Inflation targeting and the real exchange rate trend: theoretical discussion and empirical evidence for developed and developing countries

Abstract Economic literature shows evidence that a competitive real exchange rate (RER), i.e., slightly undervalued, is key for development in developing countries. This paper discusses the connections between inflation targeting (IT) regimes and RER trends in economies highly open to capital flows. Following Rodrik’s (2008. The real exchange rate and economic growth, Brookings Papers on Economic Activity, Washington, 2008, vol. 39, no. 2 (Fall), 365–439), the RER trend is estimated for a sample of 31 out of the 38 developed and developing countries that, by the final year of the period covered in this study (2019), had already adopted IT. Covering the period 2000–2019, we showed that all developed and Latin American developing countries had an RER overvaluation trend, while the European, Asian and African (South Africa) developing countries registered an undervaluation trend in the same period. Through a dynamic panel data model, we tested and validated the following hypotheses, which, to the best of our knowledge, are a seminal contribution. We found in Latin American developing countries, whose ITs are centred on the main objective of pursuing price stability, the RER overvaluation trend (a by-product of this monetary policy regime) is driven by higher interest rate differentials to the USA and is harmful to their economic growth. In developed countries, this trend is not explained by their IT framework but by their high per capita income level, which reflects their high average labour productivity and development pattern. Yet, the trend of RER undervaluation in Asian and European developing countries and South Africa reflects their governments’ ability to combine a more flexible IT regime with a floating but managed exchange rate system aimed at preserving a competitive and stable RER in the long term.