Towards adopting inflation targeting: The credibility and limitations of monetary policy under the fixed exchange system—the case of Jordan

• Date: 01 January 2021
• DOI: http://doi.org/10.1111/twec.12964
• Author: Nora Abu Asab,Juan Carlos Cuestas
• Published date: 01 January 2021

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wileyonlinelibrary.com/journal/twec World Econ. 2021;44:262–285.

© 2020 John Wiley & Sons Ltd

Received: 16 May 2019

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Revised: 2 April 2020

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Accepted: 14 April 2020

DOI: 10.1111/twec.12964

ORIGINAL ARTICLE

Towards adopting inflation targeting: The

credibility and limitations of monetary policy under

the fixed exchange system—the case of Jordan

NoraAbu Asab1

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Juan CarlosCuestas2,3

1Department of Business Economics, University of Jordan, Amman, Jordan

2Department of Economics and Finance, Tallinn University of Technology, Tallinn, Estonia

3Department of Economics and IEI, Jaume I University, Castelló, Spain

Funding information

Ministerio de Ciencia, Innovación y Universidades, Grant/Award Number: ECO2017-83255-C3-3-P and ECO2017-85503-R

KEYWORDS

inflation targeting, Jordan, monetary policy, nonlinearities, pass-through

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INTRODUCTION

It was widely believed among the advocates of activist policies that monetary policy could keep pro-

ductivity and unemployment close to their full-employment levels. The principle of ‘policy activism’

was based on the tenet that the nexus between inflation and unemployment, known as the Philips

curve, could be utilised to achieve a long-run low unemployment. However, the activist policies failed

to deliver the promises of low unemployment and rather resulted in high inflation rates. The activism

was challenged in different aspects; the most important one was the dynamics of market agents' expec-

tations about future policy outcomes. Both Friedman (1968) and Phelps (1968) state that the trade-off

between inflation and unemployment is transitory, and in the long run, due to adjustments to market

agents' wage settings, the only macroeconomic variable that can be controlled by the central bank is

the inflation rate (Bernanke, Laubach, Mishkin, & Posen, 1999). Two decades later, namely in

December 1989, New Zealand led the world to a new monetary framework called inflation targeting

(IT), with one focused objective of monetary policy, that is, price stability. The need for a low inflation

framework which could suppress inflation and provide the leverage over the discretionary intentions

of policymakers encouraged a number of middle and high-income countries to follow IT. The move-

ment to IT was supported by the failure of other monetary anchors such as monetary aggregates in the

mid-1980s and the pegged exchange rate in the early 1990s.1

Indeed, IT has become a well-known framework for monetary policy. To date, over twenty coun-

tries have shifted their monetary regimes towards IT, and the world has been divided into inflation

targeters and non-targeters. Many studies, for example Mishkin and Schmidt-Hebbel (2007), Hu

1A nominal anchor is a nominal variable that is the target of monetary policy, which restricts the price level to a certain value.

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ABU ASAB And CUESTAS

(2003), Van der Merwe (2004), have been written to assess the benefits of adopting this framework in

different developing and emerging economies.2 Empirical evidence that focuses on whether IT

strengthens the nominal anchor would be more telling about these gains.

The benefits gained from this framework have encouraged more countries, namely emerging mar-

ket economies and developing countries, to adopt it. Hence, several empirical studies have searched

for the possibility and readiness to shift towards IT in different economies, and come up with different

conclusions. In case of emerging markets, once preconditions of stable economy are met, IT can be

used to shift the economy from high to low inflation equilibrium (Martinez,2008).

Undoubtedly, adopting IT across developed countries has encouraged emerging market economies

to move towards this framework. However, the experience of IT in developing countries reflects that a

transition period was needed to adopt the highest form of IT, that is the full-fledged. Therefore, many

scholars have studied the readiness of developing inflation targeters to move towards the full-fledged

IT, while others have focused on assessing the ability of developing non-inflation targeters to follow

IT framework.

Alamsyah, Joseph, Agung, and Zulverdy (2001) investigate whether Indonesia was able to follow

the full-fledged IT after the introduction of the new central bank Act of May 1999.3 The findings

suggest that the existing preconditions cannot be satisfied and need to be improved. In Hungary, Siklos

and Abel (2002) find that the country is ready for full-fledged IT, although the relative responsibilities

and expectations of the central bank and government need clarification and elaboration.

For Tunisia, Boughrara (2007) explores the ability of Tunisia to move to IT. A VAR methodology

is used, and the results indicate that adopting IT strategy may lead to increase exchange rate volatility,

which generates uncertainty about future inflation, the effect which weakens the controllability over

inflation. In another study conducted by Boughrara, Boughzala, and Moussa (2008a), andBoughrara,

Boughzala, and Moussa (2008b) the authors simulate the effectiveness of IT under the current finan-

cial system in Tunisia, by testing the reaction of frozen loans to official interest rates, suggesting that

Tunisia has to improve its financial market structure before adopting IT.

Both Youssef (2007) and Awad (2008) review the prerequisites for IT in Egypt. The former focuses

on the financial sector, the central bank's transparency, credibility, technical capabilities and account-

ability. The latter tests the efficiency of the monetary aggregates strategy, adopted by the central bank

of Egypt, and finds that the current monetary regime is not satisfactory and adopting IT is preferred

once the institutional preconditions are reached.

Boughrara et al. (2008a, 2008b) examine the transmission mechanisms in Morocco, in an attempt

to clarify the effectiveness of monetary policy under the current financial market, concluding that

Morocco is not yet ready for adopting IT. Using the same approach, Neaime (2008) aim to shed light

on the monetary transmission mechanism across the Middle East and North Africa region. Their re-

sults show that the exchange rate has a dominant impact on the transmission mechanism of monetary

policy in Egypt, while in Jordan, Lebanon, Morocco and Tunisia, the interest rate plays a key role in

monetary policy effectiveness. The same result for Jordan is found by Poddar, Sab, and Khachatryan

(2006).

In this paper, we focus on the case of Jordan. For this country, the dollar depreciations in early

2002, and the 2008 financial crisis (Ghanem, 2010), as well as the difficult economic conditions of

Jordan after the 2003 Iraq War and the Arab Spring raise scepticism on the stability and sustainability

2Such as: Indonesia, Romania, Turkey, Ghana, South Africa, Thailand, Poland, Philippines, Peru, Mexico, Hungary, Chile

and Brazil.

3Indonesia has been categorised as a fully fledged inflation targeter since 2005.