Terms of Trade Shocks and Inflation Targeting in Emerging Market Economies

Emerging market economies (EMEs) have persistently experienced different waves of commodity terms of trade disturbances, generating macroeconomic instabilities. The adoption of in‡flation targeting (IT) by many emerging market economies has raised the questions about its relative suitability in dealing with these shocks compared with other regimes. This paper tests the robustness of infl‡ation targeting compared to monetary targeting and exchange rate targeting regimes in coping with commodity terms of trade shocks. It uses a panel VAR technique to analyse in a comparative framework, aggregate impulse response functions and variance decompositions of variables to commodity terms of trade shocks. The results show that in general, IT countries respond better to commodity terms of trade shocks especially with respect to infl‡ation and output gap. However, exchange rates are more volatile in IT countries than in exchange rate targeting countries. The results suggest that EMEs countries can reduce the adverse effects of commodity terms of trade fluctuations when they adopt in‡ation targeting, but they also need to pay attention to exchange rate movements.