Evaluating the effectiveness of exchange rate bands in reducing inflation

Tu N. Dang

Macroeconomics and Finance in Emerging Market Economies, 2012, vol. 5, issue 1, 42-61

Abstract: This paper contributes to the debate between the intermediate option and the corner solution through evaluating effectiveness of exchange rate bands (target zone and crawling band) in retaining inflation. I employ propensity score matching methods, based on the conditional independence assumption (CIA), to overcome the selection bias and problem of functional form in a sample covering observations from 88 countries from 1998 to 2005. The result suggests countries with target zones experienced significantly lower inflation rates than those with floating exchange rates. I use the sensitivity analysis for matching estimators, which highlights that the result is robust to specific failures of the CIA. Meanwhile, no significant evidence has been found that crawling bands offer a counter- inflationary benefit. It might be explained by the possibility that frequent exchange rate realignments could weaken the role of a nominal anchor and raise inflationary expectations.

Date: 2012
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DOI: 10.1080/17520843.2011.588337

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