and how much is simply the result of a more favorable global environment? This paper attempts to shed some light on this issue.

The paper addresses the following questions. First, what are the monetary policy challenges in low-income countries? Second, how has inflation in LICs evolved? Third, how well anchored are inflation expectations in LICs? Finally, what country characteristics have been associated with stronger anchoring?

In this paper, the question of the degree of anchoring of medium-term inflation expectations in LICs is tackled by estimating a novel heterogeneous panel structural vector autoregression (SVAR) model.<sup>6</sup> The model examines the extent to which core inflation in LICs has remained stable in the face of a variety of external shocks, including shocks to global core, energy, and food price inflation, and other shocks transmitted to the domestic economy through exchange rate fluctuations. The assessment is made based on the degree of sensitivity of domestic core inflation, which is determined by the degree of anchoring of inflation expectations, to external shocks. The estimation is based on a monthly panel data set that covers 104 countries (25 advanced economies and 79 EMDEs, including 18 LICs) for 1970M2-2016M12. The data set contains at least 36 months of continuous data for each country, for six variables—headline consumer price index (CPI), food CPI, energy CPI, core CPI, nominal effective exchange rate (NEER), and rainfall. Differences across income groups and subgroups in LICs in the extent to which domestic core inflation performance has been insulated from international factors are analyzed in terms of country characteristics, institutional factors, and policy regimes under a simple ordinary least squares regression framework.

The paper’s principal conclusions are as follows.

LICs, like other EMDEs, have experienced higher average levels and volatility of headline inflation than have advanced economies. However, the level and volatility of headline inflation have declined in all three country groups over the past two decades. The fall in inflation volatility in LICs is largely accounted for by declines in the volatility of core and energy price inflation. Food price inflation volatility has remained elevated.

Among LICs, core inflation has tended to be lower in countries with lower public debt ratios, fixed exchange rates, a higher degree of capital account openness, and greater central bank transparency. Although these results are largely consistent with those for advanced economies and other EMDEs, the effects of these characteristics seem to be more prominent for LICs.

Core inflation in LICs was more susceptible to external disturbances than in the other country groups. Around three-quarters of the variation in domestic core inflation rates among LICs was accounted for by external inflation shocks, and very little by shocks to domestic core inflation. This result is exactly opposite of that of advanced economies where only a quarter of the variation in domestic core inflation is explained by global inflation shocks.

> 6 The heterogeneous panel SVAR methodology, which is a variant of the Pedroni (2013) methodology, allows analyzing the consequences of various unanticipated global and domestic inflation shocks on the domestic core consumer price index. Rather than using pooled estimation, the approach incorporates group mean panel estimation methods to avoid inconsistent estimation that can occur under pooled methods when the dynamics associated with endogenous variables are heterogeneous. See Appendix for details.

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