0.71 0.73
Hansen J test 0.78 0.84 0.61 0.46
Difference-in-Hansen 0.15 0.10
Observations 192 192 153 153 192 192
Instrument columns 15 14 19 18
R-squared 0.31 0.28 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
The endogeneity bias as well as the weak instruments problem is also apparent from
estimates in tables 6.4.A and 6.4.B for inflation and output volatilities respectively. S-
GMM estimates taking into account endogeneity of IT in column (6) of tables 6.4.A and
30
6.4.B indicate that IT was favourable in reducing macroeconomic volatility but did not
have any significant effects.
Table 6.4: Estimates of Inflation targeting effects on macroeconomic volatility (1985-2002)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.4.A Inflation volatility equation
Inflation targeting dummy 1.17 -0.07 1.66 1.38 0.32 -0.10
(0.12) (0.96) (0.62) (0.68) (0.57) (0.90)
Lagged inflation volatility -0.02 -0.11 0.04 0.02 0.08 0.08
(0.73) (0.23) (0.58) (0.78) (0.25) (0.26)
High inflation dummy 20.50 25.30 8.94 9.84 1.48 0.83
(0.05) (0.03) (0.33) (0.30) (0.63) (0.77)
AR(1) test 0.80 0.65 0.46 0.42
AR(2) test 0.62 0.59 0.28 0.18
Hansen J test 0.21 0.49 0.18 0.12
Difference-in-Hansen 0.24 0.02
Observations 189 189 150 150 189 189
Instrument columns 15 14 19 18
R-squared 0.27 0.23
6.4.B Output growth volatility equation
Inflation targeting dummy 0.04 -0.25 2.31 2.30 0.23 -0.13
(0.88) (0.53) (0.53) (0.35) (0.66) (0.80)
Lagged output growth volatility 0.13 -0.21 -0.21 -0.32 -0.06 -0.11
(0.05) (0.07) (0.26) (0.22) (0.20) (0.15)
High inflation dummy 2.94 2.82 4.87 6.08 4.51 4.98
(0.00) (0.00) (0.16) (0.02) (0.07) (0.01)
AR(1) test 0.01 0.01 0.01 0.01
AR(2) test 0.69 0.76 0.85 0.72
Hansen J test 0.21 0.48 0.28 0.31
Difference-in-Hansen 0.38 0.20
Observations 192 192 153 153 192 192
Instrument columns 15 14 19 18
R-squared 0.28 0.31 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
31
The difference in Hansen C tests however rejects the additional assumptions made or
additional moment restrictions used in S-GMM at 5% level for the inflation volatility
equation in column (6) of table 6.4.A where IT is treated as endogenous variable. In this
event the D-GMM estimates are again consistent and are accepted by specification tests
however they suggest that IT was ineffective in reducing macroeconomic volatilities but
results are once again not significant at any reasonable significance level. The
specification tests do not reject the moment conditions for output growth volatility
equation in 6.4.B and no second-order serial correlation is found. Hence for output
volatility in table 6.4.B the additional instruments seem to be valid and highly
informative. Furthermore lagged output growth volatility coefficients lies in between
OLS and WG estimates – further evidence of consistency. Once again results are robust
i.e. IT is not found to have any significant adverse impact on inflation volatility as well
output growth volatility across the two sample periods.
6.3. ROBUSTNESS ANALYSIS
So far, the empirical evidence showed that IT didn’t have any significant or adverse
effects on macroeconomic volatility (tables 6.2.B and 6.4.B). There is indication that IT
had favourable impact in reducing inflation using D-GMM estimates but not with S-GMM
estimation which is expected to be more efficient however specification tests are
against the S-GMM results as found above (table 6.3.A). IT was shown to have positive
significant impact on output growth but for the period 1985-2002 it due to mean
reversion. An important question is that are these results robust?
To further test the sensitivity of the results, reduced sets of instruments are used
where only until lag 3 instruments are used. As Roodman (2009) mentions it is
important to always check for robustness of the analysis using reduced instruments.
Different IT adoption dates are also materialized10 using reduced instrument sets to
further check for sensitivity. For Chile, Czech Republic, Israel and Mexico IT adoption
dates according to Batini and Laxton (2007) are used. For Australia, Canada, Finland,
10 When using full set of instruments for different IT dates, conclusions regarding IT effects do not change
significantly but some specification tests are not supportive regarding the validity of the models hence reduced
set of instruments are used for different IT adoption dates analysis.
32
New Zealand and UK adoption dates for constant IT11 i.e. meaning unchanging target or
target range. The results are presented for S-GMM only12 as Hayakawa (2005) finds
analytically and experimentally that despite using more instruments S-GMM is more
efficient than D-GMM.
In columns (1)-(4) of table 6.5.A the S-GMM estimates of the effects of IT on inflation
is negative and now mostly significant implying that it had adverse effects on inflation.
Results are robust when using reduced instruments as in columns (1) and (2) and with
different IT adoption dates in (3) and (4). Consistent with above findings for the sample
period 1985-2002, in columns (5) and (6) of table 6.5.A IT produces positive but
insignificant impact in reducing inflation when used with reduced instruments. Hence
there is a paradox i.e. IT was largely ineffective in reducing inflation, but there is some
evidence, albeit weak that it had a positive impact on inflation. This may indicate
multiple hypotheses. In 1980-2009, IT regime has been increasingly flexible and
discretionary (pursuing expansionary polices) compared to 1985-2002 period giving
more weight to output growth. A closer examination of figure 3.1 in section 3 reveals
that post 2002 both IT and non-IT economies at low levels experienced rising inflation.
Secondly, announcement of a formal inflation target was not successful in anchoring
public’s expectations of inflation and to mimic policy under commitment thus failing to
establish credibility (see section 2 on theory) therefore unable to produce lower
inflation rates. A third view is that central banks during the last few years have pursed
discretionary monetary or fiscal policies to prevent the spread of deflationary
expectations that may have been present in the period 1985-2002. But overall at face
value and generally, the IT results for average inflation from tables 6.1.A, 6.3.A and 6.5.A
indicates that it has largely been unsuccessful in reducing in inflation and this abides
with the results found in Ball and Sheridan (2005) and Willard (2006) but results are
fairly robust for its adverse effects on inflation. However there is some evidence that IT
matters for inflation according to D-GMM estimates in columns (3) and (4) table 6.3.A
but as mentioned earlier they may be severely biased due to weak instruments problem.
Either central banks were not able anchor inflation expectations and thus establish
credibility or they were too flexible. This clearly implies two things. Firstly, given the
11 See Ball and Sheridan (2005) for constant IT. 12 Results for D-GMM were also carried out but in all cases they more inefficient relative to S-GMM indicating
the weak instrument problem.
33
Table 6.5: Estimates of Inflation targeting effects on inflation and output growth, robustness checks
Different IT adoption dates and reduced instruments 1980-
2009
Reduced instruments
1980-2009 Reduced instruments
1985-2002 Estimator: S-GMM P S-GMM E S-GMM P S-GMM E S-GMM P S-GMM E Regressors: (1) (2) (3) (4) (5) (6) 6.5.A Inflation equation Inflation targeting dummy 2.10 1.29 2.15 1.06 -0.51 -0.92 (0.00) (0.04) (0.01) (0.17) (0.84) (0.83) Lagged inflation -0.11 -0.13 -0.09 -0.15 0.36 0.36 (0.48) (0.46) (0.59) (0.48) (0.19) (0.13) High inflation dummy 65.90 63.70 58.40 62.20 -21.70 -21.71 (0.00) (0.00) (0.03) (0.04) (0.53) (0.52) AR(1) test 0.08 0.10 0.12 0.11 0.41 0.33 AR(2) test 0.13 0.14 0.16 0.17 0.56 0.49 Hansen J test 0.69 0.74 0.39 0.20 0.61 0.50 Difference-in-Hansen 0.64 0.70 0.23 0.20 0.27 0.18 Observations 340 340 340 340 190 190 Instrument columns 18 18 18 18 14 14 6.5.B Output growth equation Inflation targeting dummy 0.25 0.16 0.03 0.35 0.34 0.14 (0.48) (0.68) (0.92) (0.42) (0.60) (0.72) Lagged output growth 0.39 0.39 0.40 0.40 0.51 0.63 (0.10) (0.10) (0.00) (0.00) (0.09) (0.14) High inflation dummy -0.16 0.11 0.22 0.23 3.48 6.16 (0.89) (0.93) (0.85) (0.87) (0.20) (0.32) AR(1) test 0.00 0.00 0.00 0.00 0.05 0.10 AR(2) test 0.48 0.49 0.50 0.51 0.49 0.48 Hansen J test 0.18 0.20 0.25 0.23 0.58 0.65 Difference-in-Hansen 0.05 0.11 0.07 0.06 0.38 0.40 Observations 343 343 343 343 192 192 Instrument columns 18 18 18 18 14 14 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-
values. (1)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
decline in inflation depicted by the descriptive analyses in section 3 and general
ineffectiveness of IT confirms the conservative ‘window dressing view’ i.e. what matters
is central bank’s aversion towards inflation and not an explicit monetary policy (see
section 2). Second implication is that one need not pursue a rigid monetary framework
34
to reduce inflation by establishing credibility. Other regimes or concept of independent
central banker due to Rogoff (1985) may be better alternatives.
In columns (1)-(6) of table 6.5.B the results indicate that IT had favourable effects on
output growth but they are not significant at any reasonable levels, but again in general
(mostly at 10%) there is evidence of simple regression to mean by inferring the
estimates from lagged output growth. Thus the S-GMM results concerning output
growth in tables 6.1.B, 6.3.B and 6.5.B indicate that estimates of IT effect is very robust –
it has positive impact on growth but results are mostly insignificant (it is significant
only for 1980-2009 period in table (6.1.A)) or simply due to simple regression to mean
but there is no adverse impact indicating building credibility through a very restrictive
interest rate policy is not necessary. The results also align to that in Biondi and Toneto
(2008) for developed economies that IT was ineffective in reducing inflation (rather it
produced adverse effects) but was satisfactory in terms of output growth i.e. it did not
produce any adverse effects. The specification tests are generally robust and generally
supportive. When results in columns (1), (3) and (4) of table 6.5.B for output were
carried using only second lag instruments the difference in Hansen C test are fairly large
and accepts the validity of instruments used for levels. Collecting the results in tables
6.1, 6.3 and 6.5 for inflation and output, this paper in general does not find evidence that
this restrictive regime as its critics claim (see section 2) imposed costs on growth by
producing deflation.
Results for inflation volatility in table 6.6.A illustrate that IT has largely been
ineffective in stabilizing inflation, again robust with above findings. In table 6.6.B there
is good reason to suspect endogeneity bias in estimates of IT effects on output volatility
– the coefficient estimates of IT impact on output volatility in columns (1)-(4) of table
6.6.B changes its sign from positive to negative. Thus S-GMM that takes into account
endogeneity of IT in columns (2), (4) and (6) are the preferred results implying IT was
effective in reducing output volatility but results are not significant. Interestingly,
lagged output volatility is marginally significant indicating mean reversion in economic
volatility. Thus inferring the results from tables 6.2, 6.4 and 6.6 insignificant
ineffectiveness of IT towards macroeconomic stabilization indicates that decline in
macroeconomic volatility especially output volatility (see section 3) was due to the good
luck era (i.e. favourable external macroeconomic shocks, sound macroeconomic
35
policies, global integration etc) associated with ‘Great Moderation’13 period first
mentioned in Stock and Watson (2003). The specification tests largely support
proposed parameterization and specification in tables 6.5 and 6.6.
Table 6.6: Estimates of Inflation targeting effects on macroeconomic volatility, robustness checks
Different IT adoption dates and reduced instruments 1980-
2009
Reduced instruments
1980-2009 Reduced instruments
1985-2002
Estimator: S-GMM P S-GMM E S-GMM P S-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.6.A Inflation volatility equation
Inflation targeting dummy 0.01 0.37 0.08 0.62 0.17 -0.09
(0.98) (0.25) (0.87) (0.09) (0.87) (0.94)
Lagged inflation volatility 0.13 0.12 0.12 0.12 0.06 0.04
(0.45) (0.47) (0.47) (0.46) (0.65) (0.77)
High inflation dummy 34.8 30.00 32.90 33.70 4.56 5.52
(0.14) (0.18) (0.16) (0.20) (0.68) (0.70)
AR(1) test 0.18 0.21 0.19 0.19 0.90 0.99
AR(2) test 0.21 0.25 0.23 0.23 0.96 0.97
Hansen J test 0.45 0.71 0.51 0.42 0.29 0.64
Difference-in-Hansen 0.45 0.77 0.38 0.45 0.66 0.96
Observations 340 340 340 340 189 189
Instrument columns 18 18 18 18 14 14
6.6.B Output growth volatility equation
Inflation targeting dummy 0.16 -0.04 0.06 -0.08 -0.26 -0.36
(0.52) (0.89) (0.80) (0.78) (0.61) (0.41) Lagged output growth volatility 0.10 0.12 0.10 0.11 0.30 0.20
(0.16) (0.11) (0.13) (0.11) (0.02) (0.26)
High inflation dummy 1.30 1.25 1.19 1.05 -1.85 0.33
(0.14) (0.17) (0.17) (0.24) (0.42) (0.92)
AR(1) test 0.00 0.00 0.00 0.00 0.02 0.01
AR(2) test 0.80 0.88 0.80 0.83 0.16 0.17
Hansen J test 0.17 0.13 0.22 0.24 0.83 0.33
Difference-in-Hansen 0.09 0.17 0.57 0.66 0.59 0.23
Observations 342 342 342 342 192 192
Instrument columns 18 18 18 18 14 14 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
13 The Great moderation period refers to decline in economic volatility which started in mind 1980’s.
36
It is reasonable to question given that IT has mainly negative and positive effects on
average inflation and output respectively in table 6.5, whether the above IT impacts on
volatilities are not due to these descriptive statistics being linearly related to the
absolute size of the mean.
Table 6.7: Estimates of Inflation targeting effects on coefficient of variations of inflation and output growth, robustness checks
Different IT adoption dates and
reduced instruments 1980-
2009
Reduced instruments 1980-
2009
Reduced instruments 1985-
2002
Estimator: S-GMM P S-GMM E S-GMM P S-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
6.7.A Inflation coefficient of variation equation
Inflation targeting dummy -1.20 -0.92 -1.23 -1.06 0.39 0.43
(0.01) (0.00) (0.03) (0.01) (0.39) (0.33)
Lagged inflation coefficient of variation 0.23 0.32 0.43 0.49 0.11 0.10
(0.31) (0.14) (0.04) (0.00) (0.70) (0.75)
High inflation dummy -22.90 -22.30 -20.90 -19.30 -17.00 -17.00
(0.03) (0.02) (0.03) (0.00) (0.05) (0.04)
AR(1) test 0.02 0.01 0.01 0.01 0.21 0.21
AR(2) test 0.45 0.40 0.30 0.21 0.37 0.37
Hansen J test 0.16 0.25 0.05 0.22 0.60 0.60
Difference-in-Hansen 0.03 0.06 0.01 0.09 0.75 0.62
Observations 340 340 340 340 189 189
Instrument columns 18 18 18 18 14 14
6.7.B Output growth coefficient of variation equation
Inflation targeting dummy -0.10 -0.42 -0.20 -0.68 -0.08 -0.08
(0.74) (0.26) (0.59) (0.11) (0.89) (0.19)
Lagged output growth coefficient of variation 0.29 0.28 0.27 0.29 0.24 0.26
(0.00) (0.00) (0.00) (0.00) (0.01) (0.00)
High inflation dummy 1.51 1.62 1.35 1.39 -1.29 -0.44
(0.13) (0.14) (0.17) (0.15) (0.77) (0.91)
AR(1) test 0.00 0.00 0.00 0.00 0.01 0.01
AR(2) test 0.26 0.26 0.23 0.23 0.94 0.81
Hansen J test 0.50 0.43 0.36 0.60 0.99 0.82
Difference-in-Hansen 0.31 0.53 0.65 0.64 0.95 0.96
Observations 342 342 342 342 192 192
Instrument columns 18 18 18 18 14 14
p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values.
(1)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
37
When volatilities are measured as coefficient of variation calculated as the difference
between the standard deviation and the absolute value of the contemporaneous mean
using log data, the estimates of IT on macroeconomic volatilities becomes largely
positive (tables 6.7.A and 6.7.B). However results are largely significant for inflation
volatility in table 6.7.A in columns (1)-(4) indicating IT has significantly contributed
towards inflation stabilization with per year damping impact from -1.23% to -0.92%
and there is no evidence of any reversion to mean indicating the effectiveness of the IT
policy. Nonetheless it loses its significance and sign for the period 1985-2002 in
columns (5) and (6). Therefore in contrast to previous empirical results there is some
credence in the theoretical claim that IT is better able to cope with adverse shocks. The
difference in Hansen C tests rejects the validity on additional instruments at 5% in
columns (1) and (3), however. But since the S-GMM estimates which also take into
account endogeneity of IT provide different estimates and have more precision are
taken as the preferred estimates and the difference in Hansen C test does not reject
additional instruments for levels at 5%.
In table 6.7.B the results in columns (1)-(6) show IT had positive effect towards
output stabilization but are not significant at 10%, but some estimates are significant at
moderate level i.e. at 15% and 20% in columns (4) and (6) respectively of table 6.7.B.
Since IT estimates on its effects on output volatility are largely insignificant, decline in
output volatility are simple due to mean reversion as inferred from lagged output
volatility estimates in table 6.7.B. Hence in terms of output volatility when measured by
coefficient of variation IT has been generally ineffective lending support to the ‘Great
Moderation’ period.
6.4. INFLATION-OUTPUT TRADEOFFS
To determine whether introduction of IT has led to improvements in the inflation-
output or real economic activity tradeoff, the following equation in terms of inflation
variation is utilized which suggests an accelerationist Phillips curve:
(6.2)
38
where 14. β allows IT economies to have a different intercept and
captures the variation in inflation that is not related to output sacrifice ratio(loss of
output to trend divided by the fall in inflation). If β is negative then there is a downward
shift in the Phillips curve thus leading to lower tradeoff, higher efficiency gains and is
thus implication of credible IT policy. Negative β also implies that society lowers
sacrifice ratio15. Thus a β<0 (β>0) can be interpreted as credibility bonus16 (onus) from
IT policy. Table 6.8 provides estimates of IT effects on inflation output tradeoff. It is
apparent in columns (3)-(6) that there is strong endogeneity bias.
Table 6.8: Estimates of Inflation targeting effects on inflation-output tradeoff (1980-2009)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
Phillips curve
Inflation targeting dummy 0.91 3.19 1.83 -0.66 -0.72 0.80
(0.27) (0.09) (0.81) (0.95) (0.41) (0.46)
Output growth -3.01 -2.89 -2.44 -2.32 -2.6 -1.98
(0.01) (0.02) (0.04) (0.19) (0.01) (0.11)
Lagged output growth 2.62 2.60 1.96 1.76 2.15 1.93
(0.01) (0.01) (0.01) (0.05) (0.02) (0.01)
High inflation dummy 2.52 9.31 -3.6 -10.1 2.16 4.69
(0.49) (0.19) (0.83) (0.63) (0.76) (0.41)
AR(1) test 0.07 0.07 0.07 0.08
AR(2) test 0.85 0.98 0.84 0.71
Hansen J test 0.72 0.82 0.41 0.43
Difference-in-Hansen 0.08 0.05
Observations 340 340 301 301 340 340
Instrument columns
R-squared 0.20 0.22 30 28 35 33 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
14 The Phillips curve is represented in terms of output growth instead of unemployment since latter varies with
former i.e. unemployment varies when the actual rate of output growth differs from the natural growth rate. 15 According to Hutchison and Walsh (1998) sacrifice ratio measures the percentage point change in output per
percentage point change in inflation following a change in aggregate demand. 16
see section 6.2 second last paragraph
39
When endogeneity of IT in columns (4) and (6) is taken into account the IT
estimates on inflation-output tradeoff changes in sign and in magnitude. However the
S-GMM estimates cannot be relied upon so faithfully since the difference in Hansen C
test suggests that additional moment conditions are weakly valid or that additional
instruments in levels are weakly exogenous. Hence the D-GMM estimate in column (4) is
the preferred result and thus indicates that credible disinflation improved the tradeoff
by shifting the Phillips curve down but the effect is not significant. The D-GMM estimate
in column (4) of table 6.1.A indicates that IT did indeed produce disinflation but it is not
significant. Table 6.9 provides estimates of IT effects on the tradeoff for the period
1985-2002. Although the D-GMM estimates in columns (3)-(4) shows that IT had
credibility bonus effect but results are insignificant and are also estimated with poor
precision indicating the weak instrument problem. The S-GMM estimate however in
column (6) of table 6.9 where IT is endogenous
Table 6.9: Estimates of Inflation targeting effects on inflation-output tradeoff (1985-2002)
Estimator: TE-OLS WG D-GMM P D-GMM E S-GMM P S-GMM E
Regressors: (1) (2) (3) (4) (5) (6)
Phillips curve
Inflation targeting dummy 1.00 8.27 -61.40 -67.00 -1.55 1.11
(0.54) (0.05) (0.26) (0.36) (0.62) (0.72)
Output growth -3.67 -3.53 -6.25 -9.16 -7.21 -3.10
(0.09) (0.14) (0.22) (0.47) (0.09) (0.72)
Lagged output growth 3.23 3.56 0.88 0.53 1.46 0.94
(0.06) (0.05) (0.71) (0.85) (0.27) (0.38)
High inflation dummy 2.60 7.66 113.7 135.6 49.15 53.77
(0.28) (0.14) (0.38) (0.36) (0.37) (0.31)
AR(1) test 0.14 0.18 0.10 0.08
AR(2) test 0.65 0.62 0.97 0.82
Hansen J test 0.86 0.75 0.74 0.42
Difference-in-Hansen 0.84 0.95
Observations 190 190 151 151 190 190
Instrument columns 16 14 21 19
R-squared 0.19 0.20 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective p-values. (1)-(2) uses robust standard errors clustered by country.
(3)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
40
provides that IT infact lead to worsening of the tradeoff (credibility onus effect). Hence
on the face of it, IT was unable to cause decline in expectations rapidly and general
public or agents were also sceptic about the announced objectives of IT central banks.
This finding is robust when the sample 1980-2009 is analyzed with reduced sets of
instruments and different IT dates in table 6.10 columns (1)-(4). However for the period
1985-2002 with reduced instruments sets in columns (5) and (6) of table 6.10 suggests
the opposite – IT lead to favourable inflation-output tradeoffs by shifting down the
Phillips curve but the effects are not significant at any reasonable level. On the face it,
tables 6.8-6.10 provides inconclusive results regarding the effects of IT on the inflation
output tradeoff. The results are robust when analyzed with reduced instrument sets and
different IT adoption dates but not across sample periods. At best the results in table
6.8-6.10 do not indicate that IT has lead to worsening of inflation-output tradeoff.
Table 6.10: Estimates of Inflation targeting effects on inflation-output tradeoff, robustness checks
Different IT adoption dates and reduced instruments 1980-
2009
Reduced instruments
1980-2009 Reduced instruments
1985-2002 Estimator: S-GMM P S-GMM E S-GMM P S-GMM E S-GMM P S-GMM E Regressors: (1) (2) (3) (4) (5) (6) Phillips curve Inflation targeting
dummy 0.09 0.50 0.42 1.10 -2.40 -1.72 (0.91) (0.61) (0.66) (0.37) (0.54) (0.74) Output growth -.192 -1.41 -1.87 -1.49 -3.49 -1.53 (0.05) (0.35) 0.06 0.45 (0.14) (0.76) Lagged output growth 1.61 1.34 1.59 1.40 0.44 -0.62 (0.07) (0.07) (0.07) (0.13) (0.74) (0.56) High inflation dummy 1.30 2.75 3.7 2.96 -67.00 -95.00 (0.87) (0.69) (0.68) (0.67) (0.31) (0.20) AR(1) test 0.07 0.08 0.07 0.07 0.08 0.08 AR(2) test 0.82 0.76 0.78 0.77 0.84 0.56 Hansen J test 0.51 0.62 0.37 0.40 0.72 0.70 Difference-in-Hansen 0.53 0.78 0.53 0.39 0.70 0.54 Observations 340 340 340 340 190 190 Instrument columns 20 20 20 20 16 16 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective
p-values. (1)-(6) uses Windmeijer's (2005) corrected standard errors.
Data averaged over three year period.
In columns (4) and (6) IT is endogenous (E) whereas in (3) and (5) it is predetermined (P).
41
7. LIMITATIONS AND EXTENSIONS
There are theoretical benefits of IT but the empirical results above in general are not
supportive. In other words, the empirical analysis does not provide a strong and robust
indication that IT economies outperformed in economic performance than non-IT
economies. It may be the case that IT doesn’t matter much i.e. performance rather
depends on aggressive monetary policy or high interest rates. Many EU countries for
example Austria or Japan managed to maintain low inflation rates using fixed or free
floating exchange rate regimes. But nevertheless there are some limitations to this
general finding and potential extensions.
First countries like Germany, Switzerland and US which enjoyed lower inflation and
stability since 1980’s have been accused of implicitly practicing IT to manage inflation.
But since Germany and Switzerland also uses monetary targeting and US are implicit
about their targets, they are not considered as IT economies. Secondly, in addition to
traditional IT countries like New Zealand and Canada, there are significant numbers of
new IT economies like Chile, Hungary, South Korea, Turkey etc. Hence the latter’s group
track record with IT is short. Therefore one needs to take into account a longer time
period or a complete business cycle under IT for these newly IT economies to assess its
effectiveness. As Ball and Sheridan (2005) mentions that history of IT is rather short to
provide a definite answer on the link between IT and growth even for countries with
largest targeting history. Thirdly, this paper does not make use of control variables
grounded on growth theory as done by Mollick et al. (2001) concerning IT effects on
growth. Equation (6.1) for output growth is not a long run growth regression from
growth theory but is in the spirit of Ball and Sheridan (2005). Furthermore additional
covariates that have not been accounted for that can reveal interesting results or can
further exploit effectiveness of IT as done in Biondi and Toneto (2008). There are also
some important economic indicators of interest that weren’t taken into consideration
for example effects on IT on inflation expectations (Mishkin and Schmidt-Hebbel, 2007),
inflation persistence and convergence of inflation towards long run target (Petrusson,
2007), exchange rate volatility, interest rates or interest rate volatility (to determine
how aggressive were monetary policy under IT) or analyzing how economic system
under IT respond to various shocks, etc. These are important economic variables and
can have bearing regarding the effectiveness of IT. Also the instruments used in these
42
paper are all ‘internal’ i.e. lags of own variables unlike Willard (2006) who uses external
instruments. As far as IT impact of tradeoff is concerned, there are shortcomings of
accelerationist Phillips curve (Romer, 2006). Also it is important to take into account
whether IT had any impact on the curvature of the Phillips curve17 as this paper
concerns only intercept effects (Brito, 2009). On methodological front, this paper uses S-
GMM due to Arellano and Bover (1995) and Blundell and Bond (1998). However in
some cases specification tests are not supportive when using complete set of
instruments. Using more instruments is good for efficiency but it can bias the results.
Hence this paper analyzes robustness of the results using reduced instruments. But
reducing instruments entails losing efficiency18. Hence the use of more sophisticated
techniques should not become an end in itself.
Lastly, the theoretical case for IT is based on New Keynesian economics with its
combination of forward looking expectations and incomplete nominal adjustment of
prices. In this context IT is viewed as informing the forward looking behaviour of
economic agents and favourably conditioning economic adjustment process, overall
producing a positive impact on economic performance. The assumptions underlying
such theoretical models or New Keynesian economics may fit some countries adopting
IT better than others. Alternatively economic agents may have forward looking
expectations but those expectations may be based on diverse set models of the economy
– model uncertainty. The less forward looking the expectations, the more diverse the
implicit models, and the more extrapolative the behaviour of economic agents, the less
likely IT is to be associated with immediate positive impacts on economic performance
because the expectations of economic agents are influenced more by what the central
bank does and less by what the central bank says it will do.
17 See section 2 on theory. 18 However the empirical results and this paper did not find any robust evidence regarding this empirical
tradeoff.
43
8. CONCLUSION
In this paper an empirical assessment using dynamic panel GMM techniques has been
carried out regarding the effectiveness of IT in terms inflation, growth and stability. In
contrast to what IT advocates claim empirical evidence does not find robust evidence
that IT has positive impact in reducing inflation rates. Generally, empirical evidence is
not supportive that IT reduces inflation by anchoring inflationary expectations by
establishing credibility. Rather the paper finds robust and general evidence that IT has
been ineffective towards lowering inflation. Hence fall in the inflation rates over the
years could be explained by other external factors like labour market reforms or the
“conservative window dressing” view. This result regarding the ineffectiveness of IT
towards inflation is in line with Willard (2006), Ball and Sheridan (2005) as well as
other authors. As far as output growth is concerned there is some evidence that
especially in the sample period 1980-2009 that IT had a positive significant or
borderline significant impact on growth beyond mean reversion. However empirical
evidence indicates that IT has positive impact on growth which is fairly robust in sign
but in general insignificant or due to mean reversion as in 1985-2002. This indicates
that IT regime has largely been flexible or that central banks pursued expansionary
policies to prevent spread of deflationary expectations. There is no evidence that IT
produced lower growth by producing deflations. This result also resembles with
findings in Biondi and Toneto (2008) that IT for developed economies produced
positive effect on growth but was unsuccessful in terms of inflation. When it comes to
economic volatility there is some evidence using coefficient of variation that IT helps
stabilize prices beyond simple mean reversion lending credence that that IT matters for
stabilization. But by far and large results do not indicate IT has been helpful towards
volatility nor there is any significant adverse impact. Also taking into account whether
IT has worsened the inflation-output tradeoff, the results are inconclusive. At best there
is no significant and clear evidence that IT has worsened tradeoff. In summary the
general conclusion is that IT was ineffective in terms of macroeconomic performance
and hence building credibility through an explicit and restrictive interest rate policy is
not necessary.
Hence is IT necessary after all? In fact there is no clear answer to this because answer
can be both yes and no. No because in principle other regimes or policies could also
44
provide the required nominal anchor while still ensuring the flexibility needed to
promote overall economic stability. Secondly results exist in addition to current finding
that are unsupportive of effectiveness of IT. Yes because there may be benefits we do
not measure. Bernanke et al. (1999) argues that IT produces more open policy making,
making the “role of central bank more consistent with the principles of democratic
society”. Also no countries that adopted IT have so far abandoned it. Finally as
mentioned above there is scope for further extensions in this area and limitations to the
findings of this paper. Hence there is scope and need to probe in depth and further to
draw firm conclusions regarding the effectiveness of IT as a monetary policy regime.
45
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