The effects of capital market openness on exchange rate pass-through and welfare in an inflation-targeting small open economy
AbstractThis paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss function in an inflation-targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, the author examines whether a more open capital market in an inflation-targeting country improves the credibility of the central bank and consequently reduces exchange rate pass-through. First, the effect of capital openness on exchange rate pass-through is empirically examined using a new Keynesian Phillips curve. The empirical investigation reveals that limited capital openness leads to greater pass-through from the exchange rate to domestic inflation, which raises the marginal cost of deviation from the inflation target. This subsequently worsens the inflation output-gap trade-off and increases the social loss of the inflation targeting central bank under pure commitment. However, the calibration results suggest that the inflation output-gap trade-off improves and the social loss decreases even in the presence of larger exchange rate pass-through if the capital controls are effective at insulating the exchange rate from interest rate and risk-premia shocks.
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Bibliographic InfoPaper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 1018.
Date of creation: 2010
Date of revision:
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-11-20 (All new papers)
- NEP-CBA-2010-11-20 (Central Banking)
- NEP-IFN-2010-11-20 (International Finance)
- NEP-MAC-2010-11-20 (Macroeconomics)
- NEP-MON-2010-11-20 (Monetary Economics)
- NEP-OPM-2010-11-20 (Open Economy Macroeconomic)
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