The effects of capital market openness on exchange rate pass-through and welfare in an inflation targeting small open economy
Sanchita Mukherjee ()
MPRA Paper from University Library of Munich, Germany
This paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss in an inflation targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, I examine 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, I empirically examine the effect of capital openness on exchange rate pass-through 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; Exchange rate pass-through; Capital account openness; Small open economy (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 F41 F47 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-mon
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Working Paper: The effects of capital market openness on exchange rate pass-through and welfare in an inflation-targeting small open economy (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:pra:mprapa:30478
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