Inflation Targeting in a Small Open Economy^*

Abstract

In this paper we offer a justification for the observed wide variation in monetary practices across industrial countries. We claim that differences in the monetary policy rule adopted may simply reflect differences in economic structure and, in particular, in the types of shocks encountered and nominal rigidities present in various countries. We find that a case for inflation targeting can be made when external shocks are the prevalent source of volatility in the economy -a likely scenario for a small open economy. A policy of strict inflation targeting performs best when the main source of nominal rigidity is to be found in the labour market, while a policy of flexible inflation targeting that also puts some emphasis on exchange rate volatility has superior performance when the main source of nominal rigidity is in the goods market. Domestic supply shocks, on the other hand, call for greater tolerance of short-run inflation movements, especially in the presence of nominal wage rigidities.Ã We thank Fabio Ghironi, Alan Stockman and two anonymous referees for valuable comments and discussions. The views expressed are solely the responsibility of the authors and should not be interpreted as reflecting the views of their affiliations or of any other person associated with them.

Announced Regime Switch: Optimal Policy for Transition Period

“…However, due to the volatility of trade-offs between variables, a simple comparison of volatilities does not straightforwardly identify the regime that delivers the highest level of macroeconomic stability. As Cuche-Curti, Dellas, and Natal (2008) summarize, an exchange rate peg can outperform a flexible exchange rate regime under the assumptions of a stable external environment and that the main source of nominal rigidity is in the goods market. They also find that policies ignoring movements in the exchange rate can be dominated by a simple exchange rate targeting policy.…”

“…A focus on macroeconomic stability is used as the standard approach to the evaluation of monetary policy. This approach simplifies the analysis because of its independence of the welfare function specification, and it offers interesting comparisons, as presented by Cuche-Curti, Dellas, and Natal (2008) and Collard and Dellas (2002).…”

“…For the analysis of macroeconomic stability over the transition, it is assumed that the monetary authority follows the optimal policy with respect to the ad-hoc loss function, as in Laxton and Pesenti (2003) and Santacreu (2005). Furthermore, Cuchi--Curti, Dellas, and Natal (2008) and Dellas and Tavlas (2003) summarize that there is no straightforward recommendation for the optimal policy type. The optimal policy choice depends on many factors, such as the presence and origin of rigidities and structural shocks.…”

Monetary policy and commodity terms of trade shocks in emerging market economies

“…Indeed, recent studies have shown that monetary policy regimes such as in ‡ation targeting can play a role in dampening cyclical macroeconomic ‡uctuations and improve welfare in small open economies (see e.g. Svensson, 2000;Cuche-Curti et al, 2008). The choice of monetary policy regimes also matters because wages and prices of non-tradable goods are sticky in the short-run and the speed at which relative prices adjust depends crucially on the monetary policy regime.…”