IMF Working Papers

Inflation Targeting and Exchange Rate Management In Less Developed Countries

By Marco Airaudo, Edward F Buffie, Luis-Felipe Zanna

March 8, 2016

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Marco Airaudo, Edward F Buffie, and Luis-Felipe Zanna. Inflation Targeting and Exchange Rate Management In Less Developed Countries, (USA: International Monetary Fund, 2016) accessed November 23, 2024
Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Currencies, Exchange rate flexibility, Exchange rates, Foreign exchange, Inflation, Money, Prices, Real exchange rates

Keywords: Africa, Central and Eastern Europe, Closed economy, Core inflation, Currencies, East Asia, Eastern Europe, Exchange Rate, Exchange rate flexibility, Exchange rates, Exchange-rate-anchored IT, Indeterminacy, Inflation, Inflation rate, Inflation targeting, Managed float, Nominal interest rate, Real exchange rates, Sub-Saharan Africa, Taylor Principle, Upper bound, WP

Publication Details

  • Pages:

    65

  • Volume:

    ---

  • DOI:

    ---

  • Issue:

    ---

  • Series:

    Working Paper No. 2016/055

  • Stock No:

    WPIEA2016055

  • ISBN:

    9781513567433

  • ISSN:

    1018-5941

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