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Inflation Targeting in a Small Open Economy

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  • Nargis Bharucha

    (Reserve Bank of Australia)

  • Christopher Kent

    (Reserve Bank of Australia)

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    Abstract

    This paper investigates the merits of aggregate inflation targeting compared with non-traded inflation targeting using a model of a small open economy producing traded and non-traded goods. An important innovation of our approach is that we isolate the effects of exchange rate, supply and demand shocks by analysing the conditional variance of macroeconomic variables. We show that monetary policy should be more activist in response to exchange rate shocks for a flexible aggregate inflation target than for a flexible non-traded inflation target. However, in response to demand and supply shocks monetary policy is more activist for a flexible non-traded inflation target. The result is robust to the inclusion of forward-looking expectations, gradual exchange rate pass-through, and discretionary policy. In order to avoid excessive volatility in product and financial markets, it may be preferable to target inflation over a medium-term horizon.

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    File URL: http://www.rba.gov.au/publications/rdp/1998/pdf/rdp9807.pdf
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    Bibliographic Info

    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9807.

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    Date of creation: Jul 1998
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    Handle: RePEc:rba:rbardp:rdp9807

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    Related research

    Keywords: inflation targets; open economy; non-traded inflation; forward-looking variables; conditional variance;

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    References

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    1. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June.
    2. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
    3. E.O. Svensson, Lars, 1994. "Why exchange rate bands? : Monetary independence in spite of fixed exchange rates," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 157-199, February.
    4. Gordon de Brouwer & Neil R. Ericsson, 1995. "Modelling Inflation in Australia," RBA Research Discussion Papers rdp9510, Reserve Bank of Australia.
    5. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    6. Brent R. Moulton & Karin E. Moses, 1997. "Addressing the Quality Change Issue in the Consumer Price Index," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1), pages 305-366.
    7. Guy Debelle, 1997. "Inflation Targeting in Practice," IMF Working Papers 97/35, International Monetary Fund.
    8. Laurence Ball, 1997. "Efficient Rules for Monetary Policy," NBER Working Papers 5952, National Bureau of Economic Research, Inc.
    9. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
    10. repec:nbr:nberre:0126 is not listed on IDEAS
    11. Dwyer, Jacqueline & Kent, Christopher & Pease, Andrew, 1994. "Exchange Rate Pass-Through: Testing the Small Country Assumption for Australia," The Economic Record, The Economic Society of Australia, vol. 70(211), pages 408-23, December.
    12. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
    13. Dwyer, Jacqueline, 1992. "The Tradeable Non-tradeable Dichotomy: A Practical Approach," Australian Economic Papers, Wiley Blackwell, vol. 31(59), pages 443-59, December.
    14. T. W.Swan, 1960. "Economic Control In A Dependent Economy," The Economic Record, The Economic Society of Australia, vol. 36(73), pages 51-66, 03.
    15. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
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    Cited by:
    1. Guy Debelle, 1999. "Inflation Targeting and Output Stabilisation," RBA Research Discussion Papers rdp1999-08, Reserve Bank of Australia.
    2. Adolfson, Malin, 2001. "Monetary Policy with Incomplete Exchange Rate Pass-Through," Working Paper Series in Economics and Finance 476, Stockholm School of Economics.
    3. Cavoli, Tony, 2009. "Is fear of floating justified?: The East Asia experience," Journal of Policy Modeling, Elsevier, vol. 31(1), pages 1-16.
    4. Ana Maria Santacreu, 2005. "Reaction functions in a small open economy: What role for non-traded inflation?," Reserve Bank of New Zealand Discussion Paper Series DP2005/04, Reserve Bank of New Zealand.

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