THE FLEXIBILITY OF THE INFLATION TARGETING SYSTEM: A DYNAMIC PANEL DATA ANALYSIS WITH FRAGILE ECONOMIES

Abstract

The transitivity from exchange rate to inflation rate should be limited in inflation targeting system for the success of the strategy. Despite the fact that this transitivity has been decreased in recent years, exchange rate is still one of the main determinants of inflation in fragile economies with high current account values. Exchange rate increases detached from economic fundamentals are reflected to the prices in high percentages. Therefore, overvaluations or disvaluations require a monetary policy reaction. Changes in exchange rates should be considered when creating inflation expectations due to the impact of exchange rates on inflation. Depreciation in exchange rates began with the announcement by Fed that it will gradually exit from quantity easing. Inflation targeting has gained new flexibility to deal effectively with real economic instabilities according to recent empirical literature thanks to its ability to anchor inflation expectations. The objectives of the study were to make judgments about whether inflation targeting is a flexible monetary system or not by determining the strength of its anchoring effect on inflation expectations and to suggest some political recommendations according to the obtained results. In order to accomplish this objective, the relationship between exchange rates and inflation expectation will be analyzed via the dynamic panel method. It can be stated according to the acquired results that exchange rate continues to be an important indicator of inflation expectations for the sample group during the examined periods.