## Inflation Targeting and Exchange Rate Management In Less Developed Countries

_IMF Working Papers, March 8, 2016_

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**Canonical URL:** [Inflation Targeting and Exchange Rate Management In Less Developed Countries](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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## Bibliographic details
- 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

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### Summary and central finding
- 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.

### Model features and mechanisms
- 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.

### Policy implications and recommendations
- 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.

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## Content in this bundle

- **6.  Comparing Impulse Responses**
  - [6.  Comparing Impulse Responses (Markdown version)](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1655.pdf.md){rel="alternate" type="text/markdown"}
  - [6.  Comparing Impulse Responses (PDF)](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2016/_wp1655.pdf){rel="external" type="application/pdf"}

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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/inflation-targeting-and-exchange-rate-management-in-less-developed-countries-43778_