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Inflation Targeting in a Small Open Economy: a Challenge to Monetary Theory

  • Runchana Pongsaparn

    (Bank of Thailand)

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    This paper aims to address the role of exchange rate under inflation targeting as a practical challenge to modern monetary policy facing a central bank in a small open economy – with a particular focus on Thailand. Monetary theory and empirical evidence have provided conflicting policy recommendations regarding the role of exchange rate under inflation targeting. In theory, the objective of monetary policy could be achieved by a single policy instrument – interest rate. Exchange rate is endogenous to the change in policy rate through UIP condition and plays only subsidiary role as a channel through which the policy rate can transmit. The paper proves that, in practice, the linkage between interest rate and exchange rate is weak as evident in the failure of UIP, while exchange rate movement is found to have an important implication on output but not so much on inflation. Therefore, exchange rate may be used as another policy instrument to complement interest rate. The optimal blend between the use of interest rate and exchange rate is an important practical challenge to a small open economy under inflation targeting.

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    Paper provided by Economic Research Department, Bank of Thailand in its series Working Papers with number 2007-08.

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    Length: 31 pages
    Date of creation: Aug 2007
    Date of revision:
    Handle: RePEc:bth:wpaper:2007-08
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    1. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
    2. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
    3. Svensson, Lars E O, 1999. " Inflation Targeting: Some Extensions," Scandinavian Journal of Economics, Wiley Blackwell, vol. 101(3), pages 337-61, September.
    4. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
    5. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    6. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
    7. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
    8. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
    9. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-17, August.
    10. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-92, Summer.
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