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Is inflation targeting credible in Asia? A panel GARCH approach

Abstract

We examine the relationship between inflation targeting and the behavior of the level and volatility of inflation for eight Asian countries over the period 1987–2013. In contrast to existing studies that rely upon time series methods, we employ a novel panel GARCH model that accounts for heterogeneity and interdependence across countries. Our main contribution is to shed new light on the inflation targeting credibility hypothesis based on lower inflation and inflation volatility as well as on the correlation between unanticipated inflation shocks within a panel GARCH framework. We find strong evidence of a reduction in the level of inflation that operates from the impact of actual inflation targets in the Philippines, South Korea and Thailand. We also find that the adoption of inflation targeting helped lower inflation volatility in the Philippines and South Korea. Overall, the results suggest that Asian inflation targeting regimes are more credible in terms of reducing the level of inflation than lowering inflation volatility. There is also evidence that the covariance of inflation shocks among inflation targeting and non-targeting countries tends to increase.

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Notes

  1. 1.

    The panel GARCH methodology has been recently used, among others, by Cermeño et al. (2010), Cermeño and Sanin (2015), Drakos and Konstantinou (2013), Escobari and Lee (2014), Goulas and Zervoyianni (2013), Lee (2010b), Lee and Valera (2016) and Valera et al. (2016).

  2. 2.

    There are no other conditioning variables in Eq. (1) because our main goal is to characterize the inflation process in Asian countries taken as a panel with special attention given to the impact of inflation targeting. We later argue that our findings are robust to incorporating the effects from an oil price dummy.

  3. 3.

    The “half-year rule” is also employed in Samarina and De Haan (2014) and Lucotte (2010).

  4. 4.

    We have written the programs in RATS. We use the Broyden?Fletcher?Goldfarb?Shanno (BFGS) algorithm in the estimation process (seeBroyden 1965, 1967; Fletcher and Powell 1963).

  5. 5.

    The coefficient estimate for IT is robust to the case where the oil price is used as an alternative determinant of inflation. In this first experiment, we followed Bhar and Mallik’s (2013) approach in constructing a dummy variable for the oil price. Here, we first convert the oil price into local currency since an appreciating exchange rate can offset the impact of oil price increases. When the oil price (in local currency) rises more than 4% in three consecutive periods, we set the dummy variable equal to (+1). Likewise, we set a value of (−1) if the oil price declines more than 4% in three consecutive periods. The dummy is zero otherwise. As a further robustness check, we then used the quarterly GDP deflator as an alternative determinant of inflation. For comparison, we changed the data frequency of CPI inflation from monthly to quarterly. For both quarterly CPI and GDP deflator data, we confirmed our first panel GARCH findings and those from the first experiment.

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Acknowledgements

We are grateful for the helpful comments made by the Editors and anonymous referees, participants at the 2015 meeting of the Singapore Economics Conference and to Jim Lee for computational assistance. Financial support from the New Zealand Ministry of Foreign Affairs and Trade (MFAT) (DEVSCH:PHL:8070) is also gratefully acknowledged. Any remaining errors are our own.

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Correspondence to Harold Glenn A. Valera.

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Valera, H.G.A., Holmes, M.J. & Hassan, G.M. Is inflation targeting credible in Asia? A panel GARCH approach. Empir Econ 54, 523–546 (2018). https://doi.org/10.1007/s00181-016-1212-3

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Keywords

  • Inflation targeting
  • Inflation volatility
  • Panel GARCH
  • Credibility
  • Asia

JEL Classification

  • C33
  • E52
  • E58