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Exchange Rate Targeting in a Small Open Economy

  • Mette Ersbak Bang Nielsen


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    The paper develops a New Keynesian Small Open Economy Model charac- terized by external habit formation and Calvo price setting with dynamic inflation updating. The model is used to analyze the e¤ect of nominal ex- change rate targeting on optimal policy and impulse responses. It is found that even moderate exchange rate concerns are capable of changing both sign and magnitude of the optimal instrument response to variables, and that whether the concern is with respect to the level or first di¤erence has much impact on monetary policy. Also, the cost of exchange rate stabilization in terms of output and inflation is evident in the model, and impulse responses under moderate exchange rate targeting are not simple combinations of those under a float and a regime that cares almost only for meeting the exchange rate target.

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    Paper provided by Banco de la Republica de Colombia in its series Borradores de Economia with number 367.

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    Handle: RePEc:bdr:borrec:367
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    1. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
    2. Schmitt-Grohé, Stephanie & Uribe, Martín, 2002. "Closing Small Open Economy Models," CEPR Discussion Papers 3096, C.E.P.R. Discussion Papers.
    3. Lars E. O. Svensson, 2003. "What is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," NBER Working Papers 9421, National Bureau of Economic Research, Inc.
    4. Eduardo Moron & Diego Winkelried, 2002. "Monetary Policy Rules for Financially Vulnerable EconomieEd," Macroeconomics 0205001, EconWPA.
    5. Lars E. O. Svensson, 2000. "Open-Economy Inflation Targeting," NBER Working Papers 6545, National Bureau of Economic Research, Inc.
    6. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
    7. Alessandro Flamini, 2003. "CPI Inflation Targeting and Exchange Rate Pass-through," Macroeconomics 0306017, EconWPA.
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