3.

Inflation targeting regime and income

distribution in emerging market
economies
Lilian Rolim and Nathalie Marins

INTRODUCTION

The inflation targeting (IT) regime is one of the main policy prescriptions of
the New Consensus Macroeconomics (NCM). This framework, which sets
a low inflation rate as the main goal of monetary policy, has been adopted since
the late 1990s by a growing number of emerging market economies (EME).
Although its success in achieving lower inflation rates is highlighted by its
proponents, higher sacrifice rates for EME in terms of output and employment
have also been admitted (Brito and Bystedt, 2010, Fraga et al., 2003). Yet, the
impacts of the IT regime on income distribution are not a major concern in this
literature.1 This aspect, however, has long been emphasized by post-Keynesian
authors who highlight monetary policy’s intrinsic distributive effect.
In many aspects the IT regime is at odds with the post-Keynesian perspec-
tive,2 even though some authors do recognize that the idea of targeting an
inflation rate can be made compatible with this approach if additional instru-
ments are employed (Lima and Setterfield, 2008; Setterfield, 2006). The main
concern presented by post-Keynesians is that the pursuit of a low inflation rate
as the primary goal of monetary policy can have adverse effects on real output
and employment.
Moreover, post-Keynesians also emphasize that the IT regime has impor-
tant (and likely undesirable) distributive implications. From a conceptual
standpoint, Seccareccia and Lavoie (2010, p. 39) argue that, rather than being
a direct implication of the NCM, the IT regime was originally conceived as
“another type of incomes policy in the traditional sense of a guidepost that
could modify expectations of inflation”. Yet, as an alternative to the voluntary
guideposts, the IT regime provides the central bank (CB) with an enforcement
capacity (through interest rate policy) and is politically more viable, especially
as labor unions can try to resist compulsory incomes policies (Seccareccia

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and Lavoie, 2010). More precisely, the IT regime can influence income
distribution in two ways. It may frame the wage bargaining process so that
wages grow in line with the (targeted) inflation rate and, thus, productivity
gains are not shared with workers and their income share is negatively affected
(Seccareccia, 2019). Even when unconventional monetary policies are in place
(as in the recent US experience analyzed by Seccareccia, 2017), this character
of the regime can be verified as these policies seek solely to preserve finan-
cial assets returns or avoid financial assets price deflation (e.g., quantitative
easing policy) rather than promoting a change in the “pro-rentier policy box”
(Seccareccia, 2019). Additionally, if the IT regime requires higher interest
rates to face inflationary pressures, it can lead to a worsening in the functional
income distribution, expressed by a lower wage share (Rochon and Setterfield,
2007).3
Post-Keynesians also take an alternative view on the determinants of the
inflation rate, which leads to criticisms over the assumed monetary policy
transmission mechanisms. In this perspective, the inflation rate is understood
as resulting from the class conflict over the distribution of income. Thus,
monetary policy or, more specifically, interest rate setting, can only affect
the inflation rate if it affects the terms under which this conflict takes place
(Smithin, 2003) and, in this case, it will inevitably exert some influence on the
income distribution.
These considerations have led post-Keynesian authors to propose alter-
native monetary policy rules, which may be countercyclical rules concerned
with economic activity or rules related to income distribution (see Rochon,
2017, for a summary). The latter group of rules aims at a neutral impact on
income distribution, and each rule presents a specific understanding of what
such neutrality means and how it can be achieved, as well as different views
with respect to the euthanasia of the rentier (see Smithin, 2020, for a discussion
on these different notions). Examples of this group are the “Smithin rule”,
according to which the real interest rate should be low and positive (Smithin,
2007) or, in a more recent version, equal to zero (Smithin, 2020); the “Kansas
city rule”, which argues for a zero nominal interest rate (Wray, 2007); and the
“Pasinetti rule”, which states that the real interest rate should be equal to the
labor productivity growth rate (Lavoie and Seccareccia, 1999).
This chapter aims to contribute to this debate by focusing on the specificities
of EME. Indeed, adding to the considerations presented by post-Keynesians
with respect to the IT regime’s operation in practice, its idiosyncratic working
in EME raises further concerns. Given some specific characteristics, these
economies are more vulnerable to external shocks and the exchange rate is
a key monetary policy transmission mechanism. In a post-Keynesian perspec-
tive, such importance of the nominal exchange rate channel has relevant dis-
tributive implications, as the real exchange rate is also a distributive variable.

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Our analysis considers this channel, as well as other distributive impacts of the
interest rate that have been put forward in the literature in order to explore the
IT regime’s distributive impact. As the post-Keynesian inflation theory under-
takes a class perspective, our focus is on the functional income distribution
(how income is split between profits and wages). Therefore, hereafter the term
“income distribution” refers to the functional income distribution.4 From this
analysis, we provide some insights that can be useful for rethinking monetary
policy rules in EME.
The remainder of this chapter is organized as follows. In the next section
we present the IT regime, its specificities in EME and a critical view based on
the post-Keynesian approach to inflation. In the third section we discuss the
channels through which the IT regime can affect income distribution in EME.
Concluding remarks are presented in the final section.

AN ASSESSMENT OF THE INFLATION TARGETING

REGIME IN EME

The IT regime can be briefly described as a monetary policy framework that

involves a publicly announced target for the inflation rate by the CB and the
commitment to price stability as its primary goal. In addition, even though
there is room for other short-run stabilization objectives, the absence of any
commitment to a level of the exchange rate is considered necessary for its
credibility and success (Savastano et al., 1997). While the design and con-
duction of the regime can vary across countries, in the general framework the
short-term interest rate setting by the CB should follow a “rule-like” strategy.
That is, the CB policy interest rate should be altered with the aim of achieving
the determined inflation rate target.
In the next subsections, we explore the traditional transmission mechanisms
of monetary policy in this framework, which are used to justify the IT regime’s
effectiveness in controlling the inflation rate. Then, we present some criticisms
to this view based on empirical analyses of the IT regime in EME and on the
post-Keynesian theoretical approach to inflation.

Traditional Monetary Policy Transmission Mechanisms

The IT regime is one of the main policy prescriptions derived from the
so-called NCM. This framework results from the understanding that infla-
tion is, essentially, a demand-led phenomenon. As such, it is expected that
monetary policy transmission mechanisms operate through demand variables,
which will take the inflation rate to the targeted value. Studies that follow this
perspective usually identify five transmission channels of monetary policy in
open economies: (i) the interest rate channel; (ii) the long-term interest rate (or

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asset price) channel; (iii) the credit channel; (iv) the expectations channel; and
(v) the exchange rate channel.
The first channel, the interest rate channel, relates to the direct effect of
the policy rate, controlled by the CB, on business and household spending
decisions. The assumption is that changes in the overnight interbank rate
spread to the most relevant interest rates to investment and durable goods
consumption. Thus, the well-functioning of this channel depends both on the
propagation of the policy rate along the term structure of interest rates and on
the interest rate sensitivity of the aggregate demand components (consumption
and investment). The second channel, the asset price channel, relates changes
in monetary policy (through its effect on long-term interest rates) to bonds,
stock markets and real estate prices, as they are inversely related to long-term
interest rates. These assets prices, in turn, would influence aggregate demand,
assuming that consumption depends on households’ wealth and that new
investments respond to the stock and bond markets (Agénor and Da Silva,
2019).
The third channel, the credit channel, relies on the assumption of credit
market frictions and credit rationing by banks and can be divided into two: the
narrow credit channel and the broad credit channel, which is also known as the
balance sheet channel (Arestis and Sawyer, 2003, p. 16). The first effect relates
to the market frictions assumption and to the premise that banks rely on depos-
its, subject to reserves requirements, as a source of funding. If a policy-induced
interest rate hike leads to an increase of non-performing loans in the banks’
balance sheets then, as they cannot replace lost deposits with market borrow-
ing, credit supply would be adversely affected. In addition, through the balance
sheet channel, the banks’ credit supply could be affected by a deterioration of
borrowers’ collateral values net worth. As collateral declines, owing to higher
policy-induced interest rates that result in falling asset prices, borrowers’
access to credit would decline, thus affecting aggregate demand (Mohanty and
Turner, 2008).
The fourth channel, the expectations channel, influences the transmission
of all other channels and, theoretically, assumes forward-looking and rational
agents. It is assumed that firms and households anchor their interest rate expec-
tations to the known policy rule and their long-run inflation expectations to the
established target. Thus, after an interest rate hike, agents would expect a slow-
down in economic activity. This would affect their consumption, investment
and pricing behavior and, therefore, prices will tend to increase less (Pruski
and Szpunar, 2008).
Finally, the exchange rate transmission channel depends on the assump-
tion that a policy-led cut in the interest rate leads to capital outflows and to
a depreciation of the nominal exchange rate (increase in the nominal exchange
rate level) and it operates both directly and indirectly on the inflation rate.

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Directly, changes in the nominal exchange rate affect the domestic prices of
imported goods and thus the targeted price index. This effect is known as the
pass-through effect from the exchange rate to prices and, differently from
the channels presented above, it operates through costs rather than demand.
Indirectly, by altering the real exchange rate and relative prices, the nominal
exchange rate can affect not only inflation but also output and aggregate
demand. Assuming the sticky prices hypothesis, an increase in the nominal
exchange rate leads to a real depreciation, making domestic tradable goods
more competitive and thus increasing the demand for these products. This
expansionary effect on aggregate demand may, however, not be in place when
the import content is high. In this case the exchange rate would have a limited
impact on domestic production and the direct impact on inflation would
prevail. Also, in this perspective, the exchange rate often constitutes a key
variable for private sector expectations about inflation (Mohanty and Turner,
2008).
This last channel is likely to be particularly relevant in EME and can impose
further challenges for monetary policy setting in this framework. In the NCM
literature, the importance of the exchange rate in these economies is referred
to by Fraga et al. (2003, p. 24) as “external dominance” and is said to reflect
their “weaker fundamentals” such as a dirty floating exchange rate regime and
a low degree of openness. Instead, in the next subsection, such importance of
the exchange rate channel in EME and their vulnerability to external shocks
are presented as consequences of some specific structural characteristics of
these countries.

EME Specific Characteristics and the Role of the Exchange Rate

Although a free-floating exchange rate was initially established by the NCM

as a necessary condition for implementing an IT regime, CBs in EME do take
actions to avoid sharp exchange rate movements (Agénor and Da Silva, 2019;
Bank for International Settlements, 2005). These interventions can be justified
by some specific characteristics of their currencies, which make them subject
to imported volatility. Therefore, this section takes a closer look at the impact
of the exchange rate in these economies.
In a post-Keynesian framework, nominal exchange rate movements are
considered a function of financial flows and derivative exchange rate posi-
tions of international investors’ portfolio allocation decisions (Harvey, 2009;
Schulmeister, 2009). In this context, EME currencies are mostly used as
a speculative asset class in offshore markets (Guttmann, 2016; McCauley and
Scatigna, 2011), so that the differential between the internal and the external
interest rate and the external risk aversion sentiment can strongly influence the
international demand for these currencies (Conti et al., 2014). This asymmetric

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use in international markets makes EME’s currencies subject to appreciation

trends during booms and sharp depreciation pressures during crises (Andrade
and Prates, 2013; Kaltenbrunner, 2015) and implies that EME’s exchange rates
are more sensitive to external shocks than to internal macroeconomic condi-
tions, especially in times of crises. This feature makes the nominal exchange
rate a transmission mechanism of external shocks to the domestic economy,
which becomes more relevant the higher the degree of international integra-
tion. Also, in EMEs where the amount of external liabilities is high (even
when denominated in the country’s own currency), the impact of external dis-
turbances on the nominal exchange rate might be stronger when international
investors wish to sell their EMEs’ financial assets to meet their obligations
abroad (Kaltenbrunner, 2015).
Another consequence of the different usages of EME currencies interna-
tionally can be found in the external liabilities of public and private residents
of EME. Since their currencies are not accepted for international indebtedness
and, in some cases, not even for long-term indebtedness within their own
country, these economies tend to have their liabilities denominated in foreign
currency. The resulting currency mismatch between assets and liabilities
explains why the exchange rate channel also operates via a balance sheet effect
in EME. In highly dollarized economies (or in countries where residents are
net debtors to the rest of world), an expansionary monetary policy (reduction
of interest rates) that leads, ceteris paribus, to an increase in the exchange rate
and, thus, to a rise in private foreign liabilities (denominated in domestic cur-
rency), can generate the opposite result in aggregate demand to that expected
by the NCM framework. That is, via the balance sheet effect, depreciating
exchange rates can have a contractionary impact (Vernengo and Caldentey,
2019).
The more important role of the exchange rate as a transmission mecha-
nism in these economies also derives from EME’s underdeveloped and less
diversified industrial structure, which results in a higher share of imported
manufactured products (with high-income elasticity and low price-elasticity)
and exports mostly dependent on low value-added products and commodities
(UNCTAD, 2002).
EME with this foreign trade composition, are unable to compensate
exchange rate appreciations (decline in national currency export revenues)
with an increase in the prices of their exported products, either because these
prices are determined in the international market, as in the commodities sector,
or because this would cause a reduction in the external demand for its prod-
ucts. On the other hand, when an exchange rate depreciation occurs imported
manufactured products become more expensive and – because they are not
replaced by domestic products (owing to their low price-elasticity) – there can
be a more persistent impact on the price level (but with a temporary impact

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on the inflation rate). The increase in price level, however, will not only
affect finished goods that are produced abroad, but also all products that have
imported components in their supply chains. A similar point, although focused
on the inflation rate, is made by Bastian and Setterfield (2020), who argue
that structural vulnerabilities of developing economies make them more likely
to experience permanent effects even on their inflation rates after transitory
exchange rate shocks.
Matters are further complicated by additional characteristics of EME. For
instance, food prices have a higher relative share in household consumption
baskets than in industrial countries, which makes EME price indexes more
sensitive to the exchange rate. In addition, countries with a high or recent
inflationary memory can present higher indexation rates, so the pass-through
effect of devaluations can present long-lasting consequences (Farhi, 2007).
Thus, as Bastian and Setterfield (2020, p. 3) claim, structural aspects, such
as “the composition of final output, the baskets of goods that make up exports
and imports, the state of industrial relations, the openness of the economy to
international trade and financial flows, and the degree of external indebted-
ness”, can make developing economies more exposed to exchange rate shocks.
Another dimension of the role of the exchange rate in these economies is
that it is the main channel of monetary policy therein. For instance, the argu-
ment that demand channels do not work well, making the exchange rate the
primary mechanism to fight inflation within the IT regime in EME is made by
Summa and Serrano (2018) for the case of Brazil, by Benlialper and Cömert
(2015) for Turkey and by Ros (2015) for the Mexican case. Thus, as an excep-
tion to the channels presented in the previous subsection, which are expected to
fight inflation originated from demand pressures, the exchange rate can exert
great influence in EME’s inflation rate determination through cost pressures.
In short, the centrality of the exchange rate in EME calls into question
some of the assumptions underlying the IT regime framework. Indeed, the
working of IT monetary policy transmission relies on several theoretical NCM
assumptions that have been contested both theoretically and empirically by
post-Keynesian authors (Arestis and Sawyer, 2003; Caldentey and Vernengo,
2013; Seccareccia and Lavoie, 2010). The post-Keynesian inflation theory,
which is the focus of the next subsection, also offers an alternative framework
for understanding the critical role of the exchange rate identified for EME and
the possible transmission mechanisms of monetary policy therein.

Post-Keynesian Inflation Rate Theory

The post-Keynesian literature on inflation offers an alternative approach to

that emphasized by the mainstream literature. As discussed above, in this
latter approach, inflation is considered a monetary phenomenon mostly caused

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by demand pressures. Consequently, the IT regime expects to fight inflation

through the effect of the interest rate on demand variables. Alternatively, the
post-Keynesian inflation theory leads to a reconsideration of what are the mon-
etary policy transmission mechanisms as inflation is assumed to be a cost-side
phenomenon. Thus, the observed centrality of the exchange rate in the EME’s
experience with the IT regime can be explained as a direct implication of its
influence on cost variables and pricing decisions, rather than being treated as
an exception as in the NCM view.
Post-Keynesians consider that inflation results from the conflict between
workers and capitalists over the distribution of income, making it a cost-push,
supply-side phenomenon (Lavoie, 2014; Smithin, 2003). This is considered
the primary cause of inflation because prices are mainly determined by costs of
production (wages) and profit rates (Rochon and Rossi, 2006) and, ultimately,
it means that inflation is determined by conflict and power (Setterfield, 2005).
Yet, the post-Keynesian view of inflation does not dismiss the possibility of
demand-pull inflation, but demand pressures are not considered a dominant
explanation of inflation (Rochon, 2017).
This approach follows the contributions by Kalecki (1971, ch. 14) and
Rowthorn (1977). The former assumed that the mark-up firms add to their
unit costs reflects their market power, as well as that labor unions can try to
increase their share of income by demanding nominal wage increases. Building
on Kalecki’s contribution, Rowthorn (1977) argued that this militancy by
workers can lead to a faster rate of inflation as firms try to protect themselves
by passing on their higher costs to prices (with partial success). Conversely,
capitalists can try to increase their income share by putting in place a more
aggressive profits policy, but workers will try to protect themselves and infla-
tion increases. In sum, if workers and capitalists have inconsistent claims over
the income distribution, these claims will be conciliated through inflation as
workers try to achieve their desired income share by demanding nominal wage
increases and firms react by increasing their price levels to compensate (at
least partially) their higher labor costs, reaching a compromise in terms of the
real wage and income shares (Lavoie, 2014; Rowthorn, 1977).
Besides the extent to which workers’ and capitalists’ claims diverge, each
class’s bargaining power will also affect the inflation rate and the functional
income distribution. For instance, if there is an increase in workers’ bargaining
power, while firms’ bargaining power is kept constant, there is an increase in
the inflation rate and a shift in income distribution in favor of workers. An
increase in firms’ bargaining power will also lead to higher inflation, but the
change in income distribution will favor firms (if workers’ bargaining power
does not increase proportionally). Finally, if the discrepancy between workers’
and firms’ targeted real wages increases, inflation increases, although the final

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effect on income distribution will depend on how each targeted real wage
changed.
In this framework, institutions can exert some impact on the inflation rate.
As argued by Setterfield (2005, p. 160), structural reforms that create “a labor
market environment in which workers’ employment and income prospects are
rendered insecure” can reduce workers’ bargaining power and their ability to
fight for higher nominal wages. In this context, the labor market institutional
setting may act as a “worker discipline device” (Setterfield, 2005, p. 160).
This aspect is stressed by authors who undertake more structural analyses, for
instance, of the lower and more stable inflation rates in many economies since
the 1980s (Setterfield, 2005; Stirati and Meloni, 2018; Summa and Braga,
2019).
In addition, macroeconomic variables that affect the class conflict will also
exert some impact on the inflation and income distribution dynamics. This
would be the case of the interest rate and the exchange rate, as will be explored
in the next section. As argued by Smithin (2003, p. 178), although inflation
caused by cost-push pressures seems to be impervious to monetary policy, if
the wage bargain is responsive to variables that react to the monetary policy,
“a channel by which monetary policy can have an impact on inflation is rein-
troduced”. Thus, policy tools that affect the conditions under which this con-
flict takes place will affect both the inflation rate and the income distribution.
Therefore, while the IT regime relies on the interest rate to fight inflation-
ary pressures that most likely do not originate from demand pressures, there
are supply side channels that render some effectiveness to using interest
rates to curb inflationary pressures. One of these channels is the nominal
exchange rate, which, as shown in the previous section, is especially relevant
in EME. Consequently, in a post-Keynesian perspective, the critical role
of the exchange rate in EME can be explained, not only by EME’s specific
characteristics, but also because inflation is cost-determined and in EME the
exchange rate is an important cost factor, which also affects the class conflict
between workers and firms. In this context, the effect of the IT regime or, more
precisely, the effect of changing the interest rate to achieve an inflation target,
will be mediated by the exchange rate. As such, it will inevitably exert some
influence on the income distribution. The different partial effects of the interest
rate and the exchange rate, as well as the resulting interaction between these
variables in the IT regime, are explored in the next session.

THE DISTRIBUTIVE EFFECTS OF THE INFLATION

TARGETING REGIME

The post-Keynesian approach presented in the previous section allows a more

precise analysis of the distributive implications of the IT regime, as it shows

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that inflation and income distribution are intrinsically related. As discussed

above, the interest rate and the exchange rate are particularly important to
the working of the IT regime in EME and, from a post-Keynesian perspec-
tive, both variables alter the income distribution and the terms of the class
conflict between workers and capitalists, thus affecting the inflation rate. The
remainder of this chapter analyzes the distributive impacts of the interest rate
and includes the exchange rate as a channel through which monetary policy
affects the inflation rate and income distribution, while also exploring addi-
tional channels that may be in place. The impact of the IT regime on income
distribution is then scrutinized by considering how it operates under different
circumstances.

Partial Effects of the Interest Rate on Income Distribution

In the post-Keynesian literature, the interest rate is a distributive variable that

affects both directly and indirectly the income distribution. Therefore, the
CB’s decisions with respect to this variable can affect the different income
groups differently, redistributing income between them. This section provides
a (non-exhaustive) review of the main channels that relate the interest rate to
the functional income distribution: (i) the direct channel; (ii) the cost-push
channel; (iii) the economic activity channel; and (iv) the exchange rate channel.
First, the “direct channel” of the interest rate consists of the idea that it
redistributes income from debtors to creditors. This argument appears in
two distinct forms in the literature. Pasinetti (1962), for instance, argues that
any interest rate that differs from the natural (or fair) interest rate distorts the
income distribution. In the “labor principle of income distribution”, the natural
(or fair) interest rate would be the rate that keeps the income distribution in
terms of command over labor hours constant between debtors and creditors
(Lavoie and Seccareccia, 1999; Pasinetti, 1962). Alternatively, Argitis and
Pitelis (2001) argue that changes in the interest rate will have a direct effect
on the intraclass income distribution between industrial (debtors) and finan-
cial (creditors) capitalists. Their argument may be extended to the functional
income distribution between wages and profits if it is assumed that workers
also finance part of their consumption or residential investment through loans.
Second, the “cost-push channel” of monetary policy arises if interest pay-
ments are perceived as a production costs. In this case, and especially if the
increase in the interest rate is perceived as permanent, firms may pass their
higher financial costs on to prices or try to lower labor costs (Argitis and
Pitelis, 2001).5 Consequently, there could be a positive relation between inter-
est and inflation rates, which has also been referred to as the “price puzzle”
and appears in a number of heterodox and orthodox contributions, which rely
on different mechanisms (see Lima and Setterfield, 2010, for a review). In

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terms of income distribution, the effect of changes in the interest rate through
this channel would depend on how successful firms are in protecting their real
income (and thus affecting real wages). This mechanism is also central to the
Sraffian theory, which relates the long-term real interest rate to the income
distribution by assuming that interest rates are perceived as production and
opportunity costs, so the rate of interest is considered the regulator of the real
wage (Pivetti, 1985, 1991).
Third, through the “economic activity channel”, monetary policy may
influence the outcome of the conflict between workers and firms by affecting
workers’ bargaining power through its effect on economic activity. This
channel depends on the interest rate affecting the economic activity, which is
not guaranteed,6 as well as on the latter affecting workers’ bargaining power
(whether a lower unemployment rate reduces the effect of unemployment as
a discipline device).7 Thus, a higher interest rate can exert a negative effect on
economic activity and unemployment, reducing workers’ bargaining power
and leading to a reduction in the wage share and inflation rate (Rochon and
Setterfield, 2007; Smithin, 2003). As emphasized by Setterfield (2005, p. 157),
similarly to labor market reforms that bring insecurity to workers, this effect
controls inflation through “incomes policy based on fear” – in this case, fear
created due to a labor market outcome (unemployment).
Finally, the “exchange rate channel” operates through the changes in the
domestic currency following interest rate shocks.8 There are two effects of the
exchange rate on the variables under study. The first is the effect of a nominal
domestic currency depreciation on the price level: as imported (intermediate
and final) goods and private external debt (denominated in foreign currency)
service become more expensive in the domestic currency, the domestic price
level increases. Consequently, there is a temporary increase in the inflation
rate. This pass-through effect from the exchange rate to prices is known to be
particularly strong in EME (Mohanty and Scatigna, 2005) and, as discussed in
the previous section, it can have a persistent impact on the price level. If this
effect is not counteracted by nominal wage adjustments of the same magni-
tude, the real wage will decrease. The second effect of a domestic currency
depreciation is to increase domestic firms’ mark-up, as their international
price competitiveness increases (Blecker, 1989, 2011; Ribeiro et al., 2020).
As argued by Blecker (1989, p. 401), it would be implausible to assume that
firms keep a fixed mark-up regardless of the external scenario, as it would
imply that “firms pass on 100% of increases in unit labour costs in the form
of higher prices regardless of how uncompetitive domestic products become
and how much their market share falls”. Thus, it is reasonable to assume that
the real exchange rate affects the mark-up of private firms insofar as firms
try to benefit from their greater competitiveness. One may also consider
that this relation between firms’ mark-up rates and the exchange rate results

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from prices (in foreign currency) in the tradables sector being determined at
the international level (exogenously to the domestic economy). This would
mean that changes in the exchange rate have an automatic effect on the export
sector’s revenues, which can also have implications for inter-industrial pay
inequality (if this sector is relatively well-paid), as pointed out by Rossi and
Galbraith (2016). In the conflicting-claims inflation model, this effect can be
included by assuming that firms’ target and realized mark-up rate (or income
share) increases with increases in the real exchange rate (Blecker, 2011; Sasaki
et al., 2013).9 As a consequence, a real depreciation of the domestic currency
would cause a reduction of the wage share, as has been empirically confirmed
(Ribeiro et al., 2020; Rossi and Galbraith, 2016), as well as an increase in the
inflation rate.

Figure 3.1 Monetary policy transmission mechanisms

Therefore, a currency depreciation is expected to lead to an increase in the

level of the inflation rate as it exacerbates the conflict over the income dis-
tribution between capitalist and workers (in favor of the former). A currency
appreciation, on the other hand, is assumed to have the opposite effect. Thus,
if an increase in the domestic interest rate leads to a lower (nominal and real)
exchange rate, the “exchange rate channel” will exert a positive effect on
workers’ income share. Yet, as will be explored below, not only is this effect
of the interest rate on the exchange not guaranteed, but also the overall effect
on income distribution will depend on the other mechanisms in place.

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74 The future of central banking

In short, monetary policy presents different and potentially conflicting

partial effects on the functional income distribution, as represented in Figure
3.1. On the one hand, a lower interest rate would benefit workers through the
direct, cost-push and the economic activity channels. In most cases, a higher
inflation rate would also follow (except for the cost-push channel). On the
other hand, a lower interest rate may, ceteris paribus, lead to a currency depre-
ciation, which is expected to decrease the wage share and increase the inflation
rate through the exchange rate channel. Thus, considering the exchange rate as
a monetary policy transmission mechanism may lead to qualitatively different
conclusions about a monetary policy’s implications to income distribution and
inflation control.

Inflation Targeting Regime and Income Distribution

The distributive impact of the IT regime ought to be analyzed by considering

the transmission mechanisms summarized in Figure 3.1, making it subject
to country- and time-specific characteristics. This is particularly relevant
for EME, as the exchange rate is considered a key transmission mechanism
of monetary policy therein, which, ceteris paribus, reacts to changes in the
domestic interest rate. Indeed, monetary policy’s effect on the income distribu-
tion depends on the strength of each transmission channel, on the inflationary
sources and on the adopted institutional framework. These aspects form differ-
ent layers that interact with each other.
At the first layer, we have the strength of the transmission mechanisms
through which the IT regime operates. If the economic activity strongly
responds to the interest rate, making this the predominant channel, workers’
bargaining power may be an important transmission mechanism of the regime.
In this case, if higher interest rates are required to achieve the inflation target,
there could be a detrimental effect on workers’ income share.10 The strength
of this channel is likely to depend on country-specific characteristics, espe-
cially those related to the labor market institutions. In this sense, Summa
and Braga (2019, p. 4) argue that the relation between economic activity (or
unemployment) and wages “must be seen as mediated by social, political and
institutional aspects”. Thus, the overall effect on income distribution would
depend on how economic activity and unemployment react to changes in the
interest rate, but also on the sensitivity of workers’ bargaining power to the
unemployment rate.
An alternative outcome would occur if the exchange rate channel were
the most important channel as, in this case, inflation would be controlled by
nominal exchange rate appreciations that could benefit workers and lead to
a higher wage share. The strength of this channel depends on the sensitivity of
the exchange rate to the domestic interest rate, which can vary depending on

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 Inflation targeting regime and income distribution 75

international conditions (Conti et al., 2014). As EME’s currencies are not con-
sidered liquid (or safe assets) at the international level, their foreign demand
is subject to investors’ risk appetite (Andrade and Prates, 2013). Thus, when
global risk aversion is low, relatively small domestic interest rate increases
might be enough to attract financial flows that result in currency appreciation.
In an alternative scenario; however, interest changes by the CBs in EME
might not be enough to compensate for the depreciation pressures that might
adversely impact the inflation rate. Also, countries with large external liabili-
ties may suffer more depreciation pressures than countries that are relative less
integrated and, thus, may need a more active monetary policy response.
In addition, how exchange rate movements impact the inflation rate will
depend on domestic firms’ sensitivity to international competition, on the
relative size of the tradable sector, and on the share of imported goods. When
this effect is strong, the CB may tend to fight against depreciation and tolerate
appreciations, as the former increases the inflation rate, while the latter helps
the CB to meet the inflation target. Yet, the effect of this asymmetric mone-
tary policy response, which favors currency appreciation in order to reduce
inflation, on the wage share will depend on each country’s specific character-
istics and other policies in place. In Brazil, for instance, Summa and Serrano
(2018, p. 358) argue that “when the central bank can increase or maintain
a high interest rate differential and does not mind appreciation of the nominal
exchange rate, it can keep inflation low”. From 2004 to 2009, such exchange
rate appreciations were simultaneous to incomes policies that increased the
nominal wage and the overall effect was an increase in the wage share, as
the lower inflation rate (associated with the domestic currency appreciation)
allowed nominal wage increases to become real increases. In Mexico, on the
other hand, wage containment policies due to the historically low bargaining
power of Mexican workers (Capraro, 2015) were fundamental to keeping the
inflation rate lower and compensating for the negative effect of a more appre-
ciated currency on the Mexican export-led growth strategy.
At a second layer, we would have the different sources of inflation that will
trigger monetary policy reactions. The distributive effect of the IT regime in
response to different inflationary shocks will be subject to the strength of the
different transmission mechanisms. For instance, if there is a domestic cur-
rency depreciation, which impacts the inflation rate positively and decreases
the wage share, as in Blecker’s (2011) model, the response of the IT regime
may exacerbate this shock that has been detrimental for workers by exerting
a negative effect on the economic activity. If there is an asymmetric exchange
rate pass-through (Modenesi et al., 2017), the inflation generated by the cur-
rency depreciation will not be counteracted by an appreciation of the same
magnitude, thus demanding a strong reaction by the monetary policy and
possibly having severe implications for economic activity and the wage share.

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In this case, an alternative instrument that directly addresses the exchange rate
depreciation could be more adequate to fighting inflation.11
Conversely, if inflation results from workers’ bargaining power increasing
due to an improvement in economic activity, a policy interest rate rise (induced
by the IT regime) may not necessarily counteract the increase in the wage
share if the exchange rate channel is somewhat relevant. Yet economic activity
may be harmed depending on how domestic demand reacts to the interest rate
and net exports react to the exchange rate, but these outcomes will also be
mediated by how the exchange rate affects the income distribution, which has
implications for the relation between the exchange rate and economic growth
(Ribeiro et al., 2020). Similarly, other types of inflationary shocks (e.g., com-
modities prices) can be expected to have diverse impacts on the inflation rate
and income distribution depending on the monetary transmission mechanisms.
At the third layer, we may place the institutional setting adopted by the IT
regime, which will interact with the previous layers. The most relevant charac-
teristic in this sense would be the level of the inflation target and the adopted
tolerance band. If a low inflation rate level is targeted and/or a small tolerance
band is adopted, a relatively higher interest rate may be required. In this case,
the impact of this higher interest rate would depend on both layers previously
discussed: the inflationary source against which the regime is acting and the
strength of the transmission mechanisms. Thus, a lower interest rate associ-
ated with a less rigid regime does not always guarantee a higher wage share.
Concerning other institutional characteristics of the IT regime, such as the time
horizon, the adopted price index (core or headline index) or the consumption
basket considered in the index, the IT regime is likely to lead to higher interest
rate volatility if a more rigid framework is adopted. Yet, in terms of average
interest rates, the impact would be uncertain, unless there is a strong asymmet-
ric effect in place, which would once again induce higher interest rate levels.
At this point, another relevant aspect of the IT regime should be scrutinized.
As Seccareccia (2019) argues, this regime can work as an incomes policy that,
by altering the wage bargaining process, focuses the debate on inflation and
prevents workers from benefiting from productivity gains. Although our anal-
ysis does not consider productivity growth, we recognize that the IT regime’s
impact on how workers and labor unions form their demands (that is, whether
and to what extent their wage adjustment demands are based on the inflation
target) can be considered another institutional dimension, which is relevant
for our discussion. Yet, its effect also depends on whether other policies are
in place. As an example, in the 2000s the Brazilian economy experienced
increases in the wage share despite the IT regime adopted by the country. Not
only did the exchange rate appreciation play an important role in this process,
but also a number of public policies (in particular cash transfers and minimum
wage increases) led to real wage gains (Serrano and Summa, 2012). Thus, if

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wage adjustment negotiations can go beyond the unique focus on inflation, the
IT regime’s effect as an incomes policy can be diminished.
Therefore, the distributive effects of the IT regime in EME are quite
complex. The consideration of the exchange rate channel makes its effect
subject to various aspects that tend to be determined by structural and conjunc-
tural factors, such as the transmission mechanisms and the sources of inflation,
as well as by the IT regime institutional framework. In sum, one should not
expect a unique effect of the IT regime across different economies, especially
in EME, wherein the exchange rate channel is particularly relevant.

CONCLUSION

This chapter analyzed the distributive effects of the IT regime in EME fol-
lowing the post-Keynesian conflicting-claims inflation model. The literature
review on the IT regime indicates that it is expected to fight inflation essen-
tially through demand channels. However, post-Keynesians take issue with
this assumption as they consider that inflation is actually a cost side phenome-
non. In addition, they point out that the exclusive concern with the inflationary
control can have adverse effects on other economic variables, such as the
economic activity and the income distribution.
The EME’s experience with the IT regime adds further elements to this
critical assessment. As the main monetary policy transmission mechanism
therein is the exchange rate, it corroborates the post-Keynesian view that cost
variables are the most relevant determinants of inflation. Moreover, the impor-
tance of this channel in these economies suggests that the distributive impact
of the IT regime is quite complex. Indeed, once the exchange rate channel is
taken into account, the interest rate presents different partial (and possibly
contradictory) effects on the wage share. Therefore, the distributive impact of
the IT regime would be strongly dependent on country-specific characteristics
that are related to the strength of the transmission mechanisms, the inflationary
shocks, and the institutional framework adopted. In short, a unique effect of the
IT regime on income distribution in EME should not be expected.
Moreover, a key lesson from our analysis is that, at least when it comes to
EME, it is insufficient to analyze the effects of monetary policy on income
distribution without observing how the exchange rate reacts and affects the
economy. Consequently, while we endorse the post-Keynesian rejection of
the IT regime and the need for adopting alternative monetary policy rules
concerned with employment and income distribution, we would argue that an
extra policy kit is required. In this sense, monetary and exchange rate policies
ought to be framed in a coherent way, especially in economies that present
a strong link between the interest and exchange rates and where the exchange
rate is a particularly relevant variable, such as EME. In order to do so, any

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78 The future of central banking

alternative monetary policy rule ought to be complemented with an exchange

rate policy and/or other financial regulation tools (capital controls, foreign
exchange derivatives regulation and macroprudential policy) that may also
help to insulate the exchange rate from external disturbances and to prevent its
movements from being (mostly) determined by international financial inves-
tors’ search for capital gains, as well as take country-specific characteristics
into account. In addition, such efforts should be complemented by strengthen-
ing the working class in order to make it more resilient to the possible adverse
effects of interest and exchange rates.

ACKNOWLEDGEMENTS

The authors thank Enzo Gerioni, Ricardo Summa, Sylvio Kappes and all those
who participated in the Elgar Webinar Series on Central Banking and Monetary
Policy on May 18, 2020, especially Mario Seccareccia and Joelle Leclaire, for
their helpful comments. LR acknowledges funding from Fundação de Amparo
à Pesquisa do Estado de São Paulo (FAPESP, grant number 2018/21762-0)
and from Conselho Nacional de Desenvolvimento Científico e Tecnológico
(CNPq, grant number 140426/2018-3). NM acknowledges funding from
Conselho Nacional de Desenvolvimento Científico e Tecnológico (CNPq,
grant number 167326/2018-0).

NOTES
1. Note that there is a more recent mainstream literature concerning the impact
of monetary policy on personal income distribution (see Kappes, 2022, for
a review).
2. See Davidson (2006), Setterfield (2006), and Sawyer (2006) for a critical assess-
ment of the IT regime following a post-Keynesian approach.
3. There is some empirical evidence for advanced countries that indeed the IT
regime may have had an adverse effect on wage growth and on the wage share
(Seccareccia and Lavoie, 2010; Seccareccia, 2019; Rochon and Rossi, 2006).
4. The dynamics herein discussed may also have important implications for the
personal income distribution, which tends to become more unequal as the labor
share falls (Giovannoni, 2010).
5. Note that interest payments are overhead costs. Thus, their effect depends on the
specific pricing procedure, as overhead costs are treated differently in each one
of them (see for a review Lavoie, 2014, ch. 3). As a general rule, interest pay-
ments can either affect prices directly as costs or through firms’ mark-ups (which
can be set to cover overhead costs).
6. Numerous authors refer to the possibility of the interest rate affecting the growth
rate or the output level (Lavoie, 1995; Rochon and Setterfield, 2007; Smithin,
2003). If the economy is demand-led, and increases in the interest rate redis-
tribute income to groups with lower propensity to consume, such as rentiers,
economic activity may be harmed by a restrictive monetary policy (Rochon and

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 Inflation targeting regime and income distribution 79

Setterfield, 2008; Rochon, 2017). Some authors also refer to the effect of the
interest rate on investment, but this is not a consensual relation, as some argue
that “interest rates do not operate on investment directly” (Rochon, 2017, p. 207)
and the reaction of investment to changes in the interest rate has been found to be
weak (Fazzari, 1993).
7. In the literature, it is also assumed that firms’ bargaining power may increase if
they become closer to full capacity production, which would benefit the firms’
income share and lead to higher inflation (Rowthorn, 1977). In case higher
capacity utilization rates move together with lower unemployment rates, this
combination could increase inflation but would have uncertain effects on the
income distribution. However, rather than increasing prices (through increases in
their margins), we assume that firms most likely respond to increases in capacity
utilization by increasing production. In this case, the effect of demand on the
workers’ bargaining power predominates and, thus, we emphasize this dimen-
sion. A similar approach is adopted by Rochon and Setterfield (2007).
8. Given the main purpose of our analysis, we focus on the relation between the
exchange rate, prices and income distribution, without any explicit reference
to the growth dynamics. For a critical analysis of the relationship between real
exchange rates, income distribution and growth, see Ribeiro et al. (2020).
9. Workers may also demand higher nominal wages if there is a real depreciation,
as the price of imported goods rise. However, this effect is not expected to dom-
inate the effect on firms’ target mark-up rate as “currency depreciations tend to
reduce real wages and the wage share” (Blecker, 2011, p. 225–226).
10. Yet, note that if the direct effect of the interest rate on firms’ mark-up rates pre-
dominates (through the “cost-push” channel), there would also be a lower wage
share but this could be ineffective to control the inflation rate.
11. Note, however, that the choice of exchange rate policy instrument is also rel-
evant. For instance, if the CB buys/sells foreign reserves to prevent changes
in the exchange rate, the public debt may be altered through the sterilization
process (for more details, see Lavoie, 2001). This will have implications for the
amount of government transfers to public debt holders (Serrano and Summa,
2015), which can affect the income distribution. In addition, while there is no
limit to containing appreciation pressures with this instrument, as the CB can
buy an unlimited amount of foreign reserves, taming depreciations can be more
complex and limited by the amount of foreign reserves held by the CB and by the
economy’s balance of payment position (Serrano and Summa, 2015).

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