• Inflation Targeting and Exchange Rate Management In Less Developed Countries

Inflation Targeting and Exchange Rate Management In Less Developed Countries

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We analyze coordination of monetary and exchange rate policy in a two-sector model of asmall open economy featuring imperfect substitution between domestic and foreign financialassets. Our central finding is that management of the exchange rate greatly enhances theefficacy of inflation targeting. In a flexible exchange rate system, inflation targeting incurs ahigh risk of indeterminacy where macroeconomic fluctuations can be driven by self-fulfillingexpectations. Moreover, small inflation shocks may escalate into much larger increases ininflation ex post. Both problems disappear when the central bank leans heavily against thewind in a managed float.
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