Make-up Strategies and Exchange Rate Pass-through in a Low-Interest-Rate Environment

Abstract

We evaluate the macroeconomic stabilization properties, with particular reference to the exchange rate pass-through, of price level targeting (PLT), average inflation targeting (AIT) and inflation targeting (IT) strategies when the effective lower bound on the monetary policy rate can be binding. The results of simulating the canonical open-economy New Keynesian model -- in which the assumption of local currency pricing holds and which is calibrated without loss of generality to the euro area -- are as follows. First, make-up strategies (PLT and AIT) stabilize inflation better than IT, by favoring a smaller appreciation (larger depreciation) of the nominal exchange rate in the event of disinflationary demand (supply) shocks. Second, and in connection with this, the exchange rate pass-through to import prices is more limited under make-up strategies than under IT, as the former stabilize the inflation rate of imports to a greater extent. Third, the results are robust to alternative values of import price stickiness and elasticity of substitution between domestic and imported goods. Fourth, the stabilization properties of make-up strategies are qualitatively preserved under partially backward-looking inflation expectations, although the relative gains of make-up strategies with respect to IT are smaller than under model-consistent inflation expectations.

Keywords: effective lower bound, exchange rate pass-through, local currency pricing, make-up strategies, monetary policy

JEL Classification: E31, E52, F31, F41