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The effects of capital market openness on exchange rate pass-through and welfare in an inflation-targeting small open economy

  • Sanchita Mukherjee

This paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss function in an inflation-targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, the author examines whether a more open capital market in an inflation-targeting country improves the credibility of the central bank and consequently reduces exchange rate pass-through. First, the effect of capital openness on exchange rate pass-through is empirically examined using a new Keynesian Phillips curve. The empirical investigation reveals that limited capital openness leads to greater pass-through from the exchange rate to domestic inflation, which raises the marginal cost of deviation from the inflation target. This subsequently worsens the inflation output-gap trade-off and increases the social loss of the inflation targeting central bank under pure commitment. However, the calibration results suggest that the inflation output-gap trade-off improves and the social loss decreases even in the presence of larger exchange rate pass-through if the capital controls are effective at insulating the exchange rate from interest rate and risk-premia shocks.

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Paper provided by Federal Reserve Bank of Cleveland in its series Working Paper with number 1018.

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Date of creation: 2010
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Handle: RePEc:fip:fedcwp:1018
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