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Inflation targeting and exchange rate pass-through

Authors
Journal
Journal of International Money and Finance
0261-5606
Publisher
Elsevier
Publication Date
Volume
26
Issue
7
Identifiers
DOI: 10.1016/j.jimonfin.2007.06.003
Keywords
  • Inflation Targeting
  • Exchange Rate Pass-Through
  • Small Open-Economy
  • Direct Exchange Rate Channel
  • Optimal Monetary Policy
Disciplines
  • Economics

Abstract

Abstract This paper analyzes how endogenous imperfect exchange rate pass-through affects inflation targeting optimal monetary policies in a New Keynesian small open economy. The paper shows that an inverse relation exists between the pass-through and the insulation of the economy from foreign and monetary policy shocks, and that imperfect pass-through tends to decrease the variability of the terms of trade. Furthermore, with CPI inflation targeting, in the short run, delayed pass-through constrains monetary policy more than incomplete pass-through and interest rate smoothing amplifies this effect. When the pass-through decreases, the variability in economic activity tends to rise and the trade-off between the stabilization of CPI inflation and output worsens in direct relation to how strictly the central bank is targeting CPI inflation. In contrast, with domestic inflation targeting, optimal monetary policy is not constrained and opposite results occur. Consequently, imperfect pass-through favors the choice of domestic to CPI inflation targeting.

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