Inflation Targeting and Exchange Rate Management In Less Developed Countries

IMF Working Papers, March 8, 2016

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The paper analyzes 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.
Central finding: management of the exchange rate greatly enhances the efficacy of inflation targeting.
Under a flexible exchange rate system, inflation targeting:
- incurs a high risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfilling expectations;
- allows small inflation shocks to potentially escalate into much larger increases in inflation ex post.
Both indeterminacy and escalation of small inflation shocks disappear when the central bank leans heavily against the wind in a managed float.

Two-sector small open economy framework.
Imperfect substitution between domestic and foreign financial assets is a key assumption shaping results.
Comparison of policy regimes:
- Flexible exchange rate with inflation targeting leads to elevated risk of indeterminacy and amplification of small inflation shocks.
- Managed float with strong central bank leaning significantly reduces or eliminates these problems.

For less developed countries, combining inflation targeting with active exchange rate management improves policy outcomes relative to pure inflation targeting under a flexible exchange rate.
Recommendation: central banks should "lean heavily against the wind" in a managed float to:
- reduce the risk of self-fulfilling expectation-driven macroeconomic fluctuations;
- prevent small inflation shocks from escalating into much larger inflation outcomes.

6. Comparing Impulse Responses
- 6. Comparing Impulse Responses (Markdown version)
- 6. Comparing Impulse Responses (PDF)