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Is Inflation Targeting Operative in an Open Economy Setting?

  • Esteban Pérez Caldentey
  • Matías Vernengo

The justification for inflation targeting rests on three core propositions. The first is called ‘lean against the wind’, which refers to fact that the monetary authority contracts (expands) aggregate demand below capacity when the actual rate of inflation is above (below) target. The second is ‘the divine coincidence’, which means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The third proposition is that of stability. This means that the inflation target is part of an equilibrium configuration which generates convergence following any small disturbance to its initial conditions. These propositions are derived from a closed economy setting which is not representative of the countries that actually have adopted inflation targeting frameworks. Currently there are 27 countries, 9 of which are classified as industrialized and 18 as developing countries that have explicitly implemented a fully fledged inflation targeting regime (FFIT). These countries are open economies and are concerned by the evolution of the external sector and the exchange rate as proven by their interventions in the foreign exchange markets. We show that these three core propositions and the practice of inflation targeting are inoperative in an open economy context.

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Paper provided by Political Economy Research Institute, University of Massachusetts at Amherst in its series Working Papers with number wp324.

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Date of creation: 2013
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Handle: RePEc:uma:periwp:wp324
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  1. Svensson, Lars E. O., 1998. "Inflation targeting as a monetary policy rule," CFS Working Paper Series 1998/16, Center for Financial Studies (CFS).
  2. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
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  9. Alvaro Angeriz & Philip Arestis, 2007. "Assessing the Performance of 'Inflation Targeting Lite' Countries," The World Economy, Wiley Blackwell, vol. 30(11), pages 1621-1645, November.
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