Inflation targeting in a developing economy: policy rules, growth, and stability

Carlos Eduardo Drumond Department of Economics UESC and UFPR, Brazil Gabriel Porcile ECLAC and Department of Economics, UFPR

Motivation In recent years Post-Keynesian (PK) economists have devoted increasing attention to macrodynamics models that discusses the role of different monetary rules in fostering the stability of the economic system. The key question addressed is which policy rules are more effective in promoting stability without compromising growth and employment.

Purpose To modeling monetary rules in open developing economies in a context in which international capital flows play a key role in defining the RER. The key question addressed is which policy rules are more effective in promoting stability without compromising growth and employment.

Purpose The intended contributions of the paper are twofold: it extends the Kaleckian model for an open economy to incorporate the effects of capital flows on the RER and the interest rate; it acknowledges the possibility of having different macroeconomic regimes that reflect different preferences for inflation and employment by the government.

Structure of the model

Firms set prices following a mark-up rule;

Wages depend on the dynamics of conflicting claims and bargaining between firms and unions in the labor market; The government follows a monetary rule based on an expanded Taylor rule, which includes an employment target and an inflation target;

Structure of the model The market for foreign exchange reflects the behavior of international investors that arbitrate between assets denominated in different currencies, in such a way that the uncovered interest parity condition (UIP) holds in equilibrium.

PK Phillips curve and wage bargaining Part of wage demand is related to the expected inflation and increase in productivity Workers aim at increasing their share in real income as a positive function of the employment rate Workers consume imported goods, the level of the RER will affect real consumption

Aggregate demand Traditional Keynesian demand curve, expressed in terms of ratios with respect to the stock of capital, result in a PK IS curve:

The Taylor rule and the real interest rate The monetary policy is based on an Interest Rate Operation Procedure in which the Central Bank sets a target for the inflation rate and for the degree of capacity utilization .

UIP and the real exchange rate

The dynamic system The monetary rule and RER dynamics form a bidimensional dynamic system

Preliminary results

The system is stable Changes in economic policy may adopt the form of changes in either p or u. In both cases, at variance with what happens in new consensus models, in our PK model monetary policy will have real effects in the medium run. Tinbergen rule and long run expectative coordenation

Monetary rules under different institutional settings

Conservative Monetary Regime Central Bank sets = 0 ; The system is stable; In The long run inflation expectation converge to
effective inflation (equal to the inflation target );

As in the previous case, increases in the inflation target will lead to higher growth in the long run

Keynesian Monetary Regime

The Central Bank focuses on employment and sets = 0 In absence of anchor for expectation workers set expected prices according with a process of adaptive expectations.
Its form a 3x3 dynamic system that is unstable

 When workers expectation converge to international inflation (Carlin and Soskice, 2006) the keynesian regime form a 2x2 dynamic system that is stable. As growth depends on u, an increase in the employment target has positive effect on growth

Focus on the external balance

This is a special case in which the government adopts the KR, but the level of desired capacity utilization is not defined based on employment concerns, but on the objective of achieving equilibrium in current account. The system is stable, but, in long run growth depends on structural parameters

Concluding remarks

Monetary policy matters in the medium run for the equilibrium levels of employment and growth in the mixed regime
By choosing a higher inflation target or a higher target for capacity utilization, the government may raise growth, real wages and employment

 Although both (inflation and utilization targets) cannot be simultaneously attained, the equilibrium of the dynamic system is stable.

If actors revise their expectations after some time and inflation target no longer serves as an anchor for prices, the dynamics of the system will change.

 Although both (inflation and utilization targets) cannot be simultaneously attained, the equilibrium of the dynamic system is stable.

If actors revise their expectations after some time and inflation target no longer serves as an anchor for prices, the dynamics of the system will change.

 Then government will either abandon the target for capacity utilization (adopting a pure inflation target regime, which we call conservative regime) or abandon the inflation target (a pure Keynesian regime).

Prescription of macroeconomic policy The choice of the relative weight of growth and inflation in the definition of the IROP will depend on the prevailing levels of inflation the higher these levels, the more likely is that the government moves towards a conservative regimeand on the nature of the political regimeassociated with the relative influence of workers and firms in policies.