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Inflation Targeting and Exchange Rate Rules in an Open Economy

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  • Eric Parrado

Abstract

This paper provides a simple dynamic neo-Keynesian model that can be used to analyze the impact of monetary policy that considers inflation targeting in a small open economy. This economy is characterized by imperfect competition and short-run price rigidity. The main findings of the paper are that, depending on what shocks affect the economy, the effects of inflation targeting on output and inflation volatility depend crucially on the exchange rate regime and the inflation index being targeted. First, in the presence of real shocks, flexible exchange rates dominate managed exchange rates, while for nominal shocks the reverse is true. Second, domestically generated inflation targeting is preferable to CPI inflation targeting, because the former is more stabilizing not only in relation to both measures of inflation, but also to the output gap and the real exchange rate. Finally, flexible inflation targeting outperforms strict inflation targeting in terms of welfare.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 04/21.

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Length: 37
Date of creation: 01 Feb 2004
Date of revision:
Handle: RePEc:imf:imfwpa:04/21

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Related research

Keywords: Inflation targeting; Exchange rates; Economic models; inflation; monetary policy; central bank; aggregate demand; nominal interest rate; monetary policy rules; monetary authority; inflation target; monetary economics; real interest rate; inflation targeting regime; optimal monetary policy; monetary fund; price stability; monetary policy rule; inflation stabilization; effects of inflation; monetary policies; relative price; price level; monetary aggregates; monetary policy instrument; terms of trade; rational expectations; nominal interest rates; monetary reform; inflation rates; inflationary expectations; macroeconomic stability; monetary policy instruments; monetary condition; price elasticity; relative prices; price inflation; macroeconomic performance; monetary authorities; real interest rates; money growth; monetary sector;

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References

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  2. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
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  8. Roberto Chang & Andres Velasco, 1999. "Liquidity crises in emerging markets: Theory and policy," Working Paper 99-15, Federal Reserve Bank of Atlanta.
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  23. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
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