Inflation Targeting and Exchange Rate Volatility in Emerging Markets

The paper investigates the exchange rate on the reaction function of 24 emerging markets economies’ (EMEs) central banks from 2000Q1 to 2015Q2. This is done by first employing fixed-effects (FE) ordinary least squares and then system generalized methods of the moments techniques. Under FE, the exchange rate is important in the reaction function of EMEs. Allowing for the endogeneity of inflation, output gap, and the exchange rate, the exchange rate remains positive and statistically significant (but quantitatively less) across inflation targeting countries. When the sample is partitioned into targeting and non-targeting countries, the exchange rate remains relevant in the reaction function of non-targeters. The results remain robust to splitting the sample at the time of the financial crisis of 2007–2009 and suggest that, after the crisis, central banks of EMEs respond only to inflation movements in the interest rate reaction function