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Exchange rate versus inflation targeting: a theory of output fluctuations in traded and non-traded sectors

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  • Øistein Røisland
  • Ragnar Torvik

Abstract

This paper develops a basic model for output fluctuations in traded and non-traded sectors under two alternative monetary policy regimes; exchange rate targeting (or monetary union) and inflation targeting. The conventional wisdom from one-sector models says that inflation targeting gives better output stabilization than exchange rate targeting when demand shocks occur, but the opposite when supply shocks occur. In a model with a traded and a non-traded sector, we show that the conventional wisdom holds for the non-traded sector. However, for the traded sector, we show that inflation targeting destabilizes output compared with exchange rate targeting when both supply and demand shocks occur. The only shocks where inflation targeting provides the better output stability for the traded sector are shocks to world market prices. The two-sector structure introduces new mechanisms that may turn around earlier results for aggregate production. For instance, a demand shock may induce higher aggregate output fluctuations with inflation targeting than with exchange rate targeting. Furthermore, a positive demand shock may prove to be contractionary under inflation targeting.

Suggested Citation

  • Øistein Røisland & Ragnar Torvik, 2004. "Exchange rate versus inflation targeting: a theory of output fluctuations in traded and non-traded sectors," The Journal of International Trade & Economic Development, Taylor & Francis Journals, vol. 13(3), pages 265-285.
    • Handle: RePEc:taf:jitecd:v:13:y:2004:i:3:p:265-285
    DOI: 10.1080/0963819042000240020
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    References listed on IDEAS

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    1. Torvik, Ragnar, 2001. "Learning by doing and the Dutch disease," European Economic Review, Elsevier, vol. 45(2), pages 285-306, February.
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    7. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
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    1. Boug, Pål & Brasch, Thomas von & Cappelen, Ådne & Hammersland, Roger & Hungnes, Håvard & Kolsrud, Dag & Skretting, Julia & Strøm, Birger & Vigtel, Trond C., 2023. "Fiscal policy, macroeconomic performance and industry structure in a small open economy," Journal of Macroeconomics, Elsevier, vol. 76(C).
    2. Sergei Aivazian & Vladimir Stepanov & Maria Kozlova, 2006. "Measuring the Synthetic Categories of Quality of Life in a Region and Identification of Main Trends to Improve the Social and Economic Policy (Samara Region and its Constituent Territories)," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 2(2), pages 18-84.
    3. Leitemo,K., 1999. "Inflation targeting strategies in small open economies," Memorandum 21/1999, Oslo University, Department of Economics.
    4. Libman, Emiliano, 2017. "Asymmetric Monetary and Exchange Rate Policies in Latin America," MPRA Paper 78864, University Library of Munich, Germany.
    5. Gunnar Bardsen & Eilev S. Jansen & Ragnar Nymoen, 2003. "Econometric inflation targeting," Econometrics Journal, Royal Economic Society, vol. 6(2), pages 430-461, December.
    6. Holden,S., 1999. "Wage setting under different monetary regimes," Memorandum 12/1999, Oslo University, Department of Economics.
    7. Andrey Shulgin, 2006. "The Russian Foreign Exchange Policy on the Wave of Crisis Cycle," Applied Econometrics, Russian Presidential Academy of National Economy and Public Administration (RANEPA), vol. 4(4), pages 18-48.

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