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Dealing with Time-inconsistency: Inflation Targeting vs. Exchange Rate Targeting

Author

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  • Ippei Fujiwara

    (Keio University / ANU)

  • Scott Davis

    (Federal Reserve Bank of Dallas)

Abstract

Abandoning an objective function with multiple targets and adopting a single mandate is an effective way for a central bank to overcome the classic time-inconsistency problem. We show that the choice of a particular single mandate depends on a country's level of trade openness. Both inflation targeting and nominal exchange rate targeting come with their own costs. We show that the costs of inflation targeting are increasing in a country's level of trade openness while the costs of exchange rate targeting are decreasing in trade openness. Thus a relatively closed economy will prefer an inflation targeting mandate and a very open economy will prefer an exchange rate target. Empirical results show that as central banks become less credible they are more likely to adopt a pegged exchange rate, and crucially the empirical link between central bank credibility and the tendency to peg depends on trade openness.

Suggested Citation

  • Ippei Fujiwara & Scott Davis, 2017. "Dealing with Time-inconsistency: Inflation Targeting vs. Exchange Rate Targeting," 2017 Meeting Papers 795, Society for Economic Dynamics.
  • Handle: RePEc:red:sed017:795
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    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • F40 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - General

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