The effects of capital market openness on exchange rate pass-through and welfare in an inflation-targeting small open economy

Sanchita Mukherjee ()

No 1018, Working Papers (Old Series) from Federal Reserve Bank of Cleveland

Abstract: This paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss function in an inflation-targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, the author examines whether a more open capital market in an inflation-targeting country improves the credibility of the central bank and consequently reduces exchange rate pass-through. First, the effect of capital openness on exchange rate pass-through is empirically examined using a new Keynesian Phillips curve. The empirical investigation reveals that limited capital openness leads to greater pass-through from the exchange rate to domestic inflation, which raises the marginal cost of deviation from the inflation target. This subsequently worsens the inflation output-gap trade-off and increases the social loss of the inflation targeting central bank under pure commitment. However, the calibration results suggest that the inflation output-gap trade-off improves and the social loss decreases even in the presence of larger exchange rate pass-through if the capital controls are effective at insulating the exchange rate from interest rate and risk-premia shocks.

Keywords: Monetary policy; Inflation targeting; Foreign exchange (search for similar items in EconPapers)
Date: 2010
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac, nep-mon and nep-opm
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Related works:
Working Paper: The effects of capital market openness on exchange rate pass-through and welfare in an inflation targeting small open economy (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedcwp:1018

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DOI: 10.26509/frbc-wp-201018

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