Inflation Targeting and Exchange Rate Volatility: A Treatment Effect Regression Approach

This study empirically examines the issue of whether countries that target inflation systematically experience higher exchange rate volatility. A major challenge that immediately confronts such analysis is that countries do not choose their monetary regimes in a random fashion. In this paper, an attempt is made to take into account the problem of self-selection in the countries’ decision to target inflation via a treatment effect regression that estimates jointly the probability of being an inflation targeter and the outcome equation. The analysis indicates that nominal and real effective exchange rate volatility are both lower in inflation-targeting countries than countries that do not target inflation. More importantly, the analysis also suggest that developing countries that target inflation have lower nominal and real effective exchange rate volatility than non-inflation-targeting developing countries; in the case, however, of inflation-targeting industrial countries, it is found to be higher.