The Unsettling Behavior Of Exchange Rates Under Inflation

Paul Beaudry and Amartya Lahiri

Working Papers from Centre for Advanced Financial Research and Learning (CAFRAL)

Abstract: Over the last few decades, many central banks have adopted an inflation targeting framework and this has generally been associated with reduced inflation variability. In this paper we examine how inflation targeting has changed the behavior of exchange rates and we uncover a rather curious pattern. Using a large set of countries, we find that as countries switched to inflation targeting their currencies became tied to the price of oil, that is, under inflation targeting currencies tend to appreciate with rising oil prices while prior to inflation targeting regime they did not exhibit such a relationship. Importantly, this data pattern is observed independent of whether the country is a net oil exporter or importer. We argue that such a pattern may reflect that, under inflation targeting, the equilibrium dynamics for the nominal exchange rate becomes indeterminate when uncovered interest parity (UIP) does not hold. In such situations, oil prices may well act as a focal point for currency pricing decisions.

JEL-codes: E4 F4 (search for similar items in EconPapers)
Pages: 29
Date: 2018-10
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Persistent link: https://EconPapers.repec.org/RePEc:ris:cafral:022314

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