Latin American currencies—the Mexican or Colombian peso—like the currencies of other emerging economies, have fallen sharply against the U.S. dollar in the past few years, losing nearly half of their value. This surge in the exchange rate poses a risk to these economies, as it can be reflected in consumer prices, limiting people’s buying power and having a negative effect on the productive sector.

However, not all central banks have reacted in the same way, or at least not with policies that affect the exchange rate directly. What policies have they followed? Is one of their priorities keeping the exchange rate stable, or does price control have more weight in their decisions?

My recent research with Dr. Francisco G. Carneiro, from the World Bank, and Dr. André Varella, from the University of Texas Río Grande Valley, was published by the World Bank’s Policy Research Working Paper Series and analyzes the relationship between interest rates and exchange rates in emerging economies, based on their inflation-targeting policy. Called “Inflation Targeting and Exchange Rate Volatility in Emerging Markets,” the article compares countries where the central banks react to volatile exchange rates with the use of inflation-targeting mechanisms to countries where they do not.

Since the 1990s, central banks have put most of their effort into guaranteeing long-term price stability by using inflation-targeting policies. This policy was first used by central banks in developed countries such as New Zealand, Canada, England, Sweden, and Australia, but recently, emerging economies such as Brazil, Chile, Israel, Peru, and Mexico have started to use variants of it. So far, the countries that have adopted the inflation-targeting plan have managed to keep inflation rates down. In some cases, GDP growth has improved. But has it been as effective in keeping the exchange rate from being so volatile?

To find out, we analyzed the relevance of the exchange rate on the reaction function of the central banks of 24 emerging market economies; 9 of them have inflation-targeting policies (inflation targeters—IT), and 15 of them do not (non-inflation targeters—non-IT). The sample included Latin American, Asian, African, and Eastern European countries and used data from the first quarter of 2000 through the second quarter of 2015.

Research on the topic suggests that it is important to consider the exchange rate as part of the inflation-targeting policy package, as it interacts with other factors. For our research, we took these implications and other endogenous factors into account. Our first analysis shows that IT economies have lower average inflation levels (3.97%), compared to non-ITs (6.27%), and have less-volatile exchange rates (0.28%) than non ITs (0.73%).

We also noted that while central banks in IT and non-IT economies do not usually react to economic growth, they undoubtedly place different importance on inflation and exchange rates. On the one hand, we noted that central banks in non-IT countries reacted to exchange-rate fluctuations, but only during the period leading up to the Great Recession (2008), suggesting a structural change in actions taken by central banks, with more importance placed on inflation and less on exchange-rate volatility. On the other hand, the results show that central banks in IT countries do react to inflation movements but rarely to other factors such as short-term economic growth.

These results confirm that inflation-targeting policies have helped central banks set price expectations, making their macroeconomic management easier. However, it may not be appropriate to use an IT plan in every country. To be successful with this approach, countries must make sure that their central banks are independent, must define short- and long-term inflation targets, must be transparent with the information they present to the markets, and must report on the targets set.

Latin American currencies—the Mexican or Colombian peso—like the currencies of other emerging economies, have fallen sharply against the U.S. dollar in the past few years, losing nearly half of their value. This surge in the exchange rate poses a risk to these economies, as it can be reflected in consumer prices, limiting people’s buying power and having a negative effect on the productive sector.

However, not all central banks have reacted in the same way, or at least not with policies that affect the exchange rate directly. What policies have they followed? Is one of their priorities keeping the exchange rate stable, or does price control have more weight in their decisions?

My recent research with Dr. Francisco G. Carneiro, from the World Bank, and Dr. André Varella, from the University of Texas Río Grande Valley, was published by the World Bank’s Policy Research Working Paper Series and analyzes the relationship between interest rates and exchange rates in emerging economies, based on their inflation-targeting policy. Called “Inflation Targeting and Exchange Rate Volatility in Emerging Markets,” the article compares countries where the central banks react to volatile exchange rates with the use of inflation-targeting mechanisms to countries where they do not.

Since the 1990s, central banks have put most of their effort into guaranteeing long-term price stability by using inflation-targeting policies. This policy was first used by central banks in developed countries such as New Zealand, Canada, England, Sweden, and Australia, but recently, emerging economies such as Brazil, Chile, Israel, Peru, and Mexico have started to use variants of it. So far, the countries that have adopted the inflation-targeting plan have managed to keep inflation rates down. In some cases, GDP growth has improved. But has it been as effective in keeping the exchange rate from being so volatile?

To find out, we analyzed the relevance of the exchange rate on the reaction function of the central banks of 24 emerging market economies; 9 of them have inflation-targeting policies (inflation targeters—IT), and 15 of them do not (non-inflation targeters—non-IT). The sample included Latin American, Asian, African, and Eastern European countries and used data from the first quarter of 2000 through the second quarter of 2015.

Research on the topic suggests that it is important to consider the exchange rate as part of the inflation-targeting policy package, as it interacts with other factors. For our research, we took these implications and other endogenous factors into account. Our first analysis shows that IT economies have lower average inflation levels (3.97%), compared to non-ITs (6.27%), and have less-volatile exchange rates (0.28%) than non ITs (0.73%).

We also noted that while central banks in IT and non-IT economies do not usually react to economic growth, they undoubtedly place different importance on inflation and exchange rates. On the one hand, we noted that central banks in non-IT countries reacted to exchange-rate fluctuations, but only during the period leading up to the Great Recession (2008), suggesting a structural change in actions taken by central banks, with more importance placed on inflation and less on exchange-rate volatility. On the other hand, the results show that central banks in IT countries do react to inflation movements but rarely to other factors such as short-term economic growth.

These results confirm that inflation-targeting policies have helped central banks set price expectations, making their macroeconomic management easier. However, it may not be appropriate to use an IT plan in every country. To be successful with this approach, countries must make sure that their central banks are independent, must define short- and long-term inflation targets, must be transparent with the information they present to the markets, and must report on the targets set.