Essays on Monetary Policy, Institutions and Terms of Trade Shocks in Emerging Market Economies

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Hove, Seedwell
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University of Cape Town
Abstract This thesis focuses on two important features of emerging market economies: institutional weaknesses and the exposure to commodity terms of trade shocks and how they shape the macroeconomic dynamics and the conduct of monetary policy. These issues are discussed in three essays. The first essay empirically evaluates the role of institutional structures in inflation targeting in emerging market economies (EMEs). The second essay theoretically investigates the appropriate monetary policy responses to commodity terms of trade shocks using a multi-sector New Keynesian dynamic stochastic general equilibrium (DSGE) model. Finally, the third essay empirically analyses the .responses of different monetary policy regimes to commodity terms of trade shocks in emerging market economies. The first essay investigates whether monetary, fiscal and financial institutional structures really matter for the achievement of inflation targets in emerging market economies. Particular emphasis is placed on the extent to which inflation deviations from target bands are affected by central bank independence, fiscal discipline and financial sector development. The study contnoutes to the literature by taking stock of the intrinsic role played by institutional structures in the achievement of inflation targets since the adoption of inflation targeting in EMEs. Using the panel ordered logit model, the analysis shows that improvement in central bank independence, fiscal discipline and financial systems reduces the probability of inflation target misses. Precisely, countries with more independent central banks tend to achieve inflation targets more frequently. A one percent increase in central bank independence increases the probability of achieving the target band by 0.16%, while reducing the probability of inflation being above the target band by 0.11%. Moreover, countries with weak fiscal institutions and less developed financial systems have a higher probability of missing their inflation targets. The improvement in institutional structures also enhances the effectiveness of monetary policy. The thesis also provides evidence that other macroeconomic and structural variables such as exchange rate gap, output gapt inflation target horizon and level of openness explain inflation target misses. The results suggest that there is need to continue to reform institutional structures in order to achieve sustainable price stability.