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Exchange Rate Targeting in a Small Open Economy

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  • Mette Ersbak Bang Nielsen

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    Abstract

    The paper develops a New Keynesian Small Open Economy Model charac- terized by external habit formation and Calvo price setting with dynamic inflation updating. The model is used to analyze the e¤ect of nominal ex- change rate targeting on optimal policy and impulse responses. It is found that even moderate exchange rate concerns are capable of changing both sign and magnitude of the optimal instrument response to variables, and that whether the concern is with respect to the level or first di¤erence has much impact on monetary policy. Also, the cost of exchange rate stabilization in terms of output and inflation is evident in the model, and impulse responses under moderate exchange rate targeting are not simple combinations of those under a float and a regime that cares almost only for meeting the exchange rate target.

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    Bibliographic Info

    Paper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 367.

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    Handle: RePEc:bdr:borrec:367

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    Keywords: Flexible inflation targeting; exchange rates; fear of floating;

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    1. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, American Economic Association, vol. 41(2), pages 426-477, June.
    2. Galí, Jordi & Monacelli, Tommaso, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3346, C.E.P.R. Discussion Papers.
    3. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, Elsevier, vol. 50(1), pages 155-183, February.
    4. Schmitt-Grohe, Stephanie & Uribe, Martin, 2003. "Closing small open economy models," Journal of International Economics, Elsevier, Elsevier, vol. 61(1), pages 163-185, October.
    5. Alessandro Flamini, 2003. "CPI Inflation Targeting and Exchange Rate Pass-through," Macroeconomics, EconWPA 0306017, EconWPA.
    6. Eduardo Moron & Diego Winkelried, 2002. "Monetary Policy Rules for Financially Vulnerable EconomieEd," Macroeconomics, EconWPA 0205001, EconWPA.
    7. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, Elsevier, vol. 39(1), pages 195-214, December.
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