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Inflation Targeting in a Small Open Economy

Author

Listed:
  • Nargis Bharucha

    (Reserve Bank of Australia)

  • Christopher Kent

    (Reserve Bank of Australia)

Abstract

This paper investigates the merits of aggregate inflation targeting compared with non-traded inflation targeting using a model of a small open economy producing traded and non-traded goods. An important innovation of our approach is that we isolate the effects of exchange rate, supply and demand shocks by analysing the conditional variance of macroeconomic variables. We show that monetary policy should be more activist in response to exchange rate shocks for a flexible aggregate inflation target than for a flexible non-traded inflation target. However, in response to demand and supply shocks monetary policy is more activist for a flexible non-traded inflation target. The result is robust to the inclusion of forward-looking expectations, gradual exchange rate pass-through, and discretionary policy. In order to avoid excessive volatility in product and financial markets, it may be preferable to target inflation over a medium-term horizon.

Suggested Citation

  • Nargis Bharucha & Christopher Kent, 1998. "Inflation Targeting in a Small Open Economy," RBA Research Discussion Papers rdp9807, Reserve Bank of Australia.
  • Handle: RePEc:rba:rbardp:rdp9807
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    File URL: http://www.rba.gov.au/publications/rdp/1998/pdf/rdp9807.pdf
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    References listed on IDEAS

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    8. Guy Debelle, 1998. "Inflation Targeting in Practice," Occasional Papers, South East Asian Central Banks (SEACEN) Research and Training Centre, number occ23, April.
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    13. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," Journal of Economic Perspectives, American Economic Association, vol. 11(2), pages 97-116, Spring.
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    Citations

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    Cited by:

    1. Marcelo Sanchez, 2008. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," International Economic Journal, Taylor & Francis Journals, vol. 22(1), pages 43-61.
    2. Adolfson, Malin, 2001. "Monetary Policy with Incomplete Exchange Rate Pass-Through," SSE/EFI Working Paper Series in Economics and Finance 476, Stockholm School of Economics.
    3. Christian Gillitzer & John Simon, 2015. "Inflation Targeting: A Victim of Its Own Success," International Journal of Central Banking, International Journal of Central Banking, vol. 11(4), pages 259-287, September.
    4. Kai Leitemo & Oistein Roisland, 2002. "The Choice of Monetary Policy Regime for Small Open Economies," Annals of Economics and Statistics, GENES, issue 67-68, pages 463-494.
    5. Cavoli, Tony, 2009. "Is fear of floating justified?: The East Asia experience," Journal of Policy Modeling, Elsevier, vol. 31(1), pages 1-16.
    6. Santacreu, Ana Maria, 2005. "Reaction functions in a small open economy: What role for non-traded inflation?," Working Papers 2014-44, Federal Reserve Bank of St. Louis.
    7. Guy Debelle, 1999. "Inflation Targeting and Output Stabilisation," RBA Research Discussion Papers rdp1999-08, Reserve Bank of Australia.
    8. Kai Leitemo & Øistein Røisland & Ragnar Torvik, 2006. "Should Inflation-Targeting Central Banks Care about Traded and Non-Traded Sectors?," The IUP Journal of Bank Management, IUP Publications, vol. 0(1), pages 53-63, February.

    More about this item

    Keywords

    inflation targets; open economy; non-traded inflation; forward-looking variables; conditional variance;

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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