Consistent with earlier findings, domestic characteristics appear to matter not just for the level of domestic core inflation, but also for determining the susceptibility of core inflation to external shocks, although further research is needed to solidify this evidence.

Importantly, however, the results indicate that what sets LICs apart may not be so much that they differ from the other country groups in terms of these characteristics, but that these characteristics appear to operate differently in the LIC environment. Notably, although LICs that fix their exchange rates seem to succeed in anchoring inflation expectations about as well as other economies, those that float have had a much more difficult time in anchoring inflation expectations. This finding suggests that LICs may have in essence imported their anti-inflation credibility.

This paper presents the results of what is the first investigation reported in the literature of the effects of various inflation shocks, domestic and global, on core inflation in a large group of countries, with a specific focus on LICs. The study takes advantage of the flexibility of a heterogeneous panel SVAR framework and a large data set that includes core inflation series for 18 LICs and 61 other EMDEs. The empirical framework makes possible the analysis of the impact of global and domestic shocks on core inflation in different groups of countries in a unified framework. Moreover, it helps identify the global component of core inflation endogenously and produces a parsimonious representation of the common and idiosyncratic components of core inflation in the countries in the sample. To help identify the exogenous component of domestic agricultural supply shocks, which are typically associated with food price inflation, the study uses rainfall data as an exogenous instrument.<sup>7</sup> Finally, the paper also contributes to the literature by analyzing the country characteristics that help explain differences in core inflation responses to shocks between LICs and other country groups.

The next two sections summarize the monetary policy challenges in LICs and document the evolution of inflation over time and across countries, with special focus on LICs. The following sections introduce the heterogeneous panel SVAR model and the database, and examine the impact of global and domestic inflation shocks on core inflation in LICs. The subsequent section distills the country characteristics associated with a larger role of global shocks. The final section concludes with a discussion of policy implications for LICs’ control of inflation.

# 2. Monetary policy challenges in low-income countries

# 2.1. The role of monetary policy and its recent performance in low-income countries

A key factor in determining the ability of central banks to achieve low and stable inflation is their success in anchoring the inflation expectations of wage and price setters. If expectations are well anchored at a low inflation rate, temporary departures of inflation from this level will be less likely to set inflation expectations adrift and have prolonged effects on the inflation rate. Inflation expectations are shaped importantly by the credibility of the central bank, which depends partly on the clarity of its stated objectives, and partly on its demonstrated commitment to its objectives and ability to achieve them (Blinder et al. [2008], among many others). As indicated in the text,

> 7 The relevance of the instrumental variable is tested using statistical methods. It is significant at the 5 percent level. Refer to Appendix for details on the test results.

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