Inflation Targeting and Its Impact on the Nature of the Money Supply and the Financial Imbalances

This paper provides a theoretical framework for a thesis that the transition to the inflation targeting regime, either explicit or implicit, may be one of the causes of the long-term latent accumulations of the financial and structural imbalances, materializing much later and with more dire consequences. Due to the long-term systematic manipulation of interest rates, within the operational framework of the stabilization of consumer prices and the output gap, as well as of anti-deflationary fundamentalism, the economy can transform itself into a kind of "black box", gradually and over time causing an "escape" of credit and monetary aggregates. Money supply tends to be more endogenous and elastic, changing the causality within a link between the money supply and its effective economic materialization, both in production processes of the real economy as well as in banking and financial services. Thereby, the economy lacks a needful defensive mechanism that would pull the overheating economy back through more exogenous and inelastic money supply, automatically adjusting market interest rates. In the empirical part we employed VECM tests to show that the money supply was exogenous before the implicit adoption of inflation targeting in the USA (1985), but endogenous after it.

Keywords: monetary policy, inflation targeting, endogenous money supply, asset-price bubbles, financial imbalances, VECM