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Inflation Targeting and Exchange Rate Management In Less Developed Countries

Listed author(s):
  • Marco Airaudo
  • Edward F Buffie
  • Luis-Felipe Zanna

We analyze coordination of monetary and exchange rate policy in a two-sector model of a small open economy featuring imperfect substitution between domestic and foreign financial assets. Our central finding is that management of the exchange rate greatly enhances the efficacy of inflation targeting. In a flexible exchange rate system, inflation targeting incurs a high risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfilling expectations. Moreover, small inflation shocks may escalate into much larger increases in inflation ex post. Both problems disappear when the central bank leans heavily against the wind in a managed float.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 16/55.

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Length: 65
Date of creation: 08 Mar 2016
Handle: RePEc:imf:imfwpa:16/55
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