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