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Inflation Targeting and Exchange Rate Pass-Through

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Abstract

This paper analyzes how endogenous imperfect exchange rate pass-through affects inflation targeting optimal monetary policies in a New Keynesian small open economy. The paper shows that an inverse relation exists between the pass-through and the insulation of the economy from foreign and monetary policy shocks, and that imperfect pass-through tends to decrease the variability of the terms of trade. Furthermore, with CPI inflation targeting, in the short run, delayed pass-through constrains monetary policy more than incomplete pass-through and interest rate smoothing amplifies this effect. When the pass-through decreases, the variability in economic activity tends to raise and the trade-of between the stabilization of CPI inflation and output worsens in direct relation to how strictly the central bank is targeting CPI inflation. In contrast, with domestic inflation targeting, optimal monetary policy is not constrained and opposite results occur. Consequently, imperfect pass-through favors the choice of domestic to CPI inflation targeting.

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Bibliographic Info

Paper provided by Economics Section, The Graduate Institute of International Studies in its series IHEID Working Papers with number 04-2004.

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Length: 37
Date of creation: 15 Jun 2004
Date of revision:
Handle: RePEc:gii:giihei:heiwp04-2004

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Keywords: Inflation Targeting; Exchange Rate Pass-through; Open-Economy; Direct Exchange Rate Channel; Optimal Monetary Policy.;

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Citations

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Cited by:
  1. Winkelried, Diego, 2012. "Traspaso del tipo de cambio y metas de inflación en el Perú," Revista Estudios Económicos, Banco Central de Reserva del Perú, issue 23, pages 9-24.
  2. Rhee, Hyuk-jae & Turdaliev, Nurlan, 2012. "Optimal monetary policy in a small open economy with inflation and output persistence," Economic Modelling, Elsevier, vol. 29(6), pages 2533-2542.
  3. Naz, Farah & Mohsin, Asma & Zaman, Khalid, 2012. "Exchange rate pass-through in to inflation: New insights in to the cointegration relationship from Pakistan," Economic Modelling, Elsevier, vol. 29(6), pages 2205-2221.
  4. Flamini, Alessandro & Fracasso, Andrea, 2011. "Household's preferences and monetary policy inertia," Economics Letters, Elsevier, vol. 111(1), pages 64-67, April.
  5. Oxana Babecká-Kucharèuková, 2009. "Transmission of Exchange Rate Shocks into Domestic Inflation: The Case of the Czech Republic," Czech Journal of Economics and Finance (Finance a uver), Charles University Prague, Faculty of Social Sciences, vol. 59(2), pages 137-152, June.
  6. Pavasuthipaisit, Robert, 2010. "Should inflation-targeting central banks respond to exchange rate movements?," Journal of International Money and Finance, Elsevier, vol. 29(3), pages 460-485, April.
  7. Berk, Jan Marc & Swank, Job, 2011. "Price level convergence and regional Phillips curves in the US and EMU," Journal of International Money and Finance, Elsevier, vol. 30(5), pages 749-763, September.
  8. Daniels, Joseph P & VanHoose, David D, 2010. "Exchange-Rate Pass Through, Openness, and the Sacrifice Ratio," Working Papers and Research 2010-05, Marquette University, Center for Global and Economic Studies and Department of Economics.
  9. Jihene Bousrih, 2012. "Degree of openness and inflation targeting policy: model of a small open economy," Journal of Financial Economic Policy, Emerald Group Publishing, vol. 4(3), pages 232-246, August.
  10. Abo-Zaid, Salem, 2009. "Sticky Wages, Incomplete Pass-Through and Inflation Targeting: What is the Right Index to Target?," MPRA Paper 13177, University Library of Munich, Germany.
  11. Alessandro Flamini, 2012. "Interest Rate Forecasts in Inflation Targeting Open-Economies," DEM Working Papers Series 027, University of Pavia, Department of Economics and Management.
  12. Winkelried, Diego, 2011. "Exchange rate pass-through and inflation targeting in Peru," Working Papers 2011-012, Banco Central de Reserva del Perú.
  13. Javier García-Cicco, 2008. "Recent Developments in Monetary Policy Analysis for Emerging Countries," Ensayos Económicos, Central Bank of Argentina, Economic Research Department, vol. 1(51), pages 123-142, April - S.
  14. Hyuk Rhee & Nurlan Turdaliev, 2012. "Targeting Rules for an Open Economy," Open Economies Review, Springer, vol. 23(3), pages 447-471, July.
  15. Flamini Alessandro, 2012. "Economic Stability and the Choice of the Target Inflation Index," Studies in Nonlinear Dynamics & Econometrics, De Gruyter, vol. 16(2), pages 1-37, April.
  16. repec:col:000094:002685 is not listed on IDEAS

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