Did the introduction of Inflation Targeting represent a Regime - PowerPoint PPT Presentation

Introduction Model Estimation and Results Conclusions Did the introduction of Inflation Targeting represent a Regime Switch of Monetary Policy in Latin America? Sebastián Cadavid Sánchez Alberto Ortiz Bolaños CEMLA CEMLA and EGADE XXII Annual Meeting of the Central Bank Researchers Network November 5, 2017 S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Outline Introduction 1 Model 2 Estimation and Results 3 Conclusions 4 S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Inflation, central bank reforms, exchange rate flexibility and inflation targeting regime Table: Inflation and central banks changes in selected countries of Latin America Year of new CB Year of IT Average inflation 1980-1989 1990-1999 2000-2009 2010-2015 Exchange rate flexibility Sample starts legislation introduction No change since Brazil 121.7 147.1 6.6 6.2 1999 1999 1996 1964 Chile 19.9 11.8 3.5 3 1992 1999 1999 1996 Colombia 20.8 19.9 6.1 3.1 1992 1999 1999 1995 Mexico 53.1 18.3 5.1 3.6 1993 1995 2001 1981 Peru 111 78.5 2.6 3 1993 2002 2002 1995 S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Monetary policy and inflation determination Goals: i. analyze if these institutional changes were associated with shifts in the monetary policy implementation of Brazil, Chile, Colombia, Mexico and Peru; ii. determine if the observed reduction of inflation is explained by changes in the policy stance; iii. characterize the inflation determination process (expectations, inertia and price rigidity). Challenge: the analysis of the policy stance and inflation process is complex as they are jointly determined with other macroeconomic variables. Strategy: estimate Markov-Switching open-economy DSGE models with monetary factors to: Measure policies and exogenous shocks. Perform counterfactuals under di ff erent monetary policy stances.

Introduction Model Estimation and Results Conclusions A Monetary Small Open Economy General Equilibrium Model Model based on Gali and Monacelli (2005) and latter estimated by Lubik and Schorfheide (2007) for Commonwealth countries, and by Ortiz and Sturzenegger (2007) a set of large emerging market economies. Alstadheim et al. (2013) use a similar approach to test if some CB respond to exchange rate movements. Open-economy IS curve: y t = E t y t + 1 � [ τ + α ( 2 � α )( 1 � τ )]( R t � E t π t + 1 � ρ a a t + α E t ∆ q t + 1 ) + α ( 2 � α ) 1 � τ E t ∆ y ⇤ (1) t + 1 τ Open-economy Phillips curve: χ p , ξ sp β t π t = E t π t + 1 + π t � 1 + βα ∆ q t + 1 � α ∆ q t 1 + βχ p , ξ sp 1 + βχ p , ξ sp t t κ ξ sp + τ + α ( 2 � α )( 1 � τ ) ( y t � y t ) t (2) S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions A Monetary Small Open Economy General Equilibrium Model Interest rate rule: ⇣ ⌘h i R t = ρ R , ξ sp t R t � 1 + 1 � ρ R , ξ sp ψ π , ξ sp t π t + ψ y , ξ sp t y t + ψ ∆ e , ξ sp t ∆ e t + σ R , ξ vo t ε R , t t (3) ⇣ ⌘ ] of LCU Nominal exchange rate determination: 1 USD π t = ∆ e t +( 1 � α ) ∆ q t + π ⇤ (4) t S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Model: External Sector and Technology ⇣ P exports ⌘ AR(1) process for the terms of trade : P imports ∆ q t = ρ q ∆ q t � 1 + σ q , ξ vo t ε q , t (5) Evolution of foreign output : y ⇤ t = ρ y ⇤ y ⇤ t � 1 + σ y ⇤ , ξ vo t ε y ⇤ , t (6) Evolution of foreign inflation : π ⇤ t = ρ π ⇤ π ⇤ t � 1 + σ π ⇤ , ξ vo t ε π ⇤ , t (7) Evolution of technology : a t = ρ a a t � 1 + σ a , ξ vo t ε a , t (8) S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Empirical Strategy We estimate the previous model using macroeconomic data on inflation, interest rates, output growth, nominal exchange rate depreciation and changes in terms of trade from Brazil, Chile, Colombia, Mexico and Peru. We allow for endogenous structural breaks and classify regimes according to the relative weight of inflation in an interest rate reaction function. Observable Measurement Equation Shocks ε a , t Output growth y t � y t � 1 + a t Inflation 4 π t ε y ⇤ , t Nominal interest rate 4 r t ε R , t ε π ⇤ , t Nominal exchange rate depreciation ∆ e t Changes in terms of trade ∆ q t ε q , t S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Solving and estimating the MS-DSGE model To solve the system we use the Newton methods developed in Maih (2015) which extend the one proposed by Farmer et al. (2011)and concentrates in minimum state variable solutions of the form: X t = Ω ⇤ ( ξ sp , θ sp , H ) X t � 1 + Γ ⇤ ( ξ sp , θ sp , H ) Z t ( ξ vo , θ vo ) (9) The presence of unobserved variables and unobserved Markov states of the Markov chains implies that the standard Kalman filter cannot be used to compute the likelihood, so we use the Kim and Nelson (1999) filter. S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Solving and estimating (cont.) We use the Bayesian approach to estimate the model: 1 Use Maih (2015) algorithm to compute the likelihood introducing non-linearities and unobserved chains employing the Kim et al. (1999) filter to compute the likelihood with prior distribution of the parameters. 2 Construct the posterior kernel with the estimates from the Bee-gate optimizer routine. 3 We use the posterior mode as the initial value for the Metropolis Hastings algorithm with 100,000 iterations. 4 Utilize mean and variance of the last 50,000 iterations from (3) to run the main Metropolis Hastings algorithm. S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Brazil Low inflation policy response π t = 0 . 69 E { π t + 1 } + 0 . 31 π t � 1 � 0 . 05 4 q t + 1 . 64 ( y t � y t � 1 ) r t = 061 r t � 1 +( 1 � 0 . 61 )( 1 . 04 π t + 0 . 88 y t + 0 . 04 4 e t ) High inflaiton policy response π t = 0 . 85 E { π t + 1 } + 0 . 15 π t � 1 � 0 . 05 4 q t + 2 . 95 ( y t � y t � 1 ) r t = 0 . 76 r t � 1 +( 1 � 0 . 76 )( 3 . 49 π t + 0 . 30 y t + 0 . 04 4 e t ) S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Brazil Strong shift in monetary policy during 1999 Q3 with the introduction of inflation targeting and the greater exchange rate flexibility after a 35% Real depreciation in 1999 Q1. This was accompanied by: a lower persistence of inflation, or equivalently higher importance of expected inflation, in current inflation determination, and a stepper Phillips curve with inflation more responsive to output gap reflecting smaller price stickiness. The analysis captures the 2002 depreciation and the Cardoso - da Silva government transition as a transitory change of the monetary policy regime from 2002 Q4 to 2003 Q3. S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Chile Low inflation policy response π t = 0 . 66 E { π t + 1 } + 0 . 34 π t � 1 � 0 . 05 4 q t + 0 . 25 ( y t � y t � 1 ) r t = 0 . 49 r t � 1 +( 1 � 0 . 49 )( 0 . 87 π t + 0 . 43 y t + 0 . 07 4 e t ) High inflaiton policy response π t = 0 . 83 E { π t + 1 } + 0 . 17 π t � 1 � 0 . 05 4 q t + 0 . 31 ( y t � y t � 1 ) r t = 0 . 92 r t � 1 +( 1 � 0 . 92 )( 2 . 73 π t + 0 . 56 y t + 0 . 08 4 e t ) S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?

Introduction Model Estimation and Results Conclusions Chile Chile fully adopted inflation targeting in 1999, but as stated in Corbo et al. (2002) the scheme started to be implemented since the 1990s. The estimation captures a high response to inflation since the start of the sample in 1996 Q2. The exception was from 2008Q1 to 2009 Q4 were there was a marked shift in policy with smaller weight on inflation and larger weight on output during a stagflationary period. When moving from a high interest rate response to a low one, Chile had an increase in inflation inertia without changes in the slope of the Phillips curve. This relatively small slope reflects large price stickiness. S. Cadavid Sánchez and A. Ortiz Bolaños Did the introduction of IT represent a RS of MP in LA?