Working Paper: CEPR ID: DP2726
Authors: Alan Sutherland
Abstract: A small open economy model is presented, which allows explicit treatment of uncertainty and its effects on macroeconomic behaviour. Inflation targeting is compared to the welfare maximizing monetary rule and to a fixed nominal exchange rate. It is found that flexible inflation targeting produces too little exchange rate volatility compared to the optimal rule but delivers higher welfare than a fixed nominal exchange rate. Strict inflation targeting also delivers higher welfare than a fixed rate. In addition it is found that the welfare-maximizing monetary rule can be replicated if the central bank?s objective function includes the nominal exchange rate.
Keywords: inflation targeting; monetary policy; open economy
JEL Codes: E52; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| flexible inflation targeting (E63) | lower exchange rate volatility (F31) |
| lower exchange rate volatility (F31) | higher welfare (I31) |
| strict inflation targeting (E31) | higher welfare (I31) |
| strict inflation targeting (E31) | lower exchange rate volatility (F31) |
| inflation targeting (E31) | insufficient exchange rate fluctuations (F31) |
| central bank's inflation targeting regime (E52) | welfare implications (I30) |
| exchange rate volatility in central bank's objective function (F31) | enhanced welfare outcomes (I38) |
| welfare-maximizing weight on output (D69) | more output volatility (E39) |