Should Developing Countries Target Low, Single Digit Inflation to Promote Growth and Employment?

This paper revisits a key issue in monetary policy, namely, the setting of
inflation targets for developing countries. This review is timely because of recent
proclamations by the IMF that one needs a ‘wholesale re-examination’ of
macroeconomic policy principles in the wake of the global economic and financial
crisis of 2007-2009. The paper points out that the current tendency is to target low,
single digit inflation, but this cannot be supported by robust empirical evidence or by
the historical experience of developing countries. Indeed, most studies, using both
cross-section data and country-specific experiences, show that the relationship between
growth and inflation has clear ‘threshold effects’ suggesting that setting too low an
inflation target can impose opportunity costs in terms of foregone growth and
employment creation.
The paper also shows that implementing inflation targeting regimes represent a
major challenge in the presence of supply-shocks which are a common phenomenon in
developing countries. Furthermore, there is little evidence that the benefits of reduced
inflation are being transmitted in the form of reduced costs of borrowing since such
costs are likely to be determined by structural factors. The paper argues that it is
difficult to establish that inflation targeting developing countries do significantly better
in terms of labour productivity, vulnerable employment, working poverty and growth
than their non-inflation targeting counterparts. The paper urges a return to the
refreshing eclecticism of the founding fathers of the IMF who encouraged member
states to aim for ‘reasonable price stability’ within a framework of growth promoting
policies and refrained from prescribing low, single digit inflation targets that were
universally applicable to all member states.