Monetary Policy Rules and Inflation Processes in Open Emerging Economies

This paper has three objectives. First, it aims to reveal the logic of interest rate settings pursued by the monetary authorities of twelve new EU members. Using an estimation of an augmented Taylor rule, we find that central banks in countries with flexible exchange rates respond mainly to (expected) inflation, though often rather loosely. Countries with fixed exchange rates seem to apply an interest rate peg with the euro. Second, it sheds light on the inflation processes of these countries. To this end, we estimate an open economy Phillips curve (PC) and find that inflation rates are not only driven by backward persistency, but also have a forward-looking component. Finally, we assess the viability of existing monetary arrangements for price stability, using the conditional inflation variance obtained from a generalized autoregressive conditional heteroskedasticity estimation of the PC. We conclude that inflation targeting is preferable to an exchange rate peg because it allows for decreasing inflation rates as well as anchoring inflation volatility.