Is Inflation Targeting destabilizing? Lessons from Latin America

Abstract

This paper argues that several aspects of the productive structure and the macroeconomic policies of Latin American countries, when combined with a Taylor Rule, may produce too much output volatility and a bias towards real exchange rate overvaluation. Relaying on a simple Aggregate Demand – Aggregate Supply model, we show that this is a likely outcome when: a) the real interest rate elasticity of demand is low; b) depreciations have strong contractionary effects; and c) the exchange rate pass-through is relatively large. These conditions imply that depreciations are contractionary and a have a strong effect on inflation.