Theoretical evaluation of the effects of inflation

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In this thesis we have attempted to evaluate the effects of inflation targeting on inflation and economic growth in developing and developed countries. We have divided our study into four chapters.

The first chapter presents the general theoretical overview of the thesis. In this chapter, we have examined the main features of inflation targeting. We have presented the advantages and disadvantages of inflation targeting. We have exposed a number of ongoing debates involved with the implementation of inflation targeting and the prerequisites needed before moving to inflation targeting. We have tried to extend the previous literature among four aspects. First, we have compared between alternative definitions of inflation targeting provided by the earlier literature. Second, we have examined social and economic costs associated with high inflation. Third, we have described the origin of inflation targeting in New Zealand and we have looked at the basics assumptions of inflation targeting. Finally, we have compared between the inflation targeting approach and the previous approach to central banking. In this chapter we have achieved the following conclusions:

Previous studies commonly agree that inflation targeting includes the following set of crucial components (see Svensson, 1997-2008; Bernanke and Mishkin, 1997; Bernanke et al.; 1999 and Mishkin, 2000-2005): The public announcement of a numerical target; an institutionalized commitment to price stability as the primary goal of monetary policy to which other goals are subordinated; increased transparency of the monetary policy strategy through intensive communication with the public and the markets about the objectives of monetary policy and the justification for decisions taken by the monetary authority; inflation targeting central banks have to conduct its monetary policy with a high degree of instrumental independence and practice the inflation target without any political pressure. Nevertheless, we have detected some conflicts between authors' opinions about the time horizon of the target, the call for the publication of inflation and output forecasts and the interpretation of inflation targeting as a rule or a framework. Some authors (see for instance, Svensson, 1997; 2008; Bernanke and Mishkin, 1997 and Mishkin, 2000-2005) point out that inflation targeting central banks should target inflation at the medium-term and should publish inflation and output forecasts. However, other authors (see for example Bernanke et al.; 1999) believe that inflation targeting central banks have to target inflation at one or more horizons and they add that central banks are not obliged to publish reports containing inflation and output forecasts. In addition, the interpretation of inflation targeting as a rule or a framework has been a source of confusion between economists. Advocates of policy rules, such as Svensson (1997; 2002), believes that inflation targeting is best described as a rule while adherents of discretionary policy-making, such as Bernanke et al. (1999), Bernanke and Mishkin (1997) and Mishkin (2000; 2005), view that inflation targeting is best described as a framework rather than a rule because it still apply "constrained discretion" to respond to short-run shocks.

The adoption of inflation targeting and the exclusive focus on fighting inflation is mainly explained by the fact that high inflation is economically and socially costly. Socially, the study of public attitudes towards inflation surveyed in some developed countries (see for instance Shiller, 1996) shows that "inflation" is a major part of people's thinking, it appears to be the most commonly used economic term among the general public, it harms the standard of living, it helps to create a selfish social atmosphere and causes political disorders. Economically, a high inflation is associated with enormous economic costs in terms of excessive real output growth variability, increased inflation uncertainty and great instability of the relative price (see for instance Golob, 1994; Hess and Morris, 1996 and Horwitz, 2003). First, a rise in the inflation rate contributes to enormous variability of the real output growth, especially in low to moderate inflation developed countries. A non stable real output growth prevents economies from reaching its potential output growth. A great divergence between the real output growth and the potential output growth caused by high variability of the real output may raise the unemployment rate and stimulate inflationary pressures which in turn harm the consumer welfare and damage the production efficiency. Second, a high inflation increases uncertainty about the expected inflation which hurts consumers and businesses' future economic. Golob (1994) believes that inflation uncertainty has ex ante effects and ex post effects on the economy. According to ex ante effects, inflation uncertainty leads to higher long-term interest rates which lead consumers to reduce investment in durable goods, such as housing and businesses diminish investment in plant and equipments which destruct economic activity. The second ex ante effects postulates that inflation uncertainty amplifies uncertainty about interest rates and other variables, which in turn contributes to less investment. Moving to ex post effects, a greater inflation uncertainty will contribute to a transfer of wealth from the lender to the borrower. Third, a high inflation may be considered to be a source of excessive changes in relative prices (see for instance Golob, 1994; Hess and Morris, 1996 and Fisher, 1996). However, excessive changes in relative prices caused by high inflation lead people to make decisions that do not reflect their desires and consequently hurt the work of price system and generates heavy economic costs.

Inflation targeting has several advantages (see for instance Debelle and Lim, 1998; Jonsson, 1999; Mishkin, 2000 and Carlstrom and Fuerst, 2002). It helps countries to reach and maintain a low rate of inflation, it uses monetary and non monetary information; it directly focuses on the final objective; it helps to anchor and coordinate inflation expectations; it is highly transparent and easily understood by the public; it stimulates monetary policy to focus on domestic concerns and finally it is able to reduce the possibility of falling into time inconsistency trap. However, despite these advantages, inflation targeting has some shortcomings (see for instance Masson, 1997; Savastano and Sharma, 1997; Debelle and Lim, 1998; Jonsson, 1999; Mishkin, 2000 and Epstein, 2005). It exclusively focuses on fighting inflation and excludes other real goals such as economic growth and employment creation; the inflation target cannot be easily controlled by the central bank because the monetary policy instrument affects inflation with long and variable lags; it is difficult to central banks to manage inflation because the index used by many countries to measure the headline inflation generally includes government-controlled prices; the forward looking nature of inflation targeting requires a suitable inflation forecasting model. However, it is difficult in practice to find a precise model of the economy; it may face central banks to an important trade-off between transparency and flexibility and finally the forecast horizon is too short (two years ahead in average) and any attempt to stabilize inflation, when countries face enormous exogenous shocks, contributes to the instability of other important variables, such as output, interest rate and the external current account balance.

Inflation targeting was pioneered by New Zealand in the early 1990s when the country undertook economic policy reforms that began in the early 1980s and extended into 1990s. These reforms were mainly influenced by neoclassical theories and were made in order to move to liberalization and to abolish government's regulation.

Our comparison between the neoliberal or modern approach and the previous approach to central banking shows that inflation targeting has the main features of the neo-liberal approach. This approach is based on many hypothesis : it postulates that once stabilization is achieved, developmental issues will follow; central banks have to target very low levels of inflation because high to moderate rates of inflation harm the economic growth; the short-term interest rate is the exclusive instrument of monetary policy; central banks should focus on fighting inflation with the exclusion of other goals; central banks should have instrumental independence and finally it assumes that the exchange rate should be volatile.

The discussion of the operational design of inflation-targeting regimes shows that policy formulation has varied and some practical issues remain unresolved, especially for developing countries. These issues cover the exact timing of the adoption of inflation targeting, the time horizon of the target, the measure of the price index, the bandwidth of the target, the assignment of the target, the interaction of the target with other policy goals, the degree of the accountability of the central bank to achieve the target, the role of inflation forecasts and the importance of the flexibility in enhancing the transparency of monetary policy.

Furthermore, before moving to inflation targeting, countries have to meet three main pre-conditions, including the independence of the central bank, the absence of commitment to objectives that may be conflicted with low inflation and the presence of a sufficiently developed capital and money markets. Nonetheless, the experience shows that inflation targeting has produced excellent results for countries that do not accomplish all these criteria in advance, especially for developing countries (Debelle, 2001; Pétursson, 2004; Amato and Gerlach, 2002, Sterne, 2002 and Truman, 2003).

Moving to the second chapter, we have tried to check whether inflation targeting countries have been able to reduce the average level of inflation relative to non-targeting countries and to the pre-targeting period, using the difference-in-difference cross-country specification. In this chapter, we have tried to extend previous studies along three aspects. First, we have tested the endogeneity of the targeting regime using different determinants. Some determinants such as the pre-targeting inflation and the trade openness indicator are proposed by Mishkin and Schimidt-Hebbel (2007). We have added new determinants such as the initial inflation target and the short-run nominal interest rate. Second, we have checked the robustness of our findings by using different estimation techniques (OLS and IV estimations). Third, we have also checked the robustness of our results by considering alternative samples. The full sample covers twenty-one inflation targeting countries (with both low and high initial inflation) and thirty three non-inflation targeting countries. The restricted sample 1 excludes targeting countries with very high initial inflation, such as Brazil, Israel, Mexico, Peru and Poland. The restricted sample 2 drops targeting countries with single-digit initial inflation, including Australia, Canada, Czech Republic, Norway, South Korea, Sweden, Switzerland, Thailand and United Kingdom. In this chapter, we have reached the following conclusions:

Comparative descriptive statistics on average inflation before and after targeting show that both targeters and non-targeters have experienced a decrease in average inflation, with the largest gain in targeting countries. In fact, the percentage variation between periods is -88.61 percent for targeters and -70.23 percent for non-targeters.

Comparing targeters and non-targeters in the pre-targeting period, the average inflation is higher by 61.51 percent for targeters. In the post-targeting period, however, the average inflation becomes lower by 38.19 percent for targeters.

Looking at comparative average inflation differences between inflation targeting and non-inflation targeting, the OLS results for our full sample indicates that, after controlling to the mean, the inflation targeting dummy variable is slightly significant (at the 10 percent level) and suggests that average inflation has been about 2.6 percent lower in inflation targeters than in non-inflation targeters. Thus, inflation targeting has positive significant effects on inflation performance of targeting countries. In addition, the pre-targeting average inflation coefficient is negative and highly significant (at the 1 percent level). The R-squared is 98 percent, reflecting the strong explanatory power of the second regression.

These findings are compatible with the findings in IMF (2005) and Vega and Winkelried (2005), but inconsistent with the positive differences found in Mishkin and Schmidt-Hebbel (2007) and with the findings in Ball and Sheridan (2005) that reject any inflation differences between inflation targeters and non-infation targeters.

Nevertheless, estimated inflation differences between inflation targeters and non-inflation targeters depend largely on which country sample is used. In fact, the results for our both restricted samples show that the effects of inflation targeting are not significant. Initial inflation, however, is found to be negative and statistically significant, revealing a strong convergence to the mean.

Looking at the correlation between inflation targeting regime and its related determinants, we have found that inflation targeting regime is negatively and significantly correlated with the short-run nominal interest rate considered as the exclusive instrument of targeting central banks (see Masson, Savastano and Sharma, 1997). This result is surprising because inflation targeting is compatible with tightening monetary policies (see Cecchetti and Ehrman, 2000 and Corbo et al.2001). We have also found that inflation targeting is negatively and significantly associated with initial inflation target. This outcome supports the idea that inflation targeting central banks should target inflation at very low levels (see Svensson. 1997 and Ben Bernanke and al., 1999). However, we have found no significant correlations between inflation targeting regime and the pre-targeting inflation as well the trade openness country-specific determinants proposed by Mishkin and Shmidt-Hebbel (2002).

The endogeneity test shows inflation targeting regime is an endogenous choice when it is determined by the initial inflation target variable. In other words, the achievement of low and stable inflation target has motivated countries to switch to targeting regime.

Finally, we have used the initial inflation target variable as an instrument in our instrumental variables (IV) estimations. Instrumental variable (VI) estimation results clearly indicate that inflation targeting has no significant effects on the inflation differential between targeters and non-targeters. However, the coefficient of the pre-targeting inflation is highly significant, revealing a strong regression to the mean (at the 1 percent significant level). These results are not consistent with the OLS results. Consequently, the effects of inflation targeting depend on which estimation technique is used.

In sum, the effects of inflation targeting regime on inflation performance of targeting countries depend largely on which country sample is used as well on which estimation technique is applied.

Furthermore in the third chapter, we have checked whether inflation targeting countries have been able to improve average economic growth and its stability relative to non-targeting countries and to the pre-targeting period, using the difference-in-difference cross-country specification. In this chapter we have tried to extend the earlier literature by considering a large sample that comprises 55 developed and developing countries. In this chapter we have reached the following conclusions:

Comparative descriptive statistics on average economic growth before and after targeting show that inflation targeters have raised the average economic growth by 16.02% between the two periods. Conversely, non-inflation targeters reduce it by 3.07%. Comparing targeters and non-targeters in the pre-targeting period, the average rate of growth is smaller by 19.83% percent for targeters. In the post-targeting period, however, it becomes lower by 4.03% percent for targeters. Consequently, inflation targeters have succeeded in achieving a higher average rate of growth than non-targeters.

Furthermore, the volatility of the economic growth has decreased between periods for both groups of countries. But the decrease is lower for targeters than for non-targeters. Targeters reduce it by 40.23% and non-targeters reduced it by 59.19%. Within a given period, the volatility is smaller for targeting countries. Indeed, the difference falls (from - 51.66% to -29.20%) after the adoption of targeting regime.

Moving to comparative average economic growth differences between inflation targeting countries and non-inflation targeting countries, the OLS results indicate that, after controlling to the mean, targeting regime has no significant effects on average economic growth difference between targeters and nontargeters. However, the pre-targeting average growth coefficient is negative and highly significant (at the 1 percent level). The R-squared is 39 percent, showing the strong explanatory power of the pre-targeting average economic growth. These findings are compatible with the findings in Ball and Sheridan (2005) and Divino (2009).

Nevertheless, the study of the impact of inflation targeting on economic growth volatility indicates that the inflation targeting dummy variable has significant effects (at the 5 percent level) and suggests that economic growth volatility is about 6.72 percent lower in targeters than in non-targeters. Thus, inflation targeting has contributed to more stable economic growth. In addition, the pre-targeting economic growth volatility coefficient is negative and highly significant (at the 1 percent level). The R-squared has risen to 32 percent, reflecting the strong explanatory power of both inflation targeting dummy variable and the pre-targeting economic growth volatility. This result suggests that country's decision to switch to targeting regime is motivated by its pre-targeting economic growth volatility. These findings are compatible with the findings in Gonçalves and Salles (2007) but inconsistent with the findings in Ball and Sheridan (2005) and Divino (2009) that reject any economic growth volatility differences between inflation targeters and non-targeters.

Finally in the fourth chapter, In this chapter, we have tried to survey the different critics of inflation targeting developed by the recent literature. Especially, we will focus on the impact of inflation targeting on real economic goals (such as economic growth) and financial goals (such as financial stability and asset prices stability). We have also attempted to describe the different solutions proposed by this literature in order to replace or modify inflation targeting policy design.

When looking at the impact of inflation targeting on the real economy, results are more deceiving for developing than for developed countries. Indeed, Fraga, Goldfajn and Minella (2003) compare the relative performance of developed and developing targeting countries and find that the output growth is more volatile in developing targeting countries than in developed targeting countries. Besides, Mollick, Torres and Carneiro (2008) estimate the effects of inflation targeting on developed and developing economies' output growth over "globalization years" of 1986-2004 and they conclude that the adoption of inflation targeting has positive and significant effects on the real per capita income, with the largest gain in developed countries.

Advocates of inflation targeting, such as Lars Svensson, believe that economic growth and employment creation are the automatic products of stabilization-focused monetary policy. In other words, once the "stabilization" is achieved the economic growth and employment creation will follow. However, this assumption is not verified especially for developing countries.

Opponents of inflation targeting presume that inflation targeting policy is mainly influenced by the neoliberal approach and its failure to promote the real economy is probably caused by the wide believe that high and moderate rates of inflation harms the real economy (Pollin and Zhu, 2005 and Epstein, 2007). The study of the relationship between inflation and the real economy has created a large discrepancy between IMF economists and non-IMF economists.

According to IMF economists (Ghosh and Phillips, 1998 and Khan and Senhadji, 2001) inflation begins to harm economic growth at very low levels (inflation below 3 percent). Conversely, according to non-IMF economists (Bruno and Easterly, 1998 and Pollin and Zhu, 2005) moderate rates of inflation, inflation rates up about 15 or 20 percent, have no significant real costs and there is no reasonable justification to pursue a monetary policy oriented toward keeping inflation at very low levels, especially in developing countries.

The positive effects of moderate inflation rates on the real economy combined with the real costs associated with inflation targeting motivate some researchers to develop alternatives to inflation targeting for developing countries, namely "real targeting approach" (Frenkel and Rapetti, 2006; Barbosa-Filho, 2005; Galindo and Ros, 2006; Lim, 2006; Packard, 2005 and Epstein, 2005-2007).

Under real targeting approach, central banks target indicators that are related to the real economy and to the social welfare, such as employment, real GDP growth, investment and real exchange rate. Supporters of real targeting approach (Frenkel and Rapetti, 2006; Barbosa-Filho, 2005; Galindo and Ros, 2006; Lim, 2006; Packard, 2005; Epstein, 2005-2007) suggest that central banks have to achieve their real targets, subjected to a moderate inflation constraint. In other words, central banks should have a real target (or targets) and an inflation target (moderate rate of inflation).

Our comparison between real targeting policy and inflation targeting policy (See Table 4-1) shows that both policies share a number of features. Indeed, it commonly entail a public announcement of a numerical target; an institutionalized commitment to a specific target as the primary goal of monetary policy; increased transparency and accountability of central banks and independence of the central bank. However, the table reveals an important discrepancy between real targeting and inflation targeting. Indeed, while real targeting approach requires high degree of coordination between monetary and fiscal policy, inflation targeting approach imposes a full instrumental independence of the central bank. Also, while the short-term interest rate represents the exclusive instrument of inflation targeting central banks, real targeting framework calls for additional tools such as credit allocation regulation and capital management techniques (Epstein, 2007).

Moving to the impact of inflation targeting on financial goals, the recent financial crisis and the subsequent recession have proven the failure of inflation targeting policy to mitigate financial instability and asset prices booms (Walsh, 2009; Svensson, 2009 and Bean, 2009).

Before exposing the main reasons that may explain the failure of inflation targeting, we have surveyed the role of monetary policy in the recent financial crisis. Some arguments have claimed that the recent crisis was originated by monetary policy mistakes, especially in the United States (Taylor, 2007). However, alternatives arguments have pointed up that the recent crisis was mainly caused by macroeconomic circumstances preceding the crisis. The macroeconomic environment preceding the crisis was characterized by the great moderation period, the global imbalances period and the excessive financial market deregulations (Bean, 2009; Svensson, 2009).

The great moderation period included a long period of a stable growth, a low and a stable inflation in most of the developed economies. Many economists have given some credit for the period known as the great moderation to the success of the monetary policy based on inflation targeting framework (Bean, 2009; Svensson, 2009; Walsh, 2009). Then, the high imbalances between countries were caused by large current account surplus in emerging market economies (Bean, 2009). Finally, the excessive financial market deregulations engaged financial institutions in risky transactions. The global imbalances and the financial market deregulations have ended the great moderation period by profound recession and deflation.

The recent literature has developed three reasons that may explain the failure of inflation targeting in promoting financial stability and asset prices stability:

First, some arguments point out that inflation targeting is incapable to manage financial instability and asset prices boom by using one single instrument, namely the interest rate. But, for achieving better financial stability central banks have to use macro-prudential regulation that contains a "portfolio" of tools such as the adjustment of capital requirements, the formulation of capital barriers and the management of leverage ratios. In addition, the central bank should pursuit an effective communication strategy by publishing a regular Financial Stability Report that includes indicators describing the state of the financial sector and serving as early-warning indicators of possible future troubles. These indicators allow policymakers to take early actions to avoid future financial instability (Svensson, 2009; Walsh, 2009; Bean, 2009; Carney, 2009; Lucas, 2009). However, the right way to respond to asset prices boom is controversial (Bean, 2009). Supporters of the 'benign neglect' policy claim that central banks should not react to asset prices misalignments (Bernanke and Gertler, 2001). Conversely, advocates of 'leaning against the wind' policy argue that central banks should respond to asset prices inflation by raising interest rates as asset prices rise above acceptable levels, and lowering interest rates when asset prices fall below acceptable levels (Borio and White, 2003; Cecchetti, Genberg and Wadhwani, 2002; Svensson, 2009 and Bean, 2009).

Second, some arguments point out that inflation targeting is inappropriate because the forecast horizons of inflation and the real economy are too short and needed to be lengthened. Nevertheless, the call for longer forecast horizons allows central banks exercising excessive discretionary actions that damage its credibility (Carney, 2009).

Third, other arguments claim that the current forecasting models "do not do a good enough job" in indentifying the dynamics of financial and asset imbalances. This suggests that financial factors should be incorporated as intermediate targets (or as constraints on monetary policy) rather than ultimate targets. So, advocates of inflation targeting suggests that a forward looking flexible inflation targeting rule that include financial indicators as an intermediate target (or as a constraint on monetary policy) is "the best practice monetary policy before, during and after financial crisis" (Disyatat, 2005 and Svensson, 2009).. In this chapter we have attained the following endings:

Inflation targeting approach is based on three assumptions. First, it assumes that low and stable inflation environment will automatically improve the economic growth and employment (Svensson, 1999; Epstein, 2007). Second, it assumes that moderate and high rates of inflation harm the real economy (Svensson, 1997; Epstein, 2007). Third, it postulates that there is no practical alternative to inflation targeting (Epstein, 2007).

Nevertheless, an increasing body of literature has proved that these assumptions are misleading. Indeed, a first deal of evidence suggests that in most cases inflation targeting has failed to promote and to stabilize the real economy, especially in developing countries. Conversely, it has provided slow economic growth and high unemployment rates (Ball and Sheridan, 2003; Truman, 2003 and Divino, 2009). Besides, a further deal of evidence strongly proposes that moderate rates of inflation, inflation rates up to about 15 or 20 percent, do not harm the real economy in developing countries (Bruno and Easterly, 1998; Pollin and Zhu, 2005). These two arguments against inflation targeting lead some researchers to develop alternatives to inflation targeting for developing countries, namely "real targeting approach" (Frenkel and Rapetti, 2006; Barbosa-Filho, 2005; Galindo and Ros, 2006; Lim, 2006; Packard, 2005 and Epstein, 2005-2007).

Under real targeting approach, central banks target indicators that are related to the real economy and to the social welfare, such as employment, real GDP growth, investment and real exchange rate. It is believed that real targeting approach is responsive to stabilization needs as well as to developmental needs (Epstein, 2005-2007).

Supporters of real targeting approach (Frenkel and Rapetti, 2006; Barbosa-Filho, 2005; Galindo and Ros, 2006; Lim, 2006; Packard, 2005; Epstein, 2005-2007) suggest that central banks have to achieve their real targets, subjected to a moderate inflation constraint. In other words, central banks should have a real target (or targets) and an inflation target (moderate rate of inflation) (Epstein, 2005-2007).

Our comparison between real targeting policy and inflation targeting policy (See Table 1) suggests that the main advantage of targeting approach, in general, is that it enhances the transparency and the accountability of central banks (Epstein, 2007). However, real targeting approach requires high degree of coordination between monetary and fiscal policy (Epstein, 2009).

Real targeting and inflation targeting differs in the choice of the appropriate instrument to achieve the target (See Table 1). Indeed, real targeting framework calls for additional tools such as credit allocation regulation and capital management techniques (Epstein, 2007). Credit allocation regulation is a quantitative regulation (quota) of financial institutions that help to direct lending to employment generating investments (see Pollin, et. al, 2006 and 1994, Epstein and Heintz, 2006, Palley, 2003). Capital management financial techniques include capital and exchange controls and prudential regulation of domestic financial institutions. Capital and exchange controls allow governments to set taxes or regulations over the buying and/or selling of international assets or debt (capital controls) or foreign exchange (exchange controls). Capital management techniques can promote and improve financial stability and reduce the potential for financial crisis. Finally, they can promote desirable employment generating investments (Epstein, 2005-2007).

A multi-country studies developed by supporters of real targeting on developing countries (Argentina, Brazil, Mexico, India, The Philippines, South Africa, Turkey and Viet Nam) reveals that under this approach, the ultimate and intermediate targets should include one or several real targets (for instance, employment, activity level, exports, investment, growth, a stable and competitive real exchange rate) and an inflation target (See Table 2). The incorporation of a stable and real exchange rate targeting is explained by the fact that the international competitiveness has positives consequences on employment and economic growth as well as it allows maintaining inflation in check (See Frenkel and Rapetti, 2006; Barbosa-Filho, 2005; Galindo and Ros, 2006; Lim, 2006; Packard, 2005; Epstein, 2005).

On the other hand, the recent literature reveals a considerable debate on whether the monetary policy has contributed to the recent financial crisis. Some arguments have claimed that the recent crisis was originated by monetary policy mistakes, especially in the United States (Taylor, 2007). However, alternatives arguments have pointed up that the recent crisis was mainly caused by macroeconomic circumstances preceding the crisis (Bean, 2009; Svensson, 2009).

The macroeconomic environment preceding the crisis was characterized by the great moderation period, the global imbalances period and the excessive financial market deregulations (Bean, 2009; Svensson, 2009). The great moderation period included a long period of a stable growth, a low and a stable inflation in most of the developed economies (Bean, 2009; Svensson, 2009). Then, the high imbalances between countries were caused by large current account surplus in emerging market economies (Bean, 2009). Finally, the excessive financial market deregulations engaged financial institutions in risky transactions. The global imbalances and the financial market deregulations have ended the great moderation period by profound recession and deflation.

Furthermore, the monetary policy consensus preceding the crisis was dominated by the flexible inflation targeting approach (Walsh, 2009). Many economists have given some credit for the period known as the great moderation to the success of the monetary policy based on inflation targeting framework (Bean, 2009; Svensson, 2009; Walsh, 2009).

However, some arguments have claimed that inflation targeting regime is not an appropriate monetary policy regime for many reasons. First, it is incapable to manage financial instability and asset prices boom by using one single instrument, namely the interest rate (Svensson, 2009; Walsh, 2009; Bean, 2009; Carney, 2009; Lucas, 2009).

Indeed, for achieving better financial stability central banks have to use macro-prudential regulation that does not include a single tool, but it contains a "portfolio" of tools such as the adjustment of capital requirements, the formulation of capital barriers and the management of leverage ratios (Lucas, 2009; Svensson, 2009; Bean, 2009). In addition, the central bank should pursuit an effective communication strategy by publishing a regular Financial Stability Report that includes indicators describing the state of the financial sector and serving as early-warning indicators of possible future troubles. These indicators allow policymakers to take early actions to avoid future financial instability (Svensson, 2009; Carney, 2009).

However, the right way to respond to asset prices boom is controversial (Bean, 2009). Supporters of the 'benign neglect' policy claim that central banks should not react to asset prices misalignments (Bernanke and Gertler, 2001). Conversely, advocates of 'leaning against the wind' policy argue that central banks should respond to asset prices inflation by raising interest rates as asset prices rise above acceptable levels, and lowering interest rates when asset prices fall below acceptable levels (Borio and White, 2003; Cecchetti, Genberg and Wadhwani, 2002; Svensson, 2009; Bean; 2009).

Second, some arguments point out that inflation targeting is inappropriate because the forecast horizons of inflation and the real economy are too short and needed to be lengthened. Nevertheless, the call for longer forecast horizons allows central banks exercising excessive discretionary actions that damage its credibility (Carney, 2009).

Third, other arguments claim that the current forecasting models "do not do a good enough job" in indentifying the dynamics of financial and asset imbalances (Disyatat, 2005). This suggests that financial factors should be incorporated as intermediate targets (or as constraints on monetary policy) rather than ultimate targets (Disyatat, 2005; Svensson, 2009). So, advocates of inflation targeting suggests that a forward looking flexible inflation targeting rule that include financial indicators as an intermediate target (or as a constraint on monetary policy) is "the best practice monetary policy before, during and after financial crisis"(Svensson, 2009).

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