Inflation Targeting and Exchange Rate Management In Less Developed Countries

Marco Airaudo, Edward Buffie and Luis-Felipe Zanna

No 2016/055, IMF Working Papers from International Monetary Fund

Abstract: We analyze coordination of monetary and exchange rate policy in a two-sector model of a small open economy featuring imperfect substitution between domestic and foreign financial assets. Our central finding is that management of the exchange rate greatly enhances the efficacy of inflation targeting. In a flexible exchange rate system, inflation targeting incurs a high risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfilling expectations. Moreover, small inflation shocks may escalate into much larger increases in inflation ex post. Both problems disappear when the central bank leans heavily against the wind in a managed float.

Keywords: WP; inflation targeting; upper bound; core inflation; managed float; Exchange Rate; Indeterminacy; Taylor Principle; inflation rate; closed economy; exchange-rate-anchored IT; nominal interest rate; Exchange rates; Exchange rate flexibility; Currencies; Real exchange rates; Inflation; Sub-Saharan Africa; Africa; Central and Eastern Europe; Eastern Europe; East Asia (search for similar items in EconPapers)
Pages: 65
Date: 2016-03-08
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Citations: View citations in EconPapers (14)

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