Inflation Targeting and Exchange Rate Management in Less Developed Countries

66 Pages Posted: 26 Apr 2016

See all articles by Marco Airaudo

Marco Airaudo

Drexel University

Edward F. Buffie

Indiana University Bloomington - Department of Economics

Luis-Felipe Zanna

International Monetary Fund (IMF)

Date Written: March 2016

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: Inflation Targeting, Exchange Rate, Indeterminacy, Taylor Principle, inflation, foreign exchange, central bank, Monetary Policy (Targets, Instruments, and Effects), Open Economy Macroeconomics, All Countries,

JEL Classification: E52, F41, E58

Suggested Citation

Airaudo, Marco and Buffie, Edward F. and Zanna, Luis-Felipe, Inflation Targeting and Exchange Rate Management in Less Developed Countries (March 2016). IMF Working Paper No. 16/55. Available at SSRN: https://ssrn.com/abstract=2770290

Marco Airaudo (Contact Author)

Drexel University ( email )

3141 Chestnut St
Philadelphia, PA 19104
United States

Edward F. Buffie

Indiana University Bloomington - Department of Economics ( email )

Wylie Hall 105
107 S. Indiana Avenue
Bloomington, IN 47405-7000
United States
812-855-4848 (Phone)

Luis-Felipe Zanna

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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