Inflation Targeting and Exchange Rate Management in Less Developed Countries
66 Pages Posted: 26 Apr 2016
Date Written: March 2016
We analyze coordination of monetary and exchange rate policy in a two-sector model of a small open economy featuring imperfect substitution between domestic and foreign financial assets. Our central finding is that management of the exchange rate greatly enhances the efficacy of inflation targeting. In a flexible exchange rate system, inflation targeting incurs a high risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfilling expectations. Moreover, small inflation shocks may escalate into much larger increases in inflation ex post. Both problems disappear when the central bank leans heavily against the wind in a managed float.
Keywords: Inflation Targeting, Exchange Rate, Indeterminacy, Taylor Principle, inflation, foreign exchange, central bank, Monetary Policy (Targets, Instruments, and Effects), Open Economy Macroeconomics, All Countries,
JEL Classification: E52, F41, E58
Suggested Citation: Suggested Citation