Inflation Targeting and Exchange Rate Management In Less Developed Countries
March 8, 2016
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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.
Subject: Currencies, Exchange rate flexibility, Exchange rates, Foreign exchange, Inflation, Money, Prices, Real exchange rates
Keywords: Africa, Central and Eastern Europe, closed economy, core inflation, Currencies, East Asia, Eastern Europe, Exchange Rate, Exchange rate flexibility, Exchange rates, exchange-rate-anchored IT, Indeterminacy, Inflation, inflation rate, inflation targeting, managed float, nominal interest rate, Real exchange rates, Sub-Saharan Africa, Taylor Principle, upper bound, WP
Pages:
65
Volume:
2016
DOI:
Issue:
055
Series:
Working Paper No. 2016/055
Stock No:
WPIEA2016055
ISBN:
9781513567433
ISSN:
1018-5941
