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Did inflation targeting make a difference during the financial crisis?

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This paper seeks to explore whether inflation targeters (ITers) fared better than non-ITers in the largest recession since the ‘Great Depression’. Early evidence by Roger (2010) and Carvalho-Filho (2011) has been rather positive in this regard; suggesting superior growth performance and lower market perceptions of risk. However, these papers do not formally address the sample selection issue that has plagued the inflation targeting (IT) literature. This paper therefore aims to contribute to the literature by taking IT to be a treatment. We employ a two-pronged approach to the analysis: borrowing from the program evaluation literature, we employ propensity score matching combined with differences-in-differences. Then to understand time-varying performance during the crisis, we also employ a panel fixed effects model with country and time-fixed effects, controlling for possible time-varying heterogeneity via instrumental variables (IV). We find that ITers did perform better in the crisis, with smaller output contractions and smaller increases in 5-year Sovereign CDS spreads. However, we only find weak evidence for superior consumption growth. Turning to possible drivers behind this performance, we find that ITers cut nominal policy rates by more (and these translated into real cuts), were more successful in avoiding deflationary pressures, experienced larger depreciations in their real exchange rate, and for emerging economies (EMEs) had less need for fiscal stimulus. Therefore, we interpret this superior performance as a culmination of factors that stem from a superior ability to anchor inflation expectations.

This talk is part of the Cambridge Finance Workshop Series series.

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