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.
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|Size: ||3.0 MB|
|Publisher: ||INTERNATIONAL MONETARY FUND|
|Date published: || 2016|
|ISBN: ||9781475523164 (DRM-EPUB)|
|Read Aloud: ||not allowed|