Japan & The World Economy 50 (2019) 25–35

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Japan & The World Economy

journal homepage: www.elsevier.com/locate/jwe

The impact of financial development on the effectiveness of inflation T

targeting in developing economies
Alice Y. Ouyanga, , Ramkishen S. Rajanb
⁎

a
China Academy of Public Finance and Public Policy, Central University of Finance and Economics, #39, S. College Rd., Haidian Dist., Beijing, 100081, China
b
Lee Kuan Yew School of Public Policy, National University of Singapore, Singapore

ARTICLE INFO ABSTRACT

JEL classification: An ever-increasing number of developing economies with varied levels of financial development have adopted
E58 Inflation Targeting (IT) frameworks to guide monetary policy. Using a panel dataset of 54 developing economies
F33 over the period 1980 to 2015 (30 of which have IT frameworks), we re-visit the rather controversial issue of
Keywords: whether adoption of an IT framework leads to superior outcomes in terms of reducing inflation and its varia-
Financial development bility. After controlling for potential endogeneity and self-selection concerns of policy adoption, our main em-
Financial markets pirical finding is that IT frameworks appear to reduce inflation rates in developing economies regardless of the
Financial inclusion level of financial development, while it reduces variability of inflation rates only when we control for levels of
Inflation targeting
financial market development. We further find that the effectiveness of IT framework on inflation is highly
Inflation
dependent on financial inclusion and bank characteristics, while the effect on inflation variability is more as-
Inflation variability
sociated with components of capital market development.

1. Introduction
The global decline in inflation rates along with the “Great
Moderation” of the business cycles since the 1990s till 2007 was at-
tributed partly to the adoption of inflation targeting (IT) framework as a
monetary policy strategy by many advanced economies (Schmidt-
Hebbel, 2008). Inspired by this, a number of developing economies
followed suit, choosing to adopt a formal inflation target as a nominal
anchor and interest rates as the main monetary policy instrument of
choice as they move towards greater exchange rate flexibility.1 Having
been pioneered by New Zealand in 1989 and adopted soon after by a
few advanced economies such as Canada and United Kingdom, IT fra-
meworks have gained widespread popularity among global central
banks over the last few decades. According to the IMF (2016), as of
October 2016, 38 economies had officially adopted IT framework (10
advanced economies and the rest developing economies). Prominent
recent examples of economies jumping onto the IT bandwagon include
India in early 2015 and Argentina in 2017.2
Despite their undoubted popularity, IT frameworks have come
under some criticism following the Global Financial Crisis (GFC) and
the ensuing “Great Recession” due to their seeming narrowness and
inability to adequately deal with concerns about financial risks and
imbalances and the breakdown in the interest rate policy transmission
during that period. As Martin Wolf of the Financial Times has forcefully
noted: “Over almost three decades policymakers and academics became
ever more confident that they had found, in inflation targeting, the holy
grail of fiat…money...Now we see it was a mirage..” (Wolf, 2009).3
More specifically, Svennson, (2010a) has noted that “…financial factors
may have a very strong and deteriorating effect on the transmission
mechanism, making standard interest-rate policy much less effec-
tive…A better theoretical, empirical and operations understanding of
the role of financial factors in the transmission mechanism is urgently
required..” (pp.5 and 8).
These concerns should ring particularly true in developing econo-
mies where inflation may, at times, be driven by supply side pressures
(such as domestic food inflation) and the interest rate policy trans-
mission channel may not work effectively even in normal periods
(Agenor and DA Silva, 2013; Walsh, 2009). In particular, at a basic

Corresponding author.
⁎

E-mail addresses: Alice.Ouyang@gmail.com (A.Y. Ouyang), spprsraj@nus.edu.sg (R.S. Rajan).

1
There are some exceptions. For instance, Singapore essentially operates an IT regime but uses the trade-weighted exchange rate as the policy instrument (Cavoli
and Rajan, 2007; McCallum, 2007; Parrado, 2004).
2
This excludes Argentina which was still listed as having taken preliminary steps to adopt an IT regime as of October 2016.
3
Some have also argued that strict adherence to an IT framework led to a build-up of financial imbalances that eventually caused the GFC in the first instance
(Wolf, 2009).

https://doi.org/10.1016/j.japwor.2019.03.003
Received 27 February 2019; Received in revised form 19 March 2019; Accepted 19 March 2019
Available online 08 April 2019
0922-1425/ © 2019 Published by Elsevier B.V.
A.Y. Ouyang and R.S. Rajan
level, the interest rate policy transmission channel works in two stages.
The first stage of interest rate pass-through (IRPT) refers to changes in
the policy rates to interbank rates to market rates.4 For this stage to
work well it is important that: (a) there needs to be a degree of domestic
bank competition (along with interest rate deregulation) so that
changes in policy rates transmit to interbank rates and retail bank
lending and deposit rates; and (b) there must exist a reasonably well-
developed government bond markets such that policy rates impact
other short-term paper rates and longer-term bond yields, thus influ-
encing aggregate demand and inflation (see Gopalan and Rajan, 2017).5
Even if these preconditions – i.e. degree of financial market devel-
opment – exist for the first stage of interest pass-through to work, in-
terest rates may not be an effective policy instrument if a large segment
of the population does not have access to the formal financial system
and is not impacted directly by bank interest rate changes (Mehrotra
and Yetman, 2015). Thus, for the second stage of IRPT to operate ef-
fectively it is important that there be a fairly high degree of domestic
financial inclusion.
In addition, the interest rate transmission channel can be influenced
by bank characteristics (Kashyap and Stein, 2000; Gambacorta, 2005;
Ashcraft, 2006; Brissimis et al., 2014). The related literature has found
that the interest rate channel tends to be weak for banks with higher
liquidity, capitalization and profitability. As Brissimis et al. (2014)
argue, banks with greater market power tend to have higher profit-
ability and easier access to alternative sources of finance. Hence they
are less reliant on central bank funding and less sensitive to changes in
the marginal cost of loan production when monetary policy changes, as
is true for foreign banks that can obtain funding from parent company
via cross-border internal funds transfer (Gopalan and Rajan, 2017). The
interest rate channel can also be enhanced by the imperfect substitut-
ability between loans and securities in bank portfolios and the bor-
rowing for firms (Bernanke and Blinder, 1988). Higher degree of asset
substitutability weakens the channels of monetary policy transmission
through banks.
The effects of IT frameworks on inflation and inflation variability
conditioned on financial development are therefore the particular focus
of this paper using a panel of 54 developing economies over the period
1980 to 2015, 30 of which have adopted an IT framework. Specifically,
the paper re-examines whether the adoption of an IT framework leads
to attainment of superior macroeconomic outcomes in terms of redu-
cing the rate of inflation as well as its variability after accounting for
the possibility that a country’s choice of IT regime may be non-random,
as well as accounting for the so-called dynamic bias problem a la Brito
and Bystedt (2010). Unlike the existing IT literature, we explicitly take
into account the role of financial development.
We use a new broad-based index of financial development devel-
oped by Svirydzenka (2016) as well as its six components that sum-
marize how developed financial institutions and financial markets are
in terms of their depth, access, and efficiency. While financial markets
mainly refer to capital markets (equities and bonds), financial institu-
tions include banks, insurance companies, mutual funds, and pension
funds. With regard to the financial institutions components, we expect
to find that IT frameworks tend to be more effective if individuals/firms
in an economy have better access to formal financial institutions (i.e.
higher financial institutions access) and more transactions associated
with the formal financial institutions (i.e. higher financial institutions
depth). With regard to financial markets components, their effects on IT
frameworks effectiveness can be mixed since financial markets include
both stock and bond markets in Svirydzenka (2016)’s definition. As
4
This stage is sometimes divided into sub-stages, viz. from policy rates to
interbank rates and interbank rates to market rates (see Gopalan and Rajan,
2017).
5
See Ingves (2004) for a discussion of the nexus between monetary policy
and financial market development.
26
Japan & The World Economy 50 (2019) 25–35
stated earlier, for the interest rate channel to work we need a reason-
ably well-developed government bond markets so that policy rates can
pass-through to other short-term paper rates and longer-term bond
yields. However, greater access to stock and bond markets may also
suggest a higher degree of asset substitutability between loans and se-
curities, indicating a weak interest rate transmission channel through
banks. Therefore, the effects of financial markets components on in-
flation of IT frameworks remain unclear.
While one would expect a priori that IT frameworks in more fi-
nancially developed economies to be successful in managing inflation,
their impact on inflation variability is ambiguous. On the one hand,
greater levels of financial sector development allow the central bank to
use interest rates more effectively to manage the inflation rate and its
variability. In addition, if financial development involves enhanced
access to finance and financial inclusion, this will allow for greater
consumption-smoothing so the central bank can focus more on inflation
as opposed to output stabilization, thus facilitating lower and more
stable inflation rates (Mehrotra and Yetman, 2015).6 On the other hand,
an IT targeting central bank may be less inclined to manage exchange
rate variability as agents can hedge against such risks, which in turn
may impart higher domestic price variability. In addition, greater fi-
nancial inclusion could allow agents to hedge against inflation shocks,
thus granting central banks more leeway to operate wider inflation
target bands to deal with other objectives such as output and financial
stability.7
The remainder of the paper is organized as follows. The next section
offers a brief review of the literature. Section 2 summarizes the data
sources and definitions. Section 3 outlines the model and estimation
strategy. Section 4 discusses the results. Section 5 concludes the paper.
2. Impact of IT frameworks on inflation: literature review
Early papers by Bernanke et al. (1999) and Mishkin (1999) sug-
gested that IT frameworks should reduce inflation rates and macro-
economic variability while enhancing overall policy credibility. Since
then there has been a burgeoning literature that appears to confirm
these early insights, at least with regard to the actual rate of inflation
(for instance, see Ball and Sheridan, 2005; Batini and Laxton, 2007;
Calderon and Schmidt-Hebbel, 2010; Goncalves and Salles, 2008;
Mishkin and Schimdt-Hebbel, 2007; Vega and Winkelreid, 2005).8
However, a problem with much of the earlier empirical works is that
they did not adequately deal with the self-selection problems of policy
adoption, i.e. did economies with better macroeconomic outcomes
choose to adopt IT regimes?
Brito and Bystedt (2010) control for the endogeneity of the IT fra-
mework and estimate a dynamic panel estimator (to control for
common time-varying effects and country fixed effects) for a sample of
46 developing economies over the period 1980 and 2006 (13 of which
had adopted IT frameworks). Their main empirical finding is that there
is “no significant evidence to conclude that IT framework has met its
main goal of stabilizing inflation and output growth in developing
economies.” (p.209) They opine that while there has been lower
6
Consistent with this, Mehrotra and Yetman (2015) find that the variability
of output relative to inflation is greater with higher levels of financial inclusion,
suggestive that as households and firms are able to use the financial system to
smooth consumption, central banks place more weight on stabilizing inflation
volatility relative to stabilizing output volatility.
7
Another possible channel is that the adoption of IT frameworks could lower
sovereign risk (Balima et al., 2017 and Thornton and Vasilakis, 2016) leading to
greater capital flows which in turn could generate greater exchange rate
variability.
8
See Svensson (2010b) for a comprehensive review of the earlier literature on
the impact of IT frameworks. Arestis et al. (2014) finds that inflation rates
converge regardless of the monetary policy framework, suggesting that the
reduction of the inflation rates may not be due to the inflation targets per se.
A.Y. Ouyang and R.S. Rajan
inflation in developing economies which have adopted IT frameworks,
this was more due to “window-dressing”, i.e. the countries had lower
inflation rates as they made a conscious decision to do so. Adoption of
an IT framework per se seemed to play no independent role in reducing
inflation rates and was possibly detrimental to output growth.
Applying a similar methodology over the same time period but for a
sample of 66 economies (22 advanced and 44 developing economies, 23
of which had adopted IT) over the period 1980–2006, Alpanda and
Honig (2014) find that IT frameworks do not have any significant im-
pact on inflation rates in advanced economies and have only small ef-
fects in developing economies. Further dividing the developing
economies sample into those with low versus high central bank in-
dependence, the authors find large effects in developing economies
with low central bank independence. They suggest that the adoption of
IT frameworks in developing economies with low central bank in-
dependence has helped to discipline fiscal policy, hence leading to
lower inflation rates.
Even if IT frameworks are successful in managing inflation, their
impact on inflation variability remains ambiguous and somewhat
under-studied. The pioneering paper by Ball and Sheridan (2005) find
that IT framework has no impact either on the level of inflation or its
variability, and any improvements in these variables for the advanced
economies that had adopted IT frameworks was due to mean reversion
as they started with greater and more volatile inflation. In subsequent
work, Goncalves and Salles (2008) overturned this result using a panel
of 36 developing economies, 13 of which had adopted IT frameworks
between 1980 and 2015. They argue that the lower inflation rates and
variability that developing economies with IT frameworks attained was
due to the regime itself and not because of mean reversion. There have
been further rejoinders to this debate (see Ball, 2010 and Thornton,
2016).
The study by Brito and Bystedt (2010) noted above did not find any
obvious reduction in inflation volatility among countries that adopted
IT frameworks. Lin and Ye (2009) use a propensity score matching
(PSM) methodology to account for the likelihood that a country’s de-
cision to adopt an IT framework may be non-random. In their sample of
52 developing economies for the period 1985–2005 (13 of which had
adopted IT), they find that IT frameworks seem to have large and sig-
nificant effects in lowering the rate of inflation and its variability. In a
related earlier study using the same methodology, Lin and Ye (2007)
examine the impact of IT frameworks on 22 advanced economies (7 of
which adopted IT) over the period 1985–1999 and find they have no
impact on the inflation rate or variability in advanced economies. de
Mendonca and de Guimaraes e Souza (2010) also use a PSM metho-
dology on a sample of 180 economies for the period 1990–2007 (29 of
which had adopted IT). Consistent with Lin and Ye (2007) and (2009)
they find the adoption of IT frameworks appears to reduce inflation
rates in developing economies but not in advanced ones.9
To our knowledge, the literature to date on the effectiveness of IT
frameworks on inflation has not incorporated the impact of financial
development indicators, a gap we aim to fill.10
9
There is a related literature using the PSM methodology on the impact of IT
frameworks on exchange rate variability are Lin (2010) and Ouyang et al.
(2016). The former looks at a pooled sample of 23 economies that adopted IT
regimes by the end of 2004 and finds strong and robust evidence that IT reduces
exchange rate variability in developing economies but raises them in industrial
economies. In contrast, Ouyang et al. (2016) use a panel of 62 economies over
the period 2006-2012 and finds that IT regimes seem to have greater real ex-
change rate variability than other regimes particularly among advanced
economies. Berganza and Broto (2012) find that emerging economies with IT
frameworks experience more nominal exchange rate volatility than non-IT
countries, though foreign exchange intervention can help in lowering volatility.
For a discussion on using flexible IT and sterilized foreign exchange interven-
tion, see Ghosh et al. (2016).
10
The closest the literature has come has been to incorporate central bank
27
Japan & The World Economy 50 (2019) 25–35
3. Empirical model
3.1. Model specification
Following Brito and Bystedt (2010) and Alpanda and Honig,
2014we apply a dynamic panel estimator to examine the impact of IT
frameworks on inflation rates and variability for a panel of 54 devel-
oping economies over the period 1980 and 2015. The primary focus of
our analysis is on the effects of IT frameworks on inflation rates and
volatility. As with Brito and Bystedt (2010) we take a three-year
average of the data (not overlapping), resulting in a sample with 12
periods. Using three-year average of the data has three possible ad-
vantages as highlighted by Brito and Bystedt (2010, p.199): (1) it can
avoid instrumented variables over-fitting problem in GMM estimation;
(2) it reflects the sluggish responses of macro variables; (3) it can se-
parate the IT treatment effects from other similar events.
We start with a parsimonious model to see if inflation targeting
leads to superior macroeconomic outcomes.11
yi, t = 1 yi, t 1 + 2 ITi, t + 3 Highinfli, t + t + i + r + i, t (1)
where yi, t is a macroeconomic variable of interest (i.e. inflation and
inflation variability in our case) at period t for economy i. To prevent
the empirical results from being biased by high inflation outliers we
follow Brito and Bystedt (2010) and transform the inflation to natural
logarithm of inflation based on the formula of yi, t = 100 × ln (1 + 100
Yi, t
).
Following the literature, we also include a high inflation dummy,
Highinfli, t as a further control. It equals one if average inflation (in
natural logarithm) over a three-year period is greater than 40 percent
and zero otherwise.12 The lagged value of yi, t is added to account for
mean reversion dynamics that often occur in macroeconomic variables
when they deviate significantly from the long-term trend. ITi, t is an
indicator to measure the period that the inflation targeting regime was
in place. ITi, t equals one if an IT regime was in place in all three years of
the period; two-thirds if an IT regime was in place for only two years of
a 3-year period, and so on. Finally, both time effects ( t ) and country
fixed effects ( i ) are considered in the equation, as are regional dum-
mies ( r ). i, t is the disturbance.
We then add an array of financial factors relating to financial de-
velopment, access and competition to understand the impact of fi-
nancial factors on IT effectiveness in managing inflation. The model
specification is as below:
yi, t = 1 yi, t 1 + 2 ITi, t + 3 Financei, t + 4 (ITi, t × Financei, t )
+ 5 Highinfli, t + t + i + r + i, t (2)
Financei, t is a proxy for financial development that may influence the
impact of IT regime on macroeconomic variables performance. The fi-
nancial factors include not only the index to proxy the overall level of
financial development but also its components that measure the access,
the depth, and the efficiency of financial institutions and financial
markets. We further include the interaction term of IT and various fi-
nancial variables, allowing the effectiveness of IT regime to depend on
the level of financial development. The detailed definitions and data
sources for all the macroeconomic and financial variables used in the
paper are listed in Table 1.
We estimate the model using a two-step System GMM approach
developed by Arellano and Bover (1995) and Blundell and Bond (1998).
(footnote continued)
independence variable (Alpanda and Honig, 2014).
11
Incorporation of other macro variables such as fiscal balance, public debt,
trade/financial openness does not add anything to the results and are therefore
excluded for parsimony.
12
This threshold has been used in many past literatures. See Alpanda and
Honig (2014); Lin and Ye (2009) and de Mendonca and de Guimaraes e Souza
(2010). Results are robust if the threshold is altered to 30 percent.
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 1
Variable Definition.
Macro. Variable Definition Source

linfl _cpii, t linfl_cpi = 100*ln(1+infl_cpi/100) WDI

vlinfl _cpii, t Inflation volatility of linfl_cpi (3-year standard deviation)
cvlinfl _cpii, t Coefficients of variation of linfl_cpi (3-year standard deviation divided by 3-year mean)
Financial Variables Definition Source
FD Financial development index (constructed by financial institutions index and financial markets index), 0-1 IMF
FID Financial institutions depth (private-sector credit to GDP + pension fund assets to GDP + mutual fund assets to GDP + Insurance premiums, life IMF
and non-life to GDP), 0-1
FIA Financial institutions access (bank branches per 100,000 adults + ATMs per 100,000 adults), 0-1 IMF
FIE Financial institutions efficiency (net interest margin + lending-deposits spread + non-interest income to total income + overhead costs to total IMF
assets + return on assets + return on equity), 0-1
FMD Financial markets depth (stock market capitalization to GDP + stocks traded to GDP + international debt securities of government to GDP + total IMF
debt securities of financial corporations to GDP + total debt securities of nonfinancial corporations to GDP), 0-1
FMA Financial markets access (percent of market capitalization outside of top 10 largest companies + total number of issuers of debt (domestic and IMF
external, nonfinancial and financial corporations), 0-1
FME Financial markets efficiency (stock market turnover ratio, stocks traded to capitalization), 0-1 IMF

Due to self-selection concerns of policy adoption – i.e. are economies
with high or low inflation more likely to choose IT regimes – we treat IT
adoption as predetermined (S-GMM P) in that it is affected by past
inflation only. As a robustness check we also re-estimate the equation
by treating IT adoption as endogenous (S-GMM E) in that current in-
flation may have an influence along with past inflation, or there are
omitted variables that influence both inflation and the decision to
choose an IT framework. To avoid the overfitting problem we not only
use three-year average of the data, but also reduce the dimensionality of
the instrument matrix by collapsing its columns to fit the “small-T,
large-N” panel requirement. We also use the AR(1) and AR(2) tests,
Hansen J test, and difference-in-Hansen C test to verify whether the
error terms are serially correlated, the instruments are valid, and the
changes in instruments are uncorrelated with the fixed effect, respec-
tively.
4. Data and methodology
4.1. Data and summary statistics
There are 30 developing IT economies in our sample, including all
the 31 developing IT economies as noted in IMF (2016) (except Ka-
zakhstan since it adopted an to IT regime by late 2015). The sample
economies and the year of adoption of IT are all listed in Table 2. Most
developing IT economies are from Europe (11 economies), Latin
America (9 economies) and Asia (5 economies). Since there are dis-
agreements about when an IT regime began, we adopt “the conservative
starting year” of IT regime constructed by de Mendonca and de
Guimaraes e Souza (2010). More to the point, since the identification of
starting dates of IT adoption may be ambiguous at times, de Mendonca
and de Guimaraes e Souza (2010) construct two possible starting dates
based on past literatures. While the initial classification of starting dates
of IT regimes refers to the period of soft IT (i.e. the country announces
an inflation target but the IT regime is not full-fledged yet), con-
servative classification of starting dates refers to complete adoption of
IT. The starting year of new IT economies after 2010 is based on Miller,
et al (2012) and Schmidt-Hebbel and Carrasco (2016).13
For the measure of financial development we use a new broad-
based index of financial development developed by Svirydzenka
(2016) as well as six indices on annual frequency between 1980 and
2013 that summarize how developed financial institutions and fi-
nancial markets are in terms of their depth, access, and efficiency. All
the indices are normalized between 0 and 1. The higher the value the
13
Their initial and conservative starting dates of IT regimes are the same.
more developed are financial institutions/markets. The summary
statistics of inflation, inflation variability and various financial fac-
tors in different monetary regimes (IT regime versus non-IT regime)
can be found in Table 3.14
With regard to inflation, the data suggests that the IT regimes tend
to have much lower average inflation rates and volatilities (as measured
by standard deviation) compared to the non-IT regimes.15 With regard
to financial factors, the summary statistics show that the economies
operating IT regimes tend to have more well-developed financial mar-
kets and institutions than their non-IT regime counterparts since the
average values of financial factors are all higher in IT regimes. This
conclusion is even more robust in terms of the median value.16
4.2. Baseline results
Table 4 presents the estimates of Eq. (1) and summarizes the results
on inflation and inflation variability while IT adoption is treated as
predetermined. Focussing on the inflation rate, we see that adoption of
an IT framework lowers the inflation rate and these results are statis-
tically and economically significant. The finding is suggestive of the
possibility that an IT framework acts more as a credible nominal anchor
for inflationary expectations in developing economies and helps depo-
liticise monetary policies.17 In the case of inflation variability, IT seems
to have a negative though statistically insignificant impact for the de-
veloping economies when inflation variability is measured by either
standard deviation or coefficient of variation.18 So overall there is clear
evidence that the adoption of an IT framework has a strongly negative
impact on the inflation rate in developing economies, while its impact
of on inflation variability is less obvious.
4.3. Impact of financial development
While our finding that the adoption of IT framework lowers
14
The Financial development index database is accessible here: http://data.
imf.org/?sk=F8032E80-B36C-43B1-AC26-493C5B1CD33B
15
However, the results are not all that robust if the coefficient of variation is
used to proxy inflation volatility.
16
The standard deviation of financial factors between IT and non-IT regimes
are quite similar.
17
While not shown here, there is no impact of IT frameworks on economic
growth in developing economies.
18
The results of AR(1) and AR(2) tests suggest that there is no second-order
autocorrelation of the residuals in any of the models. All the models fail to
reject the Hansen J test and difference in Hansen C test, verifying the overall
validity of the instruments.

28
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 2
Sample Developing Economies and Dates of IT adoption.
IT Economies (30) — Initial and Conservative Classifications of Starting Year

Initial Conservative Initial Conservative

Albania 2009 2009 Mexico 1995 2001

Armenia 2006 2006 Moldova 2010 2010
Brazil 1999 1999 Paraguay 2013 2013
Chile 1991 2000 Peru 1994 2002
Colombia 2000 2000 Philippines 2002 2002
Czech Rep. 1998 1998 Poland 1999 1999
Dominican Rep. 2012 2012 Romania 2005 2006
Georgia 2009 2009 Russia 2014 2014
Ghana 2003 2007 Serbia 2006 2006
Guatemala 2005 2006 Slovak Rep.a 2005 2005
Hungary 2001 2001 South Africa 2000 2000
India 2015 2015 Thailand 2000 2000
Indonesia 2005 2006 Turkey 2002 2006
Israel 1992 1997 Uganda 2012 2012
Korea Rep. 1998 2001 Uruguay 2007 2007
Non-IT Economies (24)
Algeria Jordan
Argentina Lebanon
Botswana Malaysia
Bulgaria Nigeria
China Pakistan
Costa Rica Panama
Côte d’Ivoire Saudi Arabia
Croatia Singapore
Ecuador Tanzania
Egypt Tunisia
El Salvador Ukraine
Hong Kong Venezuela

Note: The conservative starting year of IT regime is referred to de Mendonca and de Guimaraes e Souza (2010); Miller, et al. (2012) and Schmidt-Hebbel and Carrasco
(2016). The choice of non-IT economies is referred to Brito and Bystedt (2010).
a. Slovak Republic left the IT regime to adopt the Euro in 2008.

inflation rates in developing economies is consistent with Lin, 2010 and
de Mendonca and de Guimaraes e Souza (2010),19 unlike those papers
we do not find significant impact of IT framework on inflation varia-
bility in developing economies. This may be due to the fact that our
study includes many more developing economies with high degrees of
heterogeneity in financial development that have adopted IT frame-
works over the last decade. For instance, Lin and Ye (2009) listed 13
developing economies that had adopted IT frameworks between 1985
and 2005 compared to 30 economies in our sample.
In this section we explore the impact of financial factors on inflation
and inflation variability in developing economies that have adopted IT
frameworks. To do so we estimate Eq. (2) above using various available
measures of financial development. We start with the broadest measures of
financial development which “is defined as a combination of access
(ability of individuals and companies to access financial services), depth
(size and liquidity of markets), and efficiency (ability of institutions to
provide financial services at low cost and with sustainable revenues, and
the level of activity of capital markets)” (Svirydzenka, 2016, p. 5). All the
values are bound between zero and one. The higher the value the more
developed financial institutions/markets.
Table 5 summarizes the results. The system GMM estimations show
that IT adoption itself cannot reduce inflation effectively unless overall
19
Alpanda and Honig (2014) also find small negative impact on inflation
when IT frameworks are adopted. Brito and Bystedt (2010) is the exception,
finding no effects of IT framework even on inflation rates in the case of de-
veloping economies. The difference in our results with theirs could be a com-
bination of the following: different time periods (ours extends an additional
decade and encompasses the GFC) and wider country coverage (54 in ours
study versus 46 in Brito-Bystedt’s study), inclusion of financial variables in our
analysis, as well as our use of more conservative start dates to IT regimes in
many countries.
financial development reaches a certain threshold.20 Under the as-
sumption that IT adoption is predetermined (S-GMM P case), IT will not
be able to reduce inflation significantly (at the 5 percent significance
level) unless the overall financial development index is greater than
0.15, which is less than the average for developing economies.21 IT
seems to reduce inflation variability no matter which proxy measure is
used, though the negative impact of IT on inflation variability becomes
less effective with higher levels of financial development.
Therefore, there is evidence that IT regimes lower inflation, and –
consistent with our hypothesis – this impact is enhanced with greater
levels of financial development. In contrast, while IT decreases inflation
variability, the impact is reduced with higher levels of financial de-
velopment. This is consistent with the hypothesis that greater levels of
financial development allow agents to hedge against exchange rate and
inflation shocks, hence allowing central banks to both accommodate
greater exchange rate flexibility while operating wider inflation target
bands to deal with multiple objectives (i.e. flexible IT).
4.4. Impact of financial markets/institutions components
To further examine which components of financial development
index affect the effectiveness of IT frameworks on inflation and its
variability, we delve into the components of financial market and fi-
nancial institution variables. The broad-based index of financial de-
velopment in Svirydzenka (2016) can be decomposed into six compo-
nents that summarize how developed financial markets and financial
20
There is a burgeoning literature on the role of financial thresholds in im-
pact growth, reducing poverty and for a country to positively benefit from
capital account liberalization.
21
The mean and median values for developing economies are 0.27 and 0.23,
respectively.

29
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 3 Table 4
Summary Statistics. The Effect of IT on Inflation and Inflation Variability.
Variables Obs. Mean Median S.D. Min. Max. S-GMM P Inflation Inflation Variability

All Sample yi, t = linfl _cpii, t yi, t = vlinfl _cpii, t yi, t = cvlinfl _cpii, t
linfl _cpii, t 588 17.48 7.56 36.45 −2.47 354.77
vlinfl _cpii, t 579 6.44 2.24 15.37 0.02 144.32 yi, t 1 0.0794* 0.181*** 0.0180
cvlinfl _cpii, t 579 0.44 0.31 1.15 −8.87 21.79 (0.0456) (0.0366) (0.0453)
FD 648 0.27 0.23 0.17 0.00 0.85 ITi, t −4.936*** −0.126 −0.139
FI 648 0.33 0.30 0.18 0.00 0.80 (1.459) (0.984) (0.205)
FID 648 0.21 0.14 0.20 0.00 0.97 Highinfli, t 75.62*** 34.21*** 0.386*
FIA 648 0.25 0.21 0.20 0.00 1.00 (12.27) (6.226) (0.197)
FIE 648 0.53 0.57 0.21 0.00 0.95 Observations 534 525 525
FM 648 0.20 0.11 0.21 0.00 0.89 Number of Countries 54 53 53
FMD 648 0.16 0.07 0.20 0.00 0.91 Instrument Columns 93 92 92
FMA 648 0.18 0.06 0.22 0.00 0.97 AR(1) test 0.0517 0.00845 0.0293
FME 648 0.25 0.10 0.30 0.00 1.00 AR(2) test 0.734 0.862 0.109
IT regimes Hansen J test 0.982 0.977 0.886
linfl _cpii, t 120 4.83 4.38 2.74 0.05 14.36 Difference-in Hansen 0.946 0.936 0.772
vlinfl _cpii, t 120 1.67 1.29 1.20 0.02 6.79
cvlinfl _cpii, t 120 0.62 0.32 1.99 0.004 21.79 Notes:
FD 120 0.39 0.37 0.17 0.10 0.85
(1) S-GMM P is the two-step system GMM taking the IT dummy as pre-
FI 120 0.46 0.43 0.16 0.16 0.80 determined.
FID 120 0.31 0.24 0.22 0.03 0.89 (2) Regional, time effects and country fixed effects are considered, but not re-
FIA 120 0.42 0.40 0.22 0.05 1.00 ported.
FIE 120 0.58 0.60 0.11 0.29 0.77 (3) AR(1), AR(2), Hansen J tests and Difference in Hansen C test report the
FM 120 0.31 0.33 0.22 0.004 0.89 respective p-value.
FMD 120 0.27 0.22 0.22 0.004 0.88 (4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.
FMA 120 0.32 0.37 0.24 0.00 0.93
FME 120 0.35 0.25 0.32 0.00 1.00
Non-IT regimes Table 5
linfl _cpii, t 468 20.72 9.04 40.21 −2.47 354.77 The Impact of Financial Development on Inflation and Inflation Variability of
vlinfl _cpii, t 459 7.69 2.53 17.03 0.05 144.32 Inflation Targeting Regimes.
cvlinfl _cpii, t 459 0.40 0.31 0.80 −8.87 6.95 S-GMM P Inflation Inflation Variability
FD 528 0.24 0.20 0.16 0.00 0.82
FI 528 0.30 0.28 0.17 0.00 0.77 yi, t = linfl _cpii, t yi, t = vlinfl _cpii, t yi, t = cvlinfl _cpii, t
FID 528 0.18 0.12 0.19 0.00 0.97 Financei, t = FDi, t
FIA 528 0.21 0.16 0.18 0.00 0.96
FIE 528 0.52 0.56 0.22 0.00 0.95 yi, t 0.109*** 0.155*** −0.0104
1
FM 528 0.17 0.08 0.19 0.00 0.89
(0.0181) (0.0199) (0.0270)
FMD 528 0.14 0.06 0.19 0.00 0.91
ITi, t 0.536 −2.142*** −0.590***
FMA 528 0.15 0.04 0.20 0.00 0.97
(1.859) (0.637) (0.168)
FME 528 0.23 0.09 0.30 0.00 1.00
Financei, t −6.638 −9.170** −0.357
(11.27) (3.887) (0.998)
Note: IT regimes indicate the period when the economies conduct inflation
ITi, t × Financei,t −17.62** 5.726** 1.500**
targeting, otherwise non-IT regimes.
(7.515) (2.230) (0.705)
Highinfli, t 79.82*** 30.21*** 0.328***
institutions are in terms of their depth, access, and efficiency. (3.341) (2.734) (0.0893)
We first dissect the financial institution index into its component 2 + 4 × Finance# −2.11**
parts (Table 6): institutional access,22 depth,23 and institutional effi- (FD = 0.15)
ciency.24 The results using S-GMM P indicate that IT frameworks are Observations 534 525 525
Number of Countries 54 53 53
not particularly effective in reducing inflation unless the level of fi-
Instrument Columns 111 110 110
nancial institutional access is greater than or equal to 0.39, higher than AR(1) test 0.0503 0.0279 0.0321
the average for the developing economies of 0.25. The results when AR(2) test 0.968 0.909 0.101
using financial institutional depth lead to similar conclusion, but with Hansen J test 0.819 0.666 0.971
Difference-in Hansen 0.426 0.000 0.753
much lower threshold level to make an IT regime effective. IT lowers
inflation significantly only when the level of financial institutional Notes:
depth has reached a threshold of 0.07. (There are only 3 IT economies (1) S-GMM P is the two-step system GMM taking the IT dummy as pre-
during some certain years where this index is less than 0.07).25,26 In determined.
(2) Regional, time effects and country fixed effects are considered, but not re-
ported.
22
Access consists of bank branches per 100,000 adults and ATMs per 100,000 (3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the re-
adults. spective p-value.
23
Depth includes private-sector credit to GDP and pension and mutual fund (4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.
assets to GDP. (5) # Table gives 2 + 4 × Finance for the cutoff level of corresponding fi-
24
Efficiency refers to ATMs per 100,000 adults, lending-deposits spread, non- nancial variable at which 2 + 4 × Finance becomes significant negative.
interest income to total income, overhead costs to total assets, return on assets,
and return on equity.
25
In our sample, there are only eight less-developed countries whose average
financial institutional depth is lower than this threshold level. Armenia (2006- contrast, higher levels of financial institutional efficiency appear to
2009), Ghana (2007) and Uganda (2012-2014). reduce the effectiveness of IT on inflation, possibly consistent with the
26
They are Albania, Algeria, Armenia, Georgia, Ghana, Moldova, Tanzania hypothesis that financial institutions with higher market power tend to
and Uganda. be more profitability and less sensitive to interest rate transmission

30
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 6
The Impact of Financial Institution Components on Inflation and Inflation Variability of Inflation Targeting Regimes.
S-GMM P Inflation Inflation Variability

yi, t = linfl _cpii, t yi, t = cvlinfl _cpii, t

Financei, t = FIAi, t FIDi, t FIEi, t FIAi, t FIDi, t FIEi, t

yi, t 1 0.134*** 0.111*** 0.113*** 0.00284 0.0180 −0.0210

(0.0241) (0.0205) (0.0184) (0.0217) (0.0248) (0.0245)
ITi, t 3.952** 0.119 −25.20*** −0.843*** −0.268 −1.316**
(1.543) (0.905) (5.479) (0.275) (0.174) (0.597)
Financei, t −4.689 16.61 −10.74 −0.334 0.944 −0.665
(5.615) (10.07) (9.048) (0.519) (1.860) (0.505)
ITi, t × Financei,t −19.62*** −20.90*** 35.97*** 1.776*** 0.0557 2.132**
(3.809) (6.037) (10.96) (0.534) (0.883) (0.997)
Highinfli, t 62.18*** 79.70*** 67.78*** 0.503*** 0.106 0.00294
(4.388) (4.006) (3.827) (0.106) (0.0882) (0.135)
2 + 4 × Finance# −3.70** −1.34**
(FIA = 0.39) (FID = 0.07)
Observations 534 534 534 525 525 525
Number of Countries 54 54 54 53 53 53
Instrument Columns 111 111 111 110 110 110
AR(1) test 0.0635 0.0466 0.0616 0.0305 0.0232 0.0478
AR(2) test 0.965 0.978 0.976 0.115 0.246 0.0978
Hansen J test 0.942 0.889 0.832 0.937 0.939 0.970
Difference-in Hansen 0.637 0.707 0.625 0.681 0.695 0.675

Notes:
(1) S-GMM P is the two-step system GMM taking the IT dummy as predetermined.
(2) Regional, time effects and country fixed effects are considered, but not reported.
(3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the respective p-value.
(4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.
(5) # Table gives 2 + 4 × Finance for the cutoff level of corresponding financial variable at which 2 + 4 × Finance becomes significantly negative.

channel. With regard to inflation variability,27 we find that IT reduces
inflation variability but the negative impact decreases with greater le-
vels of financial institutional access and efficiency. However, financial
institutional depth seems to have insignificant impacts on inflation
variability in IT regimes.
We similarly dissect the financial markets into its component parts,
viz. market access,28 market depth,29 and market efficiency.30 The re-
sults in Table 7 show that IT regimes reduce inflation rates effectively
no matter which financial market sub-component is used in the re-
gressions. However, the effectiveness of IT regimes on inflation reduc-
tion does not seem to be associated with financial markets components
since the interaction terms of IT dummy and financial market compo-
nents are statistically insignificant. These could be due to the fact that
both of the positive impacts from bond market development and the
negative impacts from asset substitutability on the interest rate trans-
mission channels co-exist. With respect to inflation variability, we see
that the results go through in all three cases. Regardless of the specific
indicator of financial market development that is included, it appears
that IT frameworks lower inflation variability, while greater levels of
financial market development reduce this negative impact.
27
To save space, we only show results using coefficient of variation as a
proxy.
28
Access consists of the percent of market capitalization outside of the top 10
largest companies and total number of issuers of debt (domestic and external,
nonfinancial and financial corporations).
29
Depth refers to stock market capitalization to GDP; stocks traded to GDP;
international debt securities of government to GDP; total debt securities of fi-
nancial corporations to GDP; and total debt securities of nonfinancial cor-
porations to GDP.
30
Efficiency refers to stock market turnover ratio (stocks traded to capitali-
zation).
4.5. Robustness checks
As a robustness check we re-estimate the equation by assuming IT
adoption as endogenous (S-GMM E). Table 8 shows the empirical results
with and without financial development index. Without considering the
financial development index, IT framework tends to lower inflation no
matter whether IT adoption is treated as predetermined or endogenous.
With the inclusion of the financial development index, IT is effective in
reducing inflation as long as the financial development index is at least
0.04. (None of the economies within IT regimes has financial devel-
opment level less than 0.04).31 IT seems to reduce inflation variability
no matter which proxy measure is used, though the negative impact of
IT on inflation variability becomes less effective with higher levels of
financial development if coefficient of variation is used. However, the
interaction terms of IT dummy and financial development index are
statistically insignificant in all cases.
With respect to financial institution components (see Table 9), IT
tends to reduce inflation with higher level of financial institution access
and depth, but the results become statistically insignificant while IT
adoption is treated as endogenous. The results for financial institution
efficiency remain robust, however, suggesting that financial institution
characteristics, particularly bank profitability (i.e. bank market power),
has negative and statistically significant effects on the effectiveness of
IT regimes on inflation reduction. With regard to inflation variability,
the results are generally robust. We find that IT reduces inflation
variability but the negative impact decreases with greater levels of fi-
nancial institutional access and efficiency. However, the results are
31
There are only 14 economies during some certain periods where this index
is less than 0.04. They are Albania (1980-1991), Armenia (1980-1992),
Bulgaria (1980-1990), China (1980-1981), Croatia (1980-1991), Czech
Republic (1980-1990), Georgia (1980-1994), Hong Kong (1980-1987),
Hungary (1980-1981), Moldova (1980-1990), Russia (1980-1990), Serbia
(1980-1993), Slovak Republic (1980-1991) and Uganda (1987-1998, 1995).

31
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 7
The Impact of Financial Market Components on Inflation and Inflation Variability of Inflation Targeting Regimes.
S-GMM P Inflation Inflation Variability

yi, t = linfl _cpii, t yi, t = cvlinfl _cpii, t

Financei, t = FMAi,t FMDi,t FMEi, t FMAi,t FMDi,t FMEi, t

yi, t 1 0.120*** 0.122*** 0.124*** −0.0271 −0.0402 0.00747

(0.0181) (0.0252) (0.0246) (0.0209) (0.0286) (0.0167)
ITi, t −3.176** −3.987*** −4.137*** −0.544** −0.410* −0.418***
(1.374) (1.037) (1.144) (0.204) (0.220) (0.116)
Financei, t −14.29*** 5.326 3.919 −1.156 −1.607 −0.175
(3.178) (6.021) (2.891) (0.712) (1.434) (0.260)
ITi, t × Financei,t −2.379 −6.773 −1.955 1.714*** 1.418* 0.645***
(5.890) (5.147) (2.673) (0.479) (0.716) (0.236)
Highinfli, t 80.93*** 71.16*** 78.34*** 0.207* 0.279*** 0.345***
(3.537) (5.088) (5.653) (0.104) (0.0942) (0.0958)
Observations 534 534 534 525 525 525
Number of Countries 54 54 54 53 53 53
Instrument Columns 111 111 111 110 110 110
AR(1) test 0.0357 0.0599 0.0474 0.0459 0.0429 0.0385
AR(2) test 0.936 0.979 0.951 0.0927 0.0809 0.119
Hansen J test 0.977 0.965 0.920 0.983 0.995 0.953
Difference-in Hansen 0.879 0.865 0.713 0.718 0.770 0.886

Notes:
(1) S-GMM P is the two-step system GMM taking the IT dummy as predetermined.
(2) Regional, time effects and country fixed effects are considered, but not reported.
(3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the respective p-value.
(4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Table 8
Robustness Check—Taking IT policy as Endogenous.
S-GMM E Inflation Inflation Variability

yi, t = linfl _cpii, t yi, t = vlinfl _cpii, t yi, t = cvlinfl _cpii, t

Financei, t = FDi, t

yi, t 1 0.0908* 0.0720** 0.172*** 0.194*** 0.00775 0.00636

(0.0475) (0.0309) (0.0264) (0.0236) (0.0496) (0.0279)
ITi, t −5.365** −2.671 −1.094 −0.0619 −0.0946 −0.601**
(2.045) (1.880) (0.843) (0.970) (0.206) (0.260)
Financei, t — −26.98** — 14.66** — 1.131
(10.78) (6.237) (2.640)
ITi, t × Financei,t — −18.39* — −6.262 — 1.068
(9.285) (4.652) (1.002)
Highinfli, t 79.44*** 78.52*** 28.71*** 28.74*** 0.368* 0.424***
(14.70) (5.541) (2.906) (3.045) (0.213) (0.155)
2 + 4 × Finance# −3.41**
(FD = 0.04)
Observations 534 534 525 525 525 525
Number of Countries 54 54 53 53 53 53
Instrument Columns 92 108 91 107 91 107
AR(1) test 0.0387 0.0596 0.0251 0.0275 0.0320 0.0260
AR(2) test 0.822 0.903 0.874 0.850 0.0943 0.156
Hansen J test 0.991 0.766 0.242 0.650 0.890 0.820
Difference-in Hansen 0.965 0.549 0.133 0.000 0.849 0.558

Notes:
(1) S-GMM E is the two-step system GMM taking the IT dummy as endogenous (L1.IT is the IV).
(2)Regional, time effects and country fixed effects are considered, but not reported.
(3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the respective p-value.
(4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.
(5) # Table gives 2 + 4 × Finance for the cutoff level of corresponding financial variable at which 2 + 4 × Finance becomes significant negative.

statistically significant for financial institution access only. Financial
institutional depth again has insignificant impacts on inflation varia-
bility in IT regimes.
Table 10 summarizes the results for financial market components
and remain generally robust as well. Even though financial market
depth has similar negative impacts, only financial market efficiency
enhances the effectiveness of IT frameworks in reducing inflation in a
statistically significance sense. Financial market access has negative but
insignificant impact on the effectiveness of IT regimes. With respect to
inflation variability, we see that the results go through in all three cases.
Regardless of the specific indicator of financial market development
that is included, it appears that IT frameworks lower inflation

32
A.Y. Ouyang and R.S. Rajan Japan & The World Economy 50 (2019) 25–35

Table 9
Robustness Check on the Impact of Financial Institution Components—Taking IT policy as Endogenous.
S-GMM E Inflation Inflation Variability

yi, t = linfl _cpii, t yi, t = cvlinfl _cpii, t

Financei, t = FIAi, t FIDi, t FIEi, t FIAi, t FIDi, t FIEi, t

yi, t 1 0.116*** 0.100*** 0.0922*** 0.00332 0.0120 −0.0124

(0.0212) (0.0295) (0.0262) (0.0215) (0.0220) (0.0259)
ITi, t −2.042 −3.180** −48.91*** −0.785** −0.00881 −0.867
(1.659) (1.504) (6.742) (0.311) (0.214) (0.735)
Financei, t −37.95*** 4.482 −25.83* 0.169 5.748*** −0.625
(5.970) (11.23) (14.86) (0.967) (1.647) (0.715)
ITi, t × Financei,t −0.992 −6.162 79.78*** 1.338* −0.730 1.208
(7.573) (10.94) (14.08) (0.749) (0.746) (1.365)
Highinfli, t 65.22*** 77.09*** 70.22*** 0.577*** 0.103 0.00642
(3.473) (4.857) (4.314) (0.139) (0.124) (0.179)
Observations 534 534 534 525 525 525
Number of Countries 54 54 54 53 53 53
Instrument Columns 108 108 108 107 107 107
AR(1) test 0.0574 0.0505 0.0695 0.0338 0.0378 0.0461
AR(2) test 0.954 0.933 0.875 0.0994 0.165 0.116
Hansen J test 0.840 0.987 0.979 0.891 0.846 0.934
Difference-in Hansen 0.651 0.944 0.921 0.677 0.460 0.659

Notes:
(1) S-GMM E is the two-step system GMM taking the IT dummy as endogenous (L1.IT is the IV).
(2) Regional, time effects and country fixed effects are considered, but not reported.
(3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the respective p-value.
(4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

Table 10
Robustness Check on the Impact of Financial Market Components—Taking IT policy as Endogenous.
S-GMM E Inflation Inflation Variability

yi, t = linfl _cpii, t yi, t = cvlinfl _cpii, t

Financei, t = FMAi,t FMDi,t FMEi, t FMAi,t FMDi,t FMEi, t

yi, t 1 0.104*** 0.117*** 0.139*** −0.0291* −0.0186 −0.0243

(0.0202) (0.0232) (0.0257) (0.0150) (0.0299) (0.0180)
ITi, t −4.050*** −6.668*** −3.289** −0.396* −0.397* −0.294*
(1.341) (1.380) (1.502) (0.200) (0.202) (0.162)
Financei, t −40.60*** 1.017 9.734*** −0.469 −1.600 −0.101
(6.029) (6.423) (3.172) (0.761) (1.317) (0.375)
ITi, t × Financei,t 1.093 −0.423 −7.309** 0.983* 0.825 0.683**
(5.284) (6.695) (3.158) (0.517) (0.801) (0.320)
Highinfli, t 83.99*** 71.67*** 71.12*** 0.197* 0.310*** 0.344***
(5.531) (5.167) (5.702) (0.106) (0.104) (0.0928)
Observations 534 534 534 525 525 525
Number of Countries 54 54 54 53 53 53
Instrument Columns 108 108 108 107 107 107
AR(1) test 0.0357 0.0598 0.0514 0.0435 0.0385 0.0450
AR(2) test 0.911 0.979 0.968 0.110 0.111 0.0799
Hansen J test 0.953 0.934 0.956 0.976 0.942 0.923
Difference-in Hansen 0.852 0.813 0.860 0.651 0.784 0.693

Notes:
(1) S-GMM E is the two-step system GMM taking the IT dummy as endogenous (L1.IT is the IV).
(2) Regional, time effects and country fixed effects are considered, but not reported.
(3) AR(1), AR(2), Hansen J tests and Difference in Hansen test report the respective p-value.
(4) Standard errors in parentheses. *** p < 0.01, ** p < 0.05, * p < 0.1.

variability, while greater levels of financial market development reduce
this negative impact.
Overall, there is evidence that IT frameworks are more effective in
reducing inflation rates with higher levels of financial development in
general, with financial institutional access and depth being particularly
significant. This concurs with the thesis that with higher level of
financial development it is more likely that the interest rate policy
transmission will work effectively. Two caveats are in order. One, our
empirical results suggest that there may has a threshold effect in fi-
nancial development, i.e. in some cases financial institutions and/or
overall financial development level need to surpass a certain threshold
before they can contribute positively to lower inflation. Two, the one

33
A.Y. Ouyang and R.S. Rajan
exception we find is with regard to financial institutional efficiency
which seems to deteriorate the effectiveness of IT on inflation. This
likely emphasizes the importance of bank characteristics in impacting
IT effectiveness. A higher financial institutional efficiency might not
only represent higher bank profitability and market power but may also
indicate a more concentrated banking system.32 Thus, to the extent that
higher financial institutional efficiency corresponds to either higher
bank profitability and market power or a more concentrated banking
system, this may reduce the extent of interest rate pass-through from
policy rates to bank market rates, thus making monetary policy in an IT
framework somewhat less effective.33
All the measures of financial market development seem to be par-
ticularly important in influencing the effectiveness of IT on inflation
variability. As noted above, well-developed financial markets allow
agents to hedge against exchange rate and inflation risks, hence al-
lowing central banks to operate more flexible IT frameworks, as dis-
cussed previously. This exchange rate variability could in turn pass-
through to domestic prices, causing greater extent of inflation varia-
bility. While the same general story holds when using proxies for fi-
nancial institutional development, financial access has positive and
statistically significant impacts on inflation variability of IT regimes,
stressing the importance of financial inclusion in allowing households
and firms to manage risks.
5. Conclusion
Inflation Targeting remains the predominant monetary approach
globally, with interest rates being mostly used as the operating target.
This paper has revisited the issue of the impact of an IT framework on
inflation, taking into account the role of financial development. We
follow Brito and Bystedt (2010) by applying a dynamic panel estimator
to a comprehensive panel dataset of 54 developing economies over the
period 1980 and 2015. After controlling for potential endogeneity and
self-selection concerns of policy adoption, our main empirical finding is
that IT frameworks appear to have clearly reduced inflation rates in
developing economies regardless of the level of financial development,
while the framework reduces variability of inflation rates only when we
control for levels of financial market development.
Once we account for levels of financial development, we find that IT
frameworks lower both inflation rates and inflation variability.
However, while greater levels of financial market development
strengthen the diminishing impact of IT on inflation (i.e. lowers it
further), they tend to weaken the effect in the case of inflation varia-
bility. This paper further finds that the performance of an IT framework
in terms of inflation is highly dependent on a country’s level of financial
inclusion and specific bank characteristics, while the performance of an
IT framework on inflation variability is more associated with financial
market components, an issue that has thus far been ignored in the de-
bate on the effectiveness of IT frameworks.
Acknowledgements
The authors are indebted to the anonymous referees of this journal
for their thoughtful and constructive comments on an earlier version of
the paper. Financial support from China National Social Science Fund
(#16BJY167) is greatly acknowledged.
32
There is a positive correlation coefficient of 0.34 between financial in-
stitutional efficiency index and bank concentration ratio (the correlation coef-
ficient is 0.35 if 5-bank asset concentration ratio is used) within a sample period
of 1996-2014. Due to data deficiency, we do not use a direct measure such as
bank concentration ratio or Herfindahl Index, to proxy bank competition.
33
This contrasts with Svirydzenka (2016) who emphasize that their financial
institutional efficiency index does not include banking concentration related
ratios and claims that there is no clear evidence of whether more concentrated
banking systems are more or less efficient.
34
Japan & The World Economy 50 (2019) 25–35
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