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Inflation targeting and exchange rate management in less developed countries

Edward F. Buffie, M. Airaudo and Felipe Zanna

Journal of International Money and Finance, 2018, vol. 81, issue C, 159-184

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 tight 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. Moreover, small inflation shocks may escalate into much larger increases in inflation ex post. Both problems disappear when the central bank fixes the path of the nominal exchange rate or leans heavily against the wind in a managed float.

Keywords: Inflation targeting; Exchange rate; Indeterminacy; Taylor principle (search for similar items in EconPapers)
JEL-codes: E52 E58 F41 (search for similar items in EconPapers)
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:81:y:2018:i:c:p:159-184

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