Inflation Persistence: Implications for a Design of Monetary Policy in a Small Open Economy Subject to External Shocks

46 Pages Posted: 13 Feb 2007

Date Written: March 2007

Abstract

We analyze implications of inflation persistence for business cycle dynamics following terms of trade and risk-premium shocks in a small open economy, under fixed and flexible exchange rate regimes. We show that the country's adjustment paths are slow and cyclical if there is a significant backward-looking element in the inflation dynamics and the exchange rate is fixed. We also show that such cyclical adjustment paths are moderated if there is a high proportion of forward-looking price setters. In contrast, with an independent monetary policy, flexible exchange rate allows to escape severe cycles, supporting the conventional wisdom about the insulation role of flexible exchange rates.

Keywords: inflation inertia, monetary policy, exchange rates, persistence, Phillips curve

JEL Classification: E32, F40, F41

Suggested Citation

Kuralbayeva, Karlygash, Inflation Persistence: Implications for a Design of Monetary Policy in a Small Open Economy Subject to External Shocks (March 2007). CEIS Working Paper No. 95, Available at SSRN: https://ssrn.com/abstract=962665 or http://dx.doi.org/10.2139/ssrn.962665

Karlygash Kuralbayeva (Contact Author)

King’s College London ( email )

Strand
London, England WC2R 2LS
United Kingdom

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