THE ROLE OF INFLATION TARGETING ON EXCHANGE RATE VOLATILITY: AN EVIDENCE FROM PROPENSITY SCORE MATCHING APPROACH

Abstract

This study examines the treatment effects of inflation targeting on exchange rate volatility across a large panel of 91 (36 inflation targeting) countries over the 1985-2019 period on annual basis. We apply propensity score matching methods to developed, developing, and high-income inflation targeting countries and non-inflation targeting countries. Our results reveal that, on average, adopting the inflation targeting policy exerts lower exchange rate volatility in all sample and developing economies. However, subgroups results demonstrate that inflation targeting regimes may lead to higher exchange rate volatility in developed and high-income economies. The outcome from different degrees of flexibility of exchange rates subgroups points out that the inflation targeting regime has significant and lower exchange rate volatility under free-floating regimes however this policy stance has no discernible effect on floating regimes. Additionally, adopted inflation targeting countries are affected by less damage on exchange rate volatility than those adopting exchange rate targeting regimes.