Exchange Rate Determination under Alternative Inflation Targets: The Role of Trade Costs

Abstract

This paper investigates the role of international trade costs on exchange rate determination under different inflation targets. The investigation is achieved by introducing and simulating a two-country dynamic stochastic general equilibrium (DSGE) model with individuals, firms, and central bank policy makers. The main innovations of the model are achieved by considering the effects of international trade costs in an otherwise standard DSGE model and having a positive steady-state inflation rate that is essential to consider positive inflation targets. The simulation results suggest that (i) a shock to international trade costs received by an economy induces a permanent depreciation of its nominal exchange rate, (ii) the exchange rate dynamics depend on whether shocks to international trade costs hit only one country or both economies, (iii) the real exchange rate exhibits more persistence in its adjustment path following a shock to international trade costs compared to a monetary policy shock, and (iv) the nominal exchange rate exhibits higher volatility under higher inflation targets for a given a shock to international trade costs. It is implied that monetary policy authorities should choose inflation targets with caution, especially in a context of uncertainty regarding international trade costs.

Keywords: Trade Costs, Monetary Policy, Exchange Rates, Inflation Targeting

JEL Classification: E31, E52, E58, F41