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MANHAL M ALI

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

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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.

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WORD COUNT

Number of pages: 60 Number of words: 14,992 (including title, abstract and pages 1 to 44 only).

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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.

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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:

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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 (19802009) ............................................................................................................................................................ 22

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6.2. ESTIMATES OF INFLATION TARGETING EFFECTS ON MACROECONOMIC VOLATILITY (1980-2009)................................................................................................................................................ 24 6.3. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION AND GROWTH (19852002) ............................................................................................................................................................ 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. 6.9. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF (1980-2009)................................................................................................................................................ 38 (1985-2002)................................................................................................................................................ 39 6.10. ESTIMATES OF INFLATION TARGETING EFFECTS ON INFLATION-OUTPUT TRADEOFF, ROBUSTNESS CHECKS............................................................................................................................... 40

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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 (SGMM) 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.

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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 inflation rate and is the output gap, at time t. The parameter society places on output stabilization relative to inflation stabilization and target inflation rate. As long as – if is the is the

is the weight that the

, specifying IT in terms of the social loss function

assumes that the central bank is concerned with both output and inflation stabilization 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 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: , and . The central bank’s objective

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(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

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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).

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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 bank’s implementing , central 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 4

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.

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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 (DGMM). 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 6

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 7

(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.

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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 economies 3 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 countries Australia Canada Chile Czech Republic Hungary Iceland Israel South Korea Mexico New Zealand Norway Poland Sweden Turkey UK Year of adoption 1993 1991 1991 1997 2001 2001 1992 1998 1999 1990 2001 1998 1993 2006 1992 Inflation target rate 2-3% 1-3% 2-4% 3%(±1%) 3% (±1%) 2.5%(±1.5%) 1-3% 3%(±1%) 3%(±1%) 1-3% 2.5%(±1%) 2.5%(±1%) 2%(±1%) 6.5%(±2%) 2%(±1%) Non Inflation Targeting countries Austria Belgium Denmark Cyprus Estonia Finland France Germany Greece Hong Kong SAR Ireland Italy Japan Luxembourg Malta Netherlands Portugal Singapore Slovakia Slovenia Spain Switzerland Taiwan USA

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).

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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 Mean Australia Canada Chile Czech Republic Hungary Iceland Israel Mexico New Zealand Norway Poland South Korea Sweden Turkey UK IT15*† 4.69 3.61 12.21 6.35 12.42 16.56 43.01 31.56 5.55 4.29 49.4 5.75 4.07 50.51 4.05 16.94 SD 3.21 2.96 9.56 10.59 8.59 20.44 83.55 35 5.38 3.41 112.28 5.72 3.62 29.64 3.52 22.5 Mean 7.36 6.35 21.79 8.3 15.29 20.94 99.49 46.21 11.87 5.28 79.33 7.39 7.12 56.93 7.03 24.55

Pre-IT SD 3.02 3.12 7.32 13.67 8.75 23.09 112.12 37.47 4.81 3.6 138.3 6.8 3.61 26.4 3.91 26.4

Post-IT Mean 2.71 1.82 5.82 3.39 5.29 6.3 4.96 5.22 2.2 1.84 3.85 2.9 1.67 8.48 1.93 3.56 SD 1.31 0.74 4.05 2.83 1.55 3.89 4.28 1.7 1.01 1.07 2.83 1.04 0.73 2.11 0.69 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.

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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 Mean Austria Belgium Cyprus Denmark Estonia Finland France Germany Greece Hong Kong SAR Ireland Italy Japan Luxembourg Malta Netherlands Portugal Singapore Slovakia Slovenia Spain Switzerland Taiwan USA Non-IT24* 2.6 3.02 4.06 3.51 77.57 3.74 3.71 2.32 11.45 4.71 4.87 5.95 1.16 3.46 2.64 2.48 8.35 2.07 7.66 19.72 5.85 2.19 2.83 3.71 7.9 SD 1.61 2.26 2.74 2.85 238.32 3.22 3.64 1.64 8.28 4.83 5.14 5.43 1.92 3.19 2.29 1.76 7.9 2.3 5.21 47.4 4.09 1.88 4.35 2.58 15.2 Pre-1990 Mean 3.8 4.9 5.77 6.33 7.28 7.34 2.9 19.5 7.43 9.26 11.43 2.53 5.78 2.27 2.84 16.67 2.77 SD 2.06 2.91 3.74 3.46 3.04 4.38 2.2 4.07 2.86 6.96 6.3 2.29 4.68 3.82 2.8 7.86 3.27 Post-1990 Mean 1.96 2 3.14 2.04 80.74 1.82 1.81 1.99 6.41 2.99 2.63 3.06 0.34 2.22 2.8 2.29 3.7 1.62 7.66 19.72 3.49 1.45 1.81 2.65 2.49 SD 0.9 0.95 1.59 0.59 244.4 1.06 0.78 1.26 5.18 4.96 1.47 1.44 1.16 0.89 1.01 0.99 2.7 1.6 5.21 47.4 1.6 1.51 1.66 0.98 1.63

10.25 3.27 4.64 5.55 6.79†

3.94 1.78 7.03 3.62 3.96†

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 11

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 Mean Australia Canada Chile Czech Republic Hungary Iceland Israel Mexico New Zealand Norway Poland South Korea Sweden Turkey UK IT15*† Note: *The average of statistics above †Excludes Turkey 3.26 2.53 4.56 1.81 1.27 2.92 4.21 2.55 2.33 2.75 2.25 6.57 2.08 4.01 2.14 3.02 SD 1.71 2.22 4.77 3.68 3.66 3.51 2.51 3.78 2.23 1.79 4.62 4.18 2.39 4.47 2.2 3.18

Pre-IT Mean 2.82 2.78 3.58 1.28 0.958 2.9 3.85 2.91 1.94 3.19 1.03 8.22 1.87 4.33 2.02 2.81 SD 2.33 2.44 6.67 4.02 3.75 3.1 1.88 4.04 1.99 1.75 5.5 3.34 1.87 4.39 2.44 3.23

Post-IT Mean 3.57 2.63 4.97 2.85 1.79 2.84 4.3 1.75 2.65 1.68 4 4.98 2.55 0.21 2.34 3.06 SD 0.99 1.88 3.33 3.13 3.72 4.8 2.89 3.51 2.37 1.62 1.9 2.99 2.54 4.69 2.09 2.7

12

Table 4.5: Output growth Statistics for Non-Inflation Targeting countries Entire Sample Mean Austria Belgium Cyprus Denmark Estonia Finland France Germany Greece Hong Kong SAR Ireland Italy Japan Luxembourg Malta Netherlands Portugal Singapore Slovakia Slovenia Spain Switzerland Taiwan USA Non-IT24* Note: *The average of statistics above † Excludes Slovenia 2.04 2.02 4.72 1.72 1.9 2.43 1.88 1.7 2 5.07 4.29 1.33 2.16 4.43 3.78 2.16 2.7 6.76 2.46 2.44 2.7 1.73 5.82 2.68 2.96 SD 1.59 1.63 2.74 2.17 7.55 3.3 1.43 1.97 2.32 4.13 4.04 1.86 2.67 3.13 2.79 1.95 2.59 4.05 5.49 4.59 2.07 1.76 3.02 2.08 2.96 Pre-1990 Mean 1.82 2.16 6.13 1.9 2.74 3.55 2.35 1.87 0.78 7.44 2.4 2.06 4.4 4.94 4.01 1.81 3.69 7.81 2.67 2.72 2.38 7.7 3.05 3.49 SD 1.16 1.6 1.99 2.22 1.58 1.3 1.19 1.48 2.3 4.25 1.76 1.74 1.46 3.46 3.02 1.94 2.84 4.15 1.21 2.05 1.89 2.64 2.54 2.16 Post-1990 Mean 2.05 1.89 3.84 1.63 1.98 1.94 1.6 1.37 2.75 3.88 5.1 0.91 0.81 4.11 3.49 2.24 1.9 6.04 2.68 2.44 2.64 1.29 4.78 2.5 2.67† SD 1.77 1.72 2.79 2.25 9.09 3.94 1.52 2.03 2.09 3.7 4.62 1.89 2.23 3.09 2.73 2 2 4 6.19 4.59 2.18 1.59 2.84 1.9 2.96†

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 13

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.

70 60 50

Figure 4.1: Average Inflation Non Inflation Targeting countries Inflation Targeting countries

Rate

40

30 20 10 0 1980 1983 1986 1989 1992 1995 Year 1998 2001 2004 2007

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 14

Figure 4.2: Inflation Volatility 250 Standard Deviation of Inflation rate Non Inflation Targeting countries Inflation Targeting Countries

200

150

100

50

0 1980 1983 1986 1989 1992 1995 Year 1998 2001 2004 2007

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 15

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.

Figure 4.3: Average output growth

6

4

2

Rate

0 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007

-2

Non Inflation Targeting countries Inflation Targeting Countries

-4

-6

Year

7

Standard Deviation of output growth 6 5 4 3 2 1 0 1980 1983 1986

Figure 4.4: Output Volatility Non Inflation Targeting countries Inflation Targeting countries

1989

1992

1995 Year

1998

2001

2004

2007

16

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 subscript there are dummy variable otherwise. Therefore is inflation rate, growth rate, inflation or output growth volatility. The indexes country; is the time period. The term

is included to capture persistence and mean reverting dynamics and as a consequence time observations for the dependent variable. The main interest is IT which will be equal to 1 if country i adopted IT in period t and 0 is the treatment variable which measures the average effect of includes other covariates, some possibly control for common time or period effects allows for cross country fixed effects are serially uncorrelated.

IT across all IT economies. Vector endogenous. The time or period dummies and

and capture common shocks to all countries. For concreteness,

is the disturbances. It is assumed throughout that

will be sometimes be mentioned as average inflation and similarly is log transformed using .

for other macroeconomic indicators.

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 17

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 twostep 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 18

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

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).

5

19

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 SGMM estimation combines in a system the regression in differences with regression in levels. The above moment conditions are valid if changes in any instrument uncorrelated with the fixed effect i.e. are

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 and are invariant of time or

common time effects, the first moments of and disturbances

. As mentioned above it is assumed that

are serially uncorrelated. The assumption on the initial condition given

in (iii) holds when the initial condition satisfies mean stationary assumption 6. 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. all t and IT adoption to be related to changes in inflation, similarly for 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

, where a

for and

. To prevent the problem of instrument proliferation and biasing the

results the columns of matrix of instruments for S-GMM is collapsed as mentioned

See Blundell and Bond (1998) for details on this assumption.

20

presented above relies that there is no second-order serial correlation in the first differenced disturbances, correlated even if . But by construction might be first-order serially 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 Ball and Sheridan (2005) which is equal to 1 if average inflation is greater is output growth or output volatility to find if IT had any when assessing the impacts of than 0.20 per year (in natural logarithm) in period t and 0 otherwise. As in the spirit of effects on the real economy. It is sensible to keep 21

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: Regressors: 6.1.A- Inflation equation Inflation targeting dummy Lagged inflation High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns R-squared 6.1.B Output growth equation Inflation targeting dummy Lagged output growth High inflation dummy AR(1) test AR(2) test Hansen J test 340 0.59 340 0.44 TE-OLS (1) 0.67 (0.12) 0.21 (0.01) 36.7 (0.00) WG (2) -0.28 (0.92) 0.1 (0.28) 37.6 (0.00) D-GMM P (3) -3.54 (0.66) -0.01 (0.97) 57.9 (0.00) 0.09 0.13 0.51` 301 29 D-GMM E (4) -3.72 (0.73) -0.01 (0.92) 61.5 (0.00) 0.12 0.18 0.18 301 28 S-GMM P (5) 1.77 (0.17) -0.08 (0.62) 71.5 (0.00) 0.06 0.12 0.09 0.59 340 33 S-GMM E (6) 0.85 (0.24) -0.09 (0.58) 72.8 (0.00) 0.06 0.13 0.07 0.81 340 32

0.18 (0.43) 0.41 (0.00) -1.49 (0.10)

-0.01 (0.99) 0.14 (0.01) -3.28 (0.00)

-1.10 (0.69) 0.25 (0.03) -2.60 (0.29) 0.00 0.42 0.20

-1.32 (0.66) 0.24 (0.03) -2.82 (0.27) 0.00 0.48 0.16

0.71 (0.02) 0.30 (0.00) -1.38 (0.20) 0.00 0.41 0.28

0.57 (0.11) 0.30 (0.00) -1.42 (0.22) 0.00 0.41 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 pvalues. (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).

22

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 tests 7 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)

23

depends on disturbances in the first

i.e. no second-order serial correlation for the

Table 6.2: Estimates of Inflation targeting effects on macroeconomic volatility (1980-2009) Estimator: Regressors: 6.2.A- Inflation volatility equation Inflation targeting dummy Lagged inflation volatility High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns R-squared TE-OLS (1) 0.44 (0.12) 0.201 (0.05) 22.2 (0.02) WG (2) 2.15 (0.55) 0.05 (0.64) 30.5 (0.02) D-GMM P (3) 4.97 (0.48) 0.168 (0.33) 28.6 (0.08) 0.199 0.24 0.02 301 29 D-GMM E (4) 3.88 (0.66) 0.166 (0.35) 28.9 (0.08) 0.20 0.25 0.02 301 28 S-GMM P (5) -0.54 (0.62) -0.068 (0.82) 48.8 (0.06) 0.22 0.16 0.02 0.00 340 33 S-GMM E (6) 1.30 (0.16) -0.066 (0.83) 49.5 (0.05) 0.23 0.17 0.01 0.00 340 32

340 0.3

340 0.25

6.2.B Output growth volatility equation Inflation targeting dummy -0.08 (0.68) Lagged output growth volatility 0.23 (0.00) High inflation dummy 1.92 (0.00) AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations 342

0.21 (0.41) 0.02 (0.68) 1.89 (0.00)

1.73 (0.24) 0.13 (0.06) 2.40 (0.13) 0.00 0.87 0.72

1.72 (0.26) 0.13 (0.07) 2.4 (0.15) 0.00 0.88 0.70 303

0.06 (0.78) 0.13 (0.05) 1.46 (0.02) 0.00 0.96 0.29 0.14 342

0.05 (0.86) 0.33 (0.05) 1.51 (0.02) 0.00 0.95 0.24 0.12 342

342

303

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 pvalues. (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).

24

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 DGMM 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 ( instruments ( ) for j=0,1,…,t-3 for equations in differences and the ) 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 ( 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. ) for )

25

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 10.24=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 26

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.

27

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).

28

Table 6.3: Estimates of Inflation targeting effects on inflation and output growth (1985-2002) Estimator: Regressors: 6.3.A Inflation equation Inflation targeting dummy Lagged inflation High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns R-squared 6.3.B Output growth equation Inflation targeting dummy Lagged output growth High inflation dummy 190 0.52 190 0.53 TE-OLS (1) 1.06 (0.35) -0.04 (0.82) 50.70 (0.00) WG (2) -0.50 (0.86) -0.26 (0.10) 44.40 (0.04) D-GMM P (3) -7.97 (0.08) 0.22 (0.03) 3.25 (0.81) 0.14 0.92 151 15 D-GMM E (4) -8.34 (0.15) 0.23 (0.00) 2.70 (0.83) 0.16 0.18 0.86 151 14 S-GMM P (5) -4.97 (0.55) 0.29 (0.32) -10.70 (0.81) 0.46 0.70 0.33 0.07 190 19 S-GMM E (6) -1.33 (0.41) 0.36 (0.43) -21.50 (0.75) 0.53 0.68 0.15 0.02 190 18

0.05 (0.88) 0.40 (0.00) -1.69 (0.03)

0.04 (0.96) -0.01 (0.84) -4.39 (0.00)

-8.42 (0.05) 0.15 (0.51) -15.70 (0.12) 0.12 0.64 0.78

-7.85 (0.03) 0.17 (0.35) -12.6 (0.13) 0.08 0.49 0.84

0.24 (0.55) 0.40 (0.02) 0.20 (0.98) 0.02 0.71 0.61 0.15 192 19

0.09 (0.86) 0.30 (0.14) 0.26 (0.97) 0.05 0.73 0.46 0.10 192 18

AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations 192 192 153 153 Instrument columns 15 14 R-squared 0.31 0.28 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective pvalues. (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. SGMM estimates taking into account endogeneity of IT in column (6) of tables 6.4.A and

29

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: Regressors: 6.4.A Inflation volatility equation Inflation targeting dummy Lagged inflation volatility High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns R-squared 189 0.27 189 0.23 TE-OLS (1) 1.17 (0.12) -0.02 (0.73) 20.50 (0.05) WG (2) -0.07 (0.96) -0.11 (0.23) 25.30 (0.03) D-GMM P (3) 1.66 (0.62) 0.04 (0.58) 8.94 (0.33) 0.80 0.62 0.21 150 15 D-GMM E (4) 1.38 (0.68) 0.02 (0.78) 9.84 (0.30) 0.65 0.59 0.49 150 14 S-GMM P (5) 0.32 (0.57) 0.08 (0.25) 1.48 (0.63) 0.46 0.28 0.18 0.24 189 19 S-GMM E (6) -0.10 (0.90) 0.08 (0.26) 0.83 (0.77) 0.42 0.18 0.12 0.02 189 18

6.4.B Output growth volatility equation Inflation targeting dummy 0.04 (0.88) Lagged output growth volatility 0.13 (0.05) High inflation dummy AR(1) test AR(2) test 2.94 (0.00)

-0.25 (0.53) -0.21 (0.07) 2.82 (0.00)

2.31 (0.53) -0.21 (0.26) 4.87 (0.16) 0.01 0.69

2.30 (0.35) -0.32 (0.22) 6.08 (0.02) 0.01 0.76

0.23 (0.66) -0.06 (0.20) 4.51 (0.07) 0.01 0.85

-0.13 (0.80) -0.11 (0.15) 4.98 (0.01) 0.01 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 pvalues. (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).

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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 materialized 10 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.

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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 12

See Ball and Sheridan (2005) for constant IT. Results for D-GMM were also carried out but in all cases they more inefficient relative to S-GMM indicating the weak instrument problem.

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Table 6.5: Estimates of Inflation targeting effects on inflation and output growth, robustness checks Different IT adoption dates and reduced instruments 19802009 S-GMM P (3) 2.15 (0.01) -0.09 (0.59) 58.40 (0.03) 0.12 0.16 0.39 0.23 340 18 S-GMM E (4) 1.06 (0.17) -0.15 (0.48) 62.20 (0.04) 0.11 0.17 0.20 0.20 340 18

Reduced instruments 1980-2009 Estimator: Regressors: 6.5.A Inflation equation Inflation targeting dummy Lagged inflation High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns S-GMM P (1) 2.10 (0.00) -0.11 (0.48) 65.90 (0.00) 0.08 0.13 0.69 0.64 340 18 S-GMM E (2) 1.29 (0.04) -0.13 (0.46) 63.70 (0.00) 0.10 0.14 0.74 0.70 340 18

Reduced instruments 1985-2002 S-GMM P (5) -0.51 (0.84) 0.36 (0.19) -21.70 (0.53) 0.41 0.56 0.61 0.27 190 14 S-GMM E (6) -0.92 (0.83) 0.36 (0.13) -21.71 (0.52) 0.33 0.49 0.50 0.18 190 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 pvalues. (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 33

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 34

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 19802009 S-GMM P (3) 0.08 (0.87) 0.12 (0.47) 32.90 (0.16) 0.19 0.23 0.51 0.38 340 18 S-GMM E (4) 0.62 (0.09) 0.12 (0.46) 33.70 (0.20) 0.19 0.23 0.42 0.45 340 18

Reduced instruments 1980-2009 Estimator: S-GMM P S-GMM E (2) 0.37 (0.25) 0.12 (0.47) 30.00 (0.18) 0.21 0.25 0.71 0.77 340 18 Regressors: (1) 6.6.A Inflation volatility equation Inflation targeting dummy 0.01 (0.98) Lagged inflation volatility 0.13 High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns (0.45) 34.8 (0.14) 0.18 0.21 0.45 0.45 340 18

Reduced instruments 1985-2002 S-GMM P (5) 0.17 (0.87) 0.06 (0.65) 4.56 (0.68) 0.90 0.96 0.29 0.66 189 14 S-GMM E (6) -0.09 (0.94) 0.04 (0.77) 5.52 (0.70) 0.99 0.97 0.64 0.96 189 14

6.6.B Output growth volatility equation Inflation targeting dummy 0.16 (0.52) Lagged output growth volatility 0.10 High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations (0.16) 1.30 (0.14) 0.00 0.80 0.17 0.09 342

-0.04 (0.89) 0.12 (0.11) 1.25 (0.17) 0.00 0.88 0.13 0.17 342

0.06 (0.80) 0.10 (0.13) 1.19 (0.17) 0.00 0.80 0.22 0.57 342

-0.08 (0.78) 0.11 (0.11) 1.05 (0.24) 0.00 0.83 0.24 0.66 342

-0.26 (0.61) 0.30 (0.02) -1.85 (0.42) 0.02 0.16 0.83 0.59 192

-0.36 (0.41) 0.20 (0.26) 0.33 (0.92) 0.01 0.17 0.33 0.23 192

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 pvalues. (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.

35

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 19802009 S-GMM P S-GMM E (3) (4) -1.23 (0.03) 0.43 (0.04) -20.90 (0.03) 0.01 0.30 0.05 0.01 340 18 -1.06 (0.01) 0.49 (0.00) -19.30 (0.00) 0.01 0.21 0.22 0.09 340 18

Estimator: Regressors: 6.7.A Inflation coefficient of variation equation Inflation targeting dummy Lagged inflation coefficient of variation High inflation dummy AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations Instrument columns 6.7.B Output growth coefficient of variation equation Inflation targeting dummy

Reduced instruments 19802009 S-GMM P S-GMM E (1) (2) -1.20 (0.01) 0.23 (0.31) -22.90 (0.03) 0.02 0.45 0.16 0.03 340 18 -0.92 (0.00) 0.32 (0.14) -22.30 (0.02) 0.01 0.40 0.25 0.06 340 18

Reduced instruments 19852002 S-GMM P S-GMM E (5) (6) 0.39 (0.39) 0.11 (0.70) -17.00 (0.05) 0.21 0.37 0.60 0.75 189 14 0.43 (0.33) 0.10 (0.75) -17.00 (0.04) 0.21 0.37 0.60 0.62 189 14

-0.10 -0.42 -0.20 -0.68 -0.08 (0.74) (0.26) (0.59) (0.11) (0.89) Lagged output growth coefficient of variation 0.29 0.28 0.27 0.29 0.24 (0.00) (0.00) (0.00) (0.00) (0.01) High inflation dummy 1.51 1.62 1.35 1.39 -1.29 (0.13) (0.14) (0.17) (0.15) (0.77) AR(1) test 0.00 0.00 0.00 0.00 0.01 AR(2) test 0.26 0.26 0.23 0.23 0.94 Hansen J test 0.50 0.43 0.36 0.60 0.99 Difference-in-Hansen 0.31 0.53 0.65 0.64 0.95 Observations 342 342 342 342 192 Instrument columns 18 18 18 18 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).

-0.08 (0.19) 0.26 (0.00) -0.44 (0.91) 0.01 0.81 0.82 0.96 192 14

36

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 inflationoutput or real economic activity tradeoff, the following equation in terms of inflation variation is utilized which suggests an accelerationist Phillips curve: (6.2)

37

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: Regressors: Phillips curve Inflation targeting dummy Output growth Lagged output growth High inflation dummy AR(1) test AR(2) test TE-OLS (1) 0.91 (0.27) -3.01 (0.01) 2.62 (0.01) 2.52 (0.49) WG (2) 3.19 (0.09) -2.89 (0.02) 2.60 (0.01) 9.31 (0.19) D-GMM P (3) 1.83 (0.81) -2.44 (0.04) 1.96 (0.01) -3.6 (0.83) 0.07 0.85 D-GMM E (4) -0.66 (0.95) -2.32 (0.19) 1.76 (0.05) -10.1 (0.63) 0.07 0.98 S-GMM P (5) -0.72 (0.41) -2.6 (0.01) 2.15 (0.02) 2.16 (0.76) 0.07 0.84 S-GMM E (6) 0.80 (0.46) -1.98 (0.11) 1.93 (0.01) 4.69 (0.41) 0.08 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 pvalues. (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

38

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: Regressors: Phillips curve Inflation targeting dummy Output growth Lagged output growth High inflation dummy TE-OLS (1) 1.00 (0.54) -3.67 (0.09) 3.23 (0.06) 2.60 (0.28) WG (2) 8.27 (0.05) -3.53 (0.14) 3.56 (0.05) 7.66 (0.14) D-GMM P (3) -61.40 (0.26) -6.25 (0.22) 0.88 (0.71) 113.7 (0.38) 0.14 0.65 0.86 D-GMM E (4) -67.00 (0.36) -9.16 (0.47) 0.53 (0.85) 135.6 (0.36) 0.18 0.62 0.75 S-GMM P (5) -1.55 (0.62) -7.21 (0.09) 1.46 (0.27) 49.15 (0.37) 0.10 0.97 0.74 0.84 190 21 S-GMM E (6) 1.11 (0.72) -3.10 (0.72) 0.94 (0.38) 53.77 (0.31) 0.08 0.82 0.42 0.95 190 19

AR(1) test AR(2) test Hansen J test Difference-in-Hansen Observations 190 190 151 151 Instrument columns 16 14 R-squared 0.19 0.20 p-values in parentheses. AR(1), AR(2), Hansen J tests, and difference-in-Hansen report the respective pvalues. (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).

39

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 19802009 S-GMM P (3) S-GMM E (4)

Reduced instruments 1980-2009 Estimator: Regressors: Phillips curve Inflation targeting dummy S-GMM P (1) S-GMM E (2)

Reduced instruments 1985-2002 S-GMM P (5) S-GMM E (6)

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).

40

**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 41

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 SGMM 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 18

See section 2 on theory. However the empirical results and this paper did not find any robust evidence regarding this empirical tradeoff.

42

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 43

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.

44

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