Inflation Targeting in a Small Open Economy

Nargis Bharucha and Christopher Kent
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Nargis Bharucha: Reserve Bank of Australia
Christopher Kent: Reserve Bank of Australia

RBA Research Discussion Papers from Reserve Bank of Australia

Abstract: This paper investigates the merits of aggregate inflation targeting compared with non-traded inflation targeting using a model of a small open economy producing traded and non-traded goods. An important innovation of our approach is that we isolate the effects of exchange rate, supply and demand shocks by analysing the conditional variance of macroeconomic variables. We show that monetary policy should be more activist in response to exchange rate shocks for a flexible aggregate inflation target than for a flexible non-traded inflation target. However, in response to demand and supply shocks monetary policy is more activist for a flexible non-traded inflation target. The result is robust to the inclusion of forward-looking expectations, gradual exchange rate pass-through, and discretionary policy. In order to avoid excessive volatility in product and financial markets, it may be preferable to target inflation over a medium-term horizon.

Keywords: inflation targets; open economy; non-traded inflation; forward-looking variables; conditional variance (search for similar items in EconPapers)
JEL-codes: C61 E52 E58 F41 (search for similar items in EconPapers)
Date: 1998-07
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Citations: View citations in EconPapers (16)

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Persistent link: https://EconPapers.repec.org/RePEc:rba:rbardp:rdp9807

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