〔論説〕

Inflation Targeting and the Role of Exchange Rate:
The Case of the Czech Republic

Yutaka Kurihara

Abstract
This paper analyzes the recent conduct of monetary and exchange rate
policies in Czech Republic. The Czech experience with inflation targeting
seems to have been satisfactory. The authorities have succeeded inmaintaining a stable and moderate rate of inflation. Despite the warnings ofskeptics, technical problems in the application of inflation targeting have notinterfered with the operation of this regime. The paper shows that theexchange rate system, regardless of free-floating rhetoric, does not heavily
influence the conduct of monetary policy in the Czech Republic. Also, itmatters not merely in that it is useful for forecasting inflation rate.

Introduction
Inflation targeting entails an institutional commitment to price stability as
the prime goal of monetary policy, giving the central bank accountability― 23 ―

relative to the attainment of monetary policy goals, public announcement oftargets for inflation, and a policy of communicating to the markets therationale for the decisions made by the central banks. The independence ofcentral banks is needed to give the monetary authorities the leeway necessary
to commit to stability. On the other hand, central banks are responsible forthe conduct of monetary policy and its outcomes. Also, sound, stable fiscal
policy and a stable banking system are needed to avoid problems that would
prevent the central bank from subordinating other goals to the objective of
price stability or undermining the independence of the central banks. Central
banks sometimes need to avoid the government intervention; the conduct ofinflation targeting makes central banks possible. This multidimensional
nature of this definition explains why there is no consensus about which
practice is inflation targeting especially for emerging markets.
Many obstacles to inflation targeting have raised questions regarding its
use in emerging markets. In general, changes in import prices due tomovements in the exchange rate are quickly passed to domestic market prices
in emerging markets (Calvo and Reinhart, 2000). With this type of high passthrough, a change in the exchange rate has a large short-run impact on
inflation and a small short-run impact on output not only emerging markets
but also in developed markets. The exchange rate should be adjusted to offset
the effects so as not to harm the domestic markets. Foreign deflation, forexample, will induce an inflation-targeting central bank to expand the money
supply and allow the currency to depreciate, whereas an inflationary shock
1

will induce the opposite reaction. Most developing countries have recently
experienced the former case.
The difficulty of forecasting inflation may be an obstacle to inflation
targeting. It is not realistic to hope to forecast inflation with the requisite― 24 ―

Inflation Targeting and the Role of Exchange Rate

reliability if the country is still in the process of bringing down inflation fromhigh levels, reforming the tax and public spending systems, and restructuring
the private sector. Credibility problems sometimes make inflation targeting
less attractive. They mean more volatility and less flexible policy conduct.
Theoretical arguments about the need for a nominal anchor, inflation
targeting, may help to justify a move toward inflation targeting, but it isimportant to know how well this approach has worked in actual application.
This paper is structured as follows. Section 1 reviews the monetary policy of
the Czech Republic. Section 2 presents one theoretical model for empiricalanalysis. Section 3 shows the results and analyzes them. Section 4 analyzes
the role of exchange rate. Finally, this paper ends with a summary.

１．Inflation Targeting in the Czech Republic
The Czech Republic is one of two successor states of Czechoslovakia, theother being Slovakia. The Czech Republic entered 1993 as a newly
independent country that still shared a monetary union with Slovakia. This
arrangement rapidly proved to be unsustainable and the union was dissolvedin 1993. Since then, the Czech Republic has conducted its own independent
economic and monetary policies.
The heritage of Czechoslovakia was overall macroeconomic stability. The
country had been a bulwark of fiscal and monetary prudence duringcommunism and the early transition policies confirmed this trend (Drabek etal., 1994). Restrictive monetary and fiscal policies accompanied the start ofreforms in January 1991, ensuring that inflation fell after the initial jumpcaused by price liberalization. After falling to approximately 10% in 1992,
inflation rose to about 20% in 1993 due to the introduction of value-added tax― 25 ―

(VAT) in the Czech Republic in January 1993.
The years 1993 to 1997 can generally be reckoned as a period ofprosperity. The economy recovered greatly and growth rates were quite
high. Growth was accompanied by high employment rates without parallel inother countries. Inflation stabilized at around 10%. In the second half of 1995,
the Czech Republic liberalized the current account of the balance of payments.
As a result of relatively high interest rates, a stable nominal exchange rate,and low perceived political risk, the economy of the Czech Republic began toattract large amounts of both short-term and long-term capital inflows in 1994
and 1995. However, reflecting sluggish export growth and strong increases inimports, economic growth began to slow down in 1995 to 1996. Prompted by a
combination of a major currency crisis in Asia and some European countries
and a recession, in 1997, the government passed an austerity package that
contained expenditure cuts, other measures to dampen domestic demand, andmedium-term institutional and structural measures to stimulate the supply
side of the Czech economy.
By early in 2000, the economy emerged from the recession. The new
government conducted a massive clean-up and privatization of major banks,
which led to a revival in lending activity. Fiscal policy was largely relaxed to
pay the costs of the banking restructuring and to stimulate demand byinvestment in infrastructure and significant increases in pay for public
employees. Unemployment was stabilized and inflation remained low andstable (Beblavy, 2007).
At the beginning of the transition, the Czech Republic policymakers had to
institute a monetary policy framework that would take advantage of soundeconomic fundamentals. The policy response was a fixed exchange rate as theintermediate target of monetary policy complemented by a monetary target.

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Inflation Targeting and the Role of Exchange Rate

The central bank also announced inflation targets in terms of the so-called
headline consumer price index; however, the exchange rate peg remained thenominal anchor.
The policy irrelevance of monetary targeting in the environment of highand unstable capital inflows was one of the reasons that the Czech central
bank switched to direct inflation targeting after the exchange rate crisis of
1997. In 1998, the central bank argued that monetary targeting had a problem
caused by a lack of predictable relationship between monetary aggregates andinflation. The Czech national bank set a target for net inflation as the final
target in 1998.

２．Theoretical Analysis
One way to infer the importance of inflation, the real economy, and theexchange rate in the policy decisions of the Czech National Bank is to estimate
2

an extended Taylor Rule. Assume that the call rate partially adjusts to thetarget according to the function:＊rt＝(1 − r)rt ＋ rrt-1＋ vt(1)＊where r is the call rate, rt is the target rate for it, and v is a random shock.
The coefficient r captures the degree of interest rate smoothing practiced by
the central bank.
＊rt is assumed as follows:
＊

＊＊

＊

rt ＝ rt ＋ b (E[pt＋n￨Wt− p ]＋ gE[output gapt￨Wt]＋ h [zt￨Wt]＊＊

where rt(2)

is the long-run equilibrium nominal interest rates, pt＋n is inflation

between period t＋n and period t, and z is another variable that may influence― 27 ―

the reaction of the central bank. Combining (1) and (2):tr ＝(1 − r)[a ＋ bpt＋n＋ g output gapt＋ hzt]＋ rrt-1＋ et
＊＊

(3)

＊

where a ＝(rt − bp ), and et＝(1 − r)[b (pt＋n− E[output gapt￨Wt])＋(zt− E[zt￨ Wt])＋ vt
Let ut be a vector of variables included in the central bank’s information set
at the time it sets the interest rate that are orthogonal to e.
E[et￨ut]＝ 0(4)

３．Empirical Analysis
Equation (4) entails the orthogonality conditions that we exploit toestimate the unknown parameters via GMM. I use lags 1, 2, 3, 4, 5, 6, and 12of the overnight call rate based on Eichengreen (2008), the index of industrial
production, the inflation rate, and the lagged rate of real exchange rate
depreciation as the elements of the central bank’s information set. The sample
period is 1998 to 2007.
An important step is to estimate the output gap. Many methods may be
employed for this purpose. The time series for industrial production istransformed into an output gap series in two ways following Eichengreen(2008). One is to use the two-sided linear Hodrick-Prescott filter and the otheris to use a linear trend. The results are shown in Table 1.
The results show a good fit for actual movements in the call rate. The firsttwo equations show that the call rate rises along with inflation. The call rate
also rises as actual output increases relative to capacity. The lagged
dependent variable is significant and large. However, although the presence― 28 ―

Inflation Targeting and the Role of Exchange Rate

Table 1equation
1
2
3
4

alpha

GMM Estimates: Forward-Looking Inflation
beta

gamma

rho

zeta

1.112

0.713

1.182

0.997

(0.907)(0.303)(0.162)(0.003)−0.778

1.413

0.434

0.996

(0.765)(0.207)(0.034)(0.004)

3.123

0.450

0.132

0.935

0.123

(0.884)(0.336)(0.105)(0.005)(0.015)−0.065

1.325

0.424

0.994

0.055

(0.614)(0.297)(0.037)(0.004)(0.010)gap
Hodrick＝PrescottLinear trend
Hodrick＝PrescottLinear trend

Note. Data in parentheses are adjusted standard errors.

of the lagged dependent variable explains the success of these equations infollowing trends in the call rate, the other variables still appear to have a rolein determining fluctuations.
The key result is that the rate of change in the real exchange rate also
3

influences the setting of the policy instrument. When the real exchange rate
depreciates, there is a tendency for the Czech National Bank to raise the callrate. The addition of the rate of currency depreciation reduces the magnitudeof the other coefficients but does not change the results. The Czech National
Bank cares about the movements of the real exchange rate above and beyond
its use in forecasting future inflation. The distinction between forwardlooking and backward-looking is sometimes important.
It is interesting to note that the substitution of backward-looking behavior
for forward-looking behavior produces a negative coefficient on the excess ofactual output over capacity output. Estimates of monetary policy reaction
functions that are framed in terms of backward-looking price movements can― 29 ―

Table 2

GMM Estimates: Backward-Looking Inflation

equation

alpha

beta

1

−0.505

1.314

1.312

0.994

(0.512)(0.199)(0.155)(0.004)

1.833

0.398

0.499

0.995

(0.324)(0.044)(0.043)(0.003)5.018−0.410

1.108

0.937

0.119

(0.354)(0.099)(0.112)(0.006)(0.013)4.1818−0.298

0.395

0.993

0.148

(0.2018)(0.095)(0.035)(0.005)(0.007)

2
3
4

gamma

rho

zeta

gap
Hodrick＝PrescottLinear trend
Hodrick＝PrescottLinear trend

Note. Data in parentheses are adjusted standard errors.

be seriously misleading (Eichengreen, 2008).
The differences in the two sets of estimates is consistent with theassumption that the Czech National Bank looks forward rather than backward
when it formulates monetary policy.

４．The Role of the Exchange Rate
The adoption of inflation targeting as an economy’ s monetary policy
framework does not guarantee exchange rate stability and does not eliminate
the potential for wide swings in exchange rate. Some advocates of inflation
targeting take the position that the only exchange rate regime that is fullycompatible with an inflation-targeting framework for the conduct of monetary
policy is essentially free floating. At the most basic level, the choice of
exchange rate regime, or the weight placed on changes in the exchange rate in
the central bank’ s reaction function, should be a function of a country’ s― 30 ―

Inflation Targeting and the Role of Exchange Rate

economic development strategy. The Czech Republic has been committed toa strategy of export-led growth, in which it keeps the exchange rate stable at acompetitive level. A strategy of keeping the exchange rate from appreciating
and keeping interest rates low to confer additional resources into the
production of exports ― or, more generally, into the production of those goods
for which the scope for productivity improvement is greatest ― works lesswell in a deregulated financial environment.
The other reason that the Czech policymakers may be reluctant to move togreater exchange rate fluctuation is the worry that exchange rate stability isimportant for economic growth. The main reason is that it influences the bondmarkets. Bonds markets are very important for the economy and are related
to interest rates. However, there is little evidence that greater exchange ratevariability is a significant implement for bond market development(Eichengreen, 2008). The analysis of interest rates instead of exchange rates
is sometimes important as countries pursue similar interest rate policies. The
Czech Republic is not an exception. However, this paper omits this view.

５．Conclusions
The Czech experience with inflation targeting has been satisfactory. The
authorities have succeeded in maintaining a stable and moderate rate of
inflation. The technical problems suggested by skeptics of the application of
inflation targeting have not interfered with the operation of this regime. Thissituation also suggests that the Czech National Bank cares about the realexchange rate as it has direct implications for the future course of inflation.
Reasons such as the balance of investment traded and non-traded goods
sectors impact implications for financial stability. Real exchange rates are― 31 ―

very important and are related to monetary policy.
Problems exist in judging whether or not the framework of inflation
targeting has been successful from this analysis. Targeting should restrain
inflation in the long run. Also, a strong commitment to transparency should
be guaranteed. These aspects have played important roles in the policies oftargeting countries. Furthermore, the Czech Republic has conducted an
overall package of reforms that has promoted and sustained economic growthand modernization. Inflation targeting seems to be a useful strategy for the
conduct of monetary policy; however, further research is needed to study
these issues more.

Notes
１．Anecdotal evidence suggests that this is the case for Brazil and Mexico. See Mishkin
and Savastano (2000).
２．I follow the approach of Clarida, Gali, and Gertler (1998).
３．The result is similar to Corbo (2000).

References
Beblavy, M. (2007), Monetary Policy in Central Europe, Routledge: London.
Calvo, G. and C. Reinhart (2000), “Fear of Floating,” NBER Working Paper 7993.
Clarida R., J. Gali, and M. Gertler (1998) , “Monetary Policy Rule in Practice: Some
International Evidence,” European Economic Review 46 (1), 1033-1068.
Drabek, Z., K. Janacek, and K. Tuma (1994), “Inflation in the Czech and Slovak Republics,”
Journal of Comparative Economics 18 (2), 146-174.
Eichengreen, B. (2008) , “The Role of the Exchange Rate in Inflation targeting: A Case
Study of Korea” in D. T. Bentley and E. P. Nelson (Eds.), Inflation Roles, Targeting and
Dynamics, Nova Science: New York.
Mishkin, F. and M. Savastano (2000) , “Monetary Policy Strategies for Latin America,”
NBER Working Paper 7617.

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