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Inflation Targeting in a Small Open Economy

  • Nargis Bharucha

    (Reserve Bank of Australia)

  • Christopher Kent

    (Reserve Bank of Australia)

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    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.

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    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp9807.

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    Date of creation: Jul 1998
    Date of revision:
    Handle: RePEc:rba:rbardp:rdp9807
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    1. Ben S. Bernanke & Frederic S. Mishkin, 1997. "Inflation Targeting: A New Framework for Monetary Policy?," NBER Working Papers 5893, National Bureau of Economic Research, Inc.
    2. Svensson, Lars E O, 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," CEPR Discussion Papers 742, C.E.P.R. Discussion Papers.
    3. Dwyer, Jacqueline, 1992. "The Tradeable Non-tradeable Dichotomy: A Practical Approach," Australian Economic Papers, Wiley Blackwell, vol. 31(59), pages 443-59, December.
    4. Laurence Ball, 1997. "Efficient Rules for Monetary Policy," NBER Working Papers 5952, National Bureau of Economic Research, Inc.
    5. Brent R. Moulton & Karin E. Moses, 1997. "Addressing the Quality Change Issue in the Consumer Price Index," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 28(1), pages 305-366.
    6. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
    7. Dwyer, Jacqueline & Kent, Christopher & Pease, Andrew, 1994. "Exchange Rate Pass-Through: Testing the Small Country Assumption for Australia," The Economic Record, The Economic Society of Australia, vol. 70(211), pages 408-23, December.
    8. Lars E. O. Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc.
    9. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    10. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
    11. T. W.Swan, 1960. "Economic Control In A Dependent Economy," The Economic Record, The Economic Society of Australia, vol. 36(73), pages 51-66, 03.
    12. de Brouwer, Gordon & Ericsson, Neil R, 1998. "Modeling Inflation in Australia," Journal of Business & Economic Statistics, American Statistical Association, vol. 16(4), pages 433-49, October.
    13. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
    14. Guy Debelle, 1997. "Inflation Targeting in Practice," IMF Working Papers 97/35, International Monetary Fund.
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