Description

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.

More publications in this series: Working Papers

More publications by: Marco Airaudo ; Edward F. Buffie ; Luis-Felipe Zanna