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Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results

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Abstract

Under optimal policy from a timeless perspective, a central bank targeting an inflation measure which is adjusted for changes in the real exchange rate (REX inflation) has the ability to stabilize the output gap and inflation against demand disturbances in an open economy. This distinct advantage is lost if a central bank follows a Taylor-type rule. The bank has an incentive to add the real exchange rate to the Taylor rule because it duplicates the performance of the optimal policy for portfolio shocks. The Taylor-type rule becomes a Monetary Conditions Index (MCI) that outperforms Taylor-type rules which accord no weight at all or a higher weight to the real exchange rate. In the current environment of concern about sudden increases in U.S. interest rates, the properly designed MCI would have a considerable advantage.

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  • Richard T. Froyen & Alfred V Guender, 2015. "Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results," Working Papers in Economics 15/14, University of Canterbury, Department of Economics and Finance.
    • Handle: RePEc:cbt:econwp:15/14
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    Keywords

    REX Inflation; Optimal Policy; Taylor-Type Rules; MCI; Openness; Portfolio Shocks;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F5 - International Economics - - International Relations, National Security, and International Political Economy

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