{
  "title": "Inflation Targeting and Exchange Rate Management In Less Developed Countries",
  "publication": "IMF Working Papers, March 8, 2016",
  "sourceUrl": "https://www.imf.org/en/publications/wp/issues/2016/12/31/inflation-targeting-and-exchange-rate-management-in-less-developed-countries-43778",
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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.",
  "sections": [
    {
      "heading": "Summary and central finding",
      "content": "- 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.\n- Central finding: management of the exchange rate greatly enhances the efficacy of inflation targeting.\n- Under a flexible exchange rate system, inflation targeting:\n  - incurs a high risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfilling expectations;\n  - allows small inflation shocks to potentially escalate into much larger increases in inflation ex post.\n- Both indeterminacy and escalation of small inflation shocks disappear when the central bank leans heavily against the wind in a managed float."
    },
    {
      "heading": "Model features and mechanisms",
      "content": "- Two-sector small open economy framework.\n- Imperfect substitution between domestic and foreign financial assets is a key assumption shaping results.\n- Comparison of policy regimes:\n  - Flexible exchange rate with inflation targeting leads to elevated risk of indeterminacy and amplification of small inflation shocks.\n  - Managed float with strong central bank leaning significantly reduces or eliminates these problems."
    },
    {
      "heading": "Policy implications and recommendations",
      "content": "- 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.\n- Recommendation: central banks should \"lean heavily against the wind\" in a managed float to:\n  - reduce the risk of self-fulfilling expectation-driven macroeconomic fluctuations;\n  - prevent small inflation shocks from escalating into much larger inflation outcomes.\n\n---\n\n Content in this bundle\n\n- 6.  Comparing Impulse Responses\n  - 6.  Comparing Impulse Responses (Markdown version){rel=\"alternate\" type=\"text/markdown\"}\n  - 6.  Comparing Impulse Responses (PDF){rel=\"external\" type=\"application/pdf\"}\n\n---\n\nSource: https://www.imf.org/en/publications/wp/issues/2016/12/31/inflation-targeting-and-exchange-rate-management-in-less-developed-countries-43778"
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    "Authors: Marco Airaudo, Edward F Buffie, Luis-Felipe Zanna",
    "Published: March 8, 2016",
    "Series: IMF Working Papers",
    "DOI: https://doi.org/10.5089/9781513567433.001",
    "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:",
    "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:",
    "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:",
    "**6.  Comparing Impulse Responses**"
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