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Exchange rate versus inflation targeting: a theory of output fluctuations in traded and non-traded sectors

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  • �istein R�island
  • Ragnar Torvik

Abstract

This paper develops a basic model for output fluctuations in traded and non-traded sectors under two alternative monetary policy regimes; exchange rate targeting (or monetary union) and inflation targeting. The conventional wisdom from one-sector models says that inflation targeting gives better output stabilization than exchange rate targeting when demand shocks occur, but the opposite when supply shocks occur. In a model with a traded and a non-traded sector, we show that the conventional wisdom holds for the non-traded sector. However, for the traded sector, we show that inflation targeting destabilizes output compared with exchange rate targeting when both supply and demand shocks occur. The only shocks where inflation targeting provides the better output stability for the traded sector are shocks to world market prices. The two-sector structure introduces new mechanisms that may turn around earlier results for aggregate production. For instance, a demand shock may induce higher aggregate output fluctuations with inflation targeting than with exchange rate targeting. Furthermore, a positive demand shock may prove to be contractionary under inflation targeting.

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File URL: http://www.tandfonline.com/doi/abs/10.1080/0963819042000240020
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Bibliographic Info

Article provided by Taylor & Francis Journals in its journal The Journal of International Trade & Economic Development.

Volume (Year): 13 (2004)
Issue (Month): 3 ()
Pages: 265-285

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Handle: RePEc:taf:jitecd:v:13:y:2004:i:3:p:265-285

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Related research

Keywords: Inflation targeting; exchange rate targeting; monetary policy; dependent economy model; output stability;

References

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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
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Cited by:
  1. Steinar Holden, 2002. "Wage Setting Under Different Monetary Regimes," CESifo Working Paper Series 632, CESifo Group Munich.
  2. Gunnar Bardsen & Eilev S. Jansen & Ragnar Nymoen, 2003. "Econometric inflation targeting," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 430-461, December.
  3. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
  4. Shulgin, Andrey, 2006. "The Russian Foreign Exchange Policy on the Wave of Crisis Cycle," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 4(4), pages 18-48.
  5. Aivazian, Sergei & Stepanov, Vladimir & Kozlova, Maria, 2006. "Measuring the Synthetic Categories of Quality of Life in a Region and Identification of Main Trends to Improve the Social and Economic Policy (Samara Region and its Constituent Territories)," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 2(2), pages 18-84.

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