Exchange rate versus inflation targeting: a theory of output fluctuations in traded and non-traded sectors
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.
Volume (Year): 13 (2004)
Issue (Month): 3 ()
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- Stephanie Schmitt-Grohe & Martin Uribe, 2001.
"Closing Small Open Economy Models,"
Departmental Working Papers
200115, Rutgers University, Department of Economics.
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