Monetary shocks, exchange rates and trade balances: Evidence from inflation targeting countries Mehmet Ivrendi ⁎, Bulent Guloglu 1 Pamukkale University Department of Economics Kınıklı/Denizli 20070, Turkey abstract article info Article history: Accepted 15 March 2010 JEL Classification: E42 E4 F4 F31 C32 Keywords: Monetary policy Inflation targeting Trade balance Exchange rate SVECM This paper investigates the relationship among monetary policy shocks, exchange rates and trade balances in five Inflation Targeting Countries (ITCs). The investigation is based on Structural Vector Error Correction Models (SVECMs) with long run and short run restrictions. The findings reveal that a contractionary monetary policy shock leads to a decrease in price level, a decrease in output, an appreciation in exchange rate, and an improvement in trade balance in the very short run. Our findings contradict the findings of price, output, exchange rate and trade puzzles that have been found in many empirical studies. Furthermore they are consistent with the theoretical expectations regarding the effect of a contractionary policy. The only long run restriction that we imposed on our models is that money does not affect real macroeconomic variables in the long run, which is consistent with both Keynesian and monetarist approaches. © 2010 Elsevier B.V. All rights reserved. 1. Introduction The effect of monetary policy shock on exchange rates and trade balances has been and remains a prominent topic among academicians, policy makers and researchers. The reason is that the topic has important policy implications but empirical researches on the topic provide conflicting results. The empirical investigation regarding the effect of monetary policy shocks on macroeconomic variables is generally based on multivariate models such as VAR, SVAR, VECM, SVECM and the impulse response derived from them. To identify the monetary policy shock, it is necessary to impose some restrictions on the above econometric models. Such models are called Structural Vector Autore- gressive (SVAR) or Structural Vector Error Correction Models (SVECM), depending on cointegrating relationships among the variables. Most of the conflicting empirical results in the literature occur in consequence of restrictions imposed on the aforementioned econometric models. Previous studies found conflicted result regarding to the effect of IT monetary policy on macroeconomic variables. On the one hand, the influential paper of Mishkin and Schmidt-Hebbel (2007) argues that inflation targeting is successful in terms of achieving lower inflation, having smaller negative effects of oil price and exchange rate shocks on inflation, reinforcing monetary policy independence, improving monetary policy efficiency and obtaining inflation that is close to target level. But, in this paper, they claim that despite these successes, it is not clear whether monetary policy performance in countries adopted inflation targeting outperforms monetary policy in non-inflation targeting countries. On the other hand, Ball and Sheridan (2005) argue that inflation targeting does not make any difference in industrial countries: the apparent success of inflation targeting is due to the fact that inflation falls faster in countries that start with high inflation than in countries that start with a low inflation rate. That means the success reflects regression toward the mean, which should not be associated with the success of inflation targeting policy. Others arguing in this vein include Mishkin and Schmidt-Hebbel (2002) and Gertler (2005). They claim that the adoption of inflation targeting is an endogenous choice. Therefore, the findings of better monetary policy performance that are associated with inflation targeting may not imply that inflation targeting leads to better performance. In his recent paper, Mishkin (2008) argues that “inflation targeting has been a highly successful monetary policy strategy for many emerging market countries and has led to greater improvements in performance for advanced-country inflation targeters”. He compares emerging market inflation targeters with emerging market nontar- geters and claims that the former recorded close to a 0.8% reduction in inflation just after adopting inflation targeting and a 7.0% reduction in the long term. Furthermore, he stresses that emerging market inflation Economic Modelling 27 (2010) 1144–1155 ⁎ Corresponding author. Tel.: + 90 258 2962730; fax: + 90 258 2962696. E-mail addresses: mivrendi@pau.edu.tr (M. Ivrendi), bguloglu@pau.edu.tr (B. Guloglu). 1 Tel.: +90 258 2962739; fax: +90 258 2962696. 0264-9993/$ – see front matter © 2010 Elsevier B.V. All rights reserved. doi:10.1016/j.econmod.2010.03.005 Contents lists available at ScienceDirect Economic Modelling journal homepage: www.elsevier.com/locate/ecmod