Should inflation-targeting central banks care about dynamic instabilities in an open economy?
This paper studies the stability conditions in a simple dynamic economy model, in which central banks adopt an inflation-targeting regime to conduct their policy in a context of flexible exchange rates. We show that when inflation-targeting central banks place a low weight on their inflation target (a relatively high degree of inflation-targeting flexibility), the economy will have a saddle-point stationary equilibrium. In the opposite, when inflation-targeting central banks place a high weight on their inflation target (they have a relatively low degree of inflation-targeting flexibility), a stable equilibrium is impossible. Thus, inflation targeting will automatically give greater weight to exchange rate developments the more open is the economy. Responding too quickly to what may prove to be temporary exchange rate fluctuations, inflation-targeting central banks can set up dynamic instabilities.
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Volume (Year): 8 (2005)
Issue (Month): 2 (Winter)
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