Inflation Targeting and Exchange Rate Management In Less Developed Countries

Author/Editor: Marco Airaudo ; Edward F. Buffie ; Luis-Felipe Zanna
Publication Date: March 08, 2016
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Disclaimer: This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate
Summary: 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.
Series: Working Paper No. 16/55
Subject(s): Inflation targeting | Monetary policy | Exchange rate policy | Flexible exchange rates | Developing countries | Emerging markets | Econometric models

Publication Date: March 08, 2016
ISBN/ISSN: 9781513567433/1018-5941 Format: Paper
Stock No: WPIEA2016055 Pages: 65
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