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  • Inflation Targeting and Monetary Integration

    in European Emerging Market Economies

    Inaugural-Dissertation

    zur Erlangung des akademischen Grades eines Doktors

    der Wirtschafts- und Sozialwissenschaften

    der Christian-Albrechts-Universität zu Kiel

    vorgelegt von

    Diplom-Volkswirt Felix Hammermann

    aus Wuppertal

    Kiel 2008

  • i

    Gedruckt mit Genehmigung

    der Wirtschafts- und Sozialwissenschaftlichen Fakultät

    der Christian-Albrechts-Universität zu Kiel

    Dekan: Professor Dr. Helmut Herwartz

    Erstberichterstatter: Professor Dr. Thomas Lux

    Zweitberichterstatter: Professor Dr. Rolf J. Langhammer

    Tag der Abgabe der Arbeit: 4. Februar 2008

    Tag der mündlichen Prüfung: 15. Mai 2008

  • ii

    Acknowledgement

    I would like to thank my supervisors Professor Thomas Lux and Professor Rolf J.

    Langhammer for their unstinting support. I am particularly indebted to Rainer Schweickert for

    his continual encouragement. His numerous comments on all stages provided invaluable

    guidance. I also owe many thanks to my co-author Mark Flanagan.

    I am grateful for the hospitality of the International Monetary Fund and the Universitat

    Pompeu Fabra as well as for the financial support of the German Academic Exchange Service

    (DAAD) and the Monetary Stability Foundation of the Deutsche Bundesbank.

    I am thankful to Professor Dennis Snower, the professors in the Advanced Studies Program,

    the guest researchers at the Kiel Institute, and the Money-Macro Reading Group for thrilling

    discussions on the most recent advances in macroeconomics and international economics.

    I benefited from insightful discussions with Guido Ascari, Joachim Benner, Paul Bergin, Sven

    Blank, Dora Borbély, Claudia Buch, Kai Carstensen, Martina Cecioni, Alper Çenesiz, Björn

    Christensen, Ester Faia, Jordi Galí, Rafael Gerke, Gerd Hansen, Albert Jäger, Annette and

    Christophe Kamps, Jörn Kleinert, Robert Kollmann, Harmen Lehment, Matthias Lücke,

    Carsten-Patrick Meier, Tommaso Monacelli, Franziska Ohnsorge, Frank Oskamp, Christian

    Pierdzioch, Vahe Sahakyan, Anna Schenck, Andrea Schertler, Marcus Sonntag, Mewael

    Tesfaselassie, Cédric Tille, Markus Urban, Jaume Ventura, Lúcio Vinhas de Souza, Peter

    Welz, and Roland Winkler.

    I am also grateful for research assistance and technical support from Sabine Hübener,

    Michaela Rank, Christiane Gebühr, Anke Walsdorf, Marion Glowatzka, Werner Ente, Roger

    Raddatz, and Manfred Salden.

    I dedicate this thesis to my parents and siblings.

    Frankfurt, July 2008 Felix Hammermann

  • iii

    Contents

    Acknowledgement ................................................................................................................... ii Contents...................................................................................................................................iii List of Tables............................................................................................................................ v List of Figures ........................................................................................................................vii List of Abbreviations.............................................................................................................. ix 1 Introduction ................................................................................................................. 1 2 The Central Banks’ Choice of Inflation Targets: What Explains Persistent Inflation Differentials across European Emerging Market Economies?............... 7 2.1 Introduction ................................................................................................................... 7 2.2 Could the Inflation Differential Simply Be a Statistical Artifact? ................................ 9 2.3 Modeling the Inflation Differential ................................................................................ 12 2.4 Empirical Methodology and Results ........................................................................... 18 2.5 The Empirical Model .................................................................................................. 22 2.6 What Does the Model Say about the Inflation Differential?....................................... 29 2.7 Summary and Conclusions.......................................................................................... 33 Appendix ..................................................................................................................... 35 3 Evaluating the Role of the Exchange Rate in Inflation Targeting Regimes of Latin American and European Emerging Market Economies......................... 40 3.1 Introduction ................................................................................................................. 40 3.2 A Generalized Reaction Function ............................................................................... 41 3.3 Empirical Evidence from Inflation Targeting Regimes ................................................ 46 3.3.1 VAR Models for Countries in Latin America and Central Europe.............................. 46 3.3.2 Evidence from Latin America—Case Studies ............................................................... 50 3.3.3 Evidence from Central Europe—Case Studies.............................................................. 62 3.4 Conclusions ................................................................................................................. 71 Appendix ..................................................................................................................... 73 4 Inflation Targeting and Monetary Integration under ERM 2: Modeling Third-Country Effects from Production Sharing .................................................. 83 4.1 Introduction ................................................................................................................. 83 4.2 A New Keynesian Three-Country Model for Analyzing Optimal Monetary Policy Rules under ERM 2.......................................................................................... 86 4.2.1 Households .................................................................................................................. 87 4.2.2 Firms............................................................................................................................ 93 4.2.3 Solving the Model ....................................................................................................... 95 4.3 Simulation Results....................................................................................................... 98 4.3.1 Technology Shock in a Two-Country Model.............................................................. 98 4.3.2 Technology Shock in a Three-Country Model.......................................................... 101 4.3.3 Optimal Simple Rules in a Three-Country Model .................................................... 109 4.4 Conclusions ............................................................................................................... 112

  • iv

    Appendix ................................................................................................................... 115 5 Conclusions .............................................................................................................. 119 6 References ................................................................................................................ 122 7 Technical Appendix to Chapter 4 .......................................................................... 134 7.1 Households ................................................................................................................ 134 7.1.1 Utility Functions and Consumption Indexes............................................................. 134 7.1.2 Price Index................................................................................................................. 137 7.1.3 Exchange Rates ......................................................................................................... 138 7.1.4 Budget Constraint...................................................................................................... 148 7.1.5 Household’s Utility Maximization............................................................................ 150 7.1.6 Deriving Demand Functions ..................................................................................... 155 7.1.7 Aggregate Demand Function .................................................................................... 160 7.1.8 Individual Demand in Terms of CPI Basket ............................................................. 180 7.1.9 Goods Market Clearing ............................................................................................. 181 7.1.10 Loglinerarizations...................................................................................................... 193 7.1.11 Rewriting Some Equations........................................................................................ 212 7.2 Firms.......................................................................................................................... 216 7.2.1 Variables.................................................................................................................... 216 7.2.2 Firm’s Cost Min