External Shocks and Inflation in Developing Countries Under a Real Exchange Rate Rule


WP/92/75-EA

External Shocks and Inflation in Developing Countries
Under a Real Exchange Rate Rule
by Peter J. Montiel and Jonathan D. Ostry

This paper examines the response of a small open developing economy to
external shocks when the authorities target the real exchange rate. It
shows that, under these circumstances, real external shocks alter the
economy's long-run inflation rate, unlike when a fixed exchange rate or
preannounced crawling peg is in place. Under real exchange rate targeting,
the expenditure-switching function of changes in the real exchange rate is
replaced by an expenditure-reducing function of changes in the inflation
rate and, hence, in the inflation tax. In addition, the paper argues that
choosing an appropriate level at which to target the real exchange rate--
that is, one that avoids destabilizing the price level in the face of
shocks--is no easy matter because it requires detailed knowledge of a range
of parameters and structural relationships, which the authorities are
unlikely to possess.

The paper then asks whether or not monetary policy can mitigate the
destabilizing effects of shocks under real exchange rate targeting. It
finds that money cannot replace the exchange rate as a nominal anchor for
the domestic price level, irrespective of the degree of capital mobility.
This conclusion is shown to apply over all time horizons, except possibly
over the very short run.