Can Inflation Targeting Be a Framework for Monetary Policy in Developing Countries? - Finance & Development - March 1998 - Paul R. Masson, Miguel A. Savastano, and Sunil Sharma

ARLIER in the decade, a number of industrial countries adopted a framework for carrying out monetary policy that became known as inflation targeting. They adopted this framework as a response to the difficulties they had encountered in conducting their monetary policy using an exchange rate peg or some monetary aggregate as the main intermediate target. At the same time, they saw the move as a way to improve their record of controlling inflation and to make their monetary policies more transparent and accountable, all measures conducive to improving the credibility of monetary policy. In practice, inflation targeting has also served as a means of explaining to the public the costs of an expansionary monetary policy and the need to preempt any inflationary pressures. So far only a few industrial countries have practiced inflation targeting—in chronological order, the seven countries are New Zealand, Canada, the United Kingdom, Sweden, Finland, Australia, and Spain. This article examines whether this policy can be applied more widely, particularly in developing countries, which face similar, though often much more difficult problems in designing and conducting monetary policy. Before reaching any conclusions, it is necessary first to consider a conceptual framework in which to understand inflation targeting. Basic premises The case for inflation targeting begins with the premise that the main goal of monetary policy in any country must be to attain and preserve a low and stable rate of inflation. Although this premise was the subject of controversy among economists not too long ago, it is widely accepted today because of general agreement on the following four basic propositions: • An increase in the money supply is neutral in the medium-to-long run. This means that money supply increases have lasting effects only on the price level, not on output or employment. • High and variable inflation is costly, in terms of either the allocation of resources or long-run growth in output, or both. • Money is not neutral in the short run. In other words, monetary policy has important transitory effects on a number of real variables, including output and unemployment. There is, however, still an imperfect understanding of the nature and size of these effects, their time frame, and the