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"Good Governance” in Monetary Policy and the Negative Real Effects of Inflation Targeting in Developing Economies

By Gilberto Libanio | October 18, 2005

Abstract: This paper analyzes the growth and employment effects of inflation targeting regimes in emerging market economies. In particular, it focuses on the case of three Latin American economies where the inflation-targeting framework has been implemented, namely Brazil, Chile and Mexico. One of the main issues to be addressed in this study is the procyclical character of monetary policy under inflation targeting, especially in developing countries with liberalized capital accounts and flexible exchange rates. It is argued that not only monetary policy is procyclical under inflation targeting, but also that it is likely to react in an asymmetric way to fluctuations in economic activity and exchange rates (too ‘tight’ during recessions, not so ‘loose’ during expansions). Such pattern may generate a downward bias in aggregate demand, with negative long-run real effects on output growth and employment. Our results suggest that monetary policy is procyclical and asymmetrical in Brazil and Chile, but not in Mexico. The main economic policy implication of this study is that central banks should consider more seriously the effects of monetary policy on output and employment.

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Read More: Economy, Finance, Brazil, Chile, Mexico, Americas

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