Chapter

IV Different Roles for the Exchange Rate and the Policy Trade-Offs

Author(s):
Anna Nordstrom, Scott Roger, Mark Stone, Seiichi Shimizu, Turgut Kisinbay, and Jorge Restrepo
Published Date:
November 2009
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This section uses a model-based approach to evaluate the performance of different inflation-targeting approaches.9 First, a taxonomy of inflation-targeting approaches is developed, modifying the conventional approach to take more explicit account of the role of exchange rate considerations in monetary policy formulation. Then, the performance of these approaches is evaluated in different types of economies and for handling different types of shocks.

Research focusing mainly on models of industrial economies suggests that including the exchange rate in the central bank’s policy reaction function is unlikely to deliver significant benefits. Taylor (2001) suggests that this may reflect the fact that exchange rate movements are already taken into account indirectly in a standard inflation-targeting framework and also that the appropriate response to the exchange rate depends on the nature of the underlying shock. Nonetheless, both Taylor (2000) and Mishkin (2000) underscore the need for further research in this area, particularly for emerging economies.

More recent research tends to focus on whether particular characteristics of emerging economies might justify including the exchange rate directly in the reaction function. Batini, Levine, and Pearlman (2007) find that no weight should be put on the exchange rate in a financially vulnerable economy and argue that, because dollarization weakens the output gap channel of transmission relative to the exchange rate channel, nothing should be done to limit the flexibility of the exchange rate in order to achieve the inflation target. Ravenna and Natalucci (2008) also caution against putting much weight on exchange rate stabilization, particularly in the event of productivity shocks. Others, including Morón and Winkelried (2005) and Cavoli and Rajan (2006), suggest that there may be some benefit in including the exchange rate in the reaction function in financially vulnerable economies, but they also find that the optimal weight is low. Leitemo and Söderstöm (2005) consider the choice of policy rules when there is exchange rate uncertainty and find that a plain vanilla rule is slightly more robust than an open-economy rule, whereas Wollmershäuser (2006), examining a wider range of rules and uncertainties, comes to the opposite conclusion. McCallum (2006) also finds that an exchange-rate-based approach to inflation targeting may be beneficial in a very open economy.

A Taxonomy of Inflation-Targeting Approaches

This subsection outlines a taxonomy of approaches for bringing the exchange rate into the inflation-targeting framework:

  • the conventional open-economy inflation-targeting framework—plain vanilla inflation targeting—in which exchange rate movements are taken into account only indirectly;
  • an open-economy approach, which adds an explicit exchange rate objective to the plain vanilla approach;
  • inflation targeting with an explicit exchange rate band; and
  • inflation targeting with the exchange rate rather than a short-term interest rate as the policy instrument.

These approaches have three important features in common. The first is that stabilizing inflation around the target rate is the overriding policy objective over the medium term.10 Second, the central bank may also seek to reduce the volatility of output, interest rates, and the exchange rate, but it must do so in a way that is consistent with the medium-term inflation target.11 Third, the various rules involve a systematic approach to policy in the sense that the elements of the central bank’s policy reaction function, and the weights placed on the elements, are stable over time.

Plain Vanilla Inflation Targeting in an Open Economy

The plain vanilla approach describes the conventional open-economy inflation-targeting framework practiced in advanced economies.12 Monetary policy formulation involves periodic adjustments in a target policy interest rate, guided primarily by deviations of projected inflation from the target and, to a lesser extent, by the deviation of actual GDP from potential GDP (the output gap). Typically, the central bank also seeks to smooth the path of interest rates. This approach to policy formulation is represented here by the policy reaction function:

where:

i^tit(r¯+πT) is the deviation of policy target interest rate i in period t from its long-run steady-state value, defined as the long-run equilibrium real interest rate r¯, plus the target inflation rate πT;

π^t(πtfπT) is the deviation of the period t inflation forecast, πtf, from the inflation target πT;

y^t(yty¯t) is the deviation of real output y from Y¯, the estimated level of potential output, in period t;

vt represents additional policy judgment as well as imprecision in policy implementation.

Key features of the plain vanilla reaction function are the following.

  • The exchange rate does not appear explicitly in the policy reaction function. However, exchange rate developments and prospects are taken into account implicitly because they affect the inflation forecasts and output.13
  • To ensure that the central bank’s actions are consistent with achieving the inflation target, the value of a should be greater than 1, so that the real interest rate changes by at least as much as any change in deviation of projected inflation from target.14
  • Although the central bank does not have a long-run target for the level of output or growth, it places some weight on dampening output volatility around the sustainable, noninflationary level of output (potential output) to ensure long-run consistency with the primary inflation objective.15
  • The parameter λ characterizes the degree of policy inertia. If λ is high, the central bank will normally adjust the policy stance only gradually in response to economic developments or prospects.

Open-Economy Inflation Targeting

Open-economy inflation targeting involves explicitly taking exchange rate developments into account in the central bank’s policy reaction function, rather than doing so only indirectly through the effects on output and the inflation forecast. The exchange rate enters the reaction function in essentially the same way as output: there is no target for the exchange rate, but some weight is placed on dampening exchange rate volatility:16

where:

q^t is the deviation of the real exchange rate in period t from its steady-state equilibrium value.

This specification allows for dampening volatility in the level of the exchange rate relative to the long-run equilibrium rate, dampening changes in the exchange rate, or both:

  • If ϕ = 0, the central bank systematically dampens deviations in the level of the real exchange rate from the steady-state equilibrium rate.17
  • Alternatively, if ϕ = 1, the central bank dampens changes in the real exchange rate, consistent with limiting exchange rate volatility.
  • More generally, if 0 <ϕ< 1, the central bank places some weight on dampening rapid changes in the exchange rate and some weight on limiting exchange rate misalignment.

Including the exchange rate in the reaction function does not imply the establishment of an exchange rate target. Indeed, it is essential that policy measures to dampen exchange rate volatility be conducted in a manner that is consistent with the noninflationary long-term equilibrium of the economy. This is particularly important if the policy responds to deviations in the level of the exchange rate around the estimated steady-state value, because errors in estimating the long-term equilibrium level may lead to both a systematic bias in the policy stance and a conflict between the inflation and exchange rate objectives.18

In practice, many inflation-targeting emerging economies appear to adjust interest rates systematically in response to exchange rate movements, consistent with an open-economy inflation-targeting approach.19 Several case studies (including Peru) suggest that monetary policy in these countries might be better characterized as open-economy inflation targeting than as plain vanilla inflation targeting, insofar as the central banks have shown a fairly systematic tendency to “lean against” significant movements in their exchange rates.

Inflation Targeting with an Exchange Rate Band

Inflation targeting with an exchange rate band involves setting limits on the acceptable range of movement for the exchange rate. In the case of a symmetric exchange rate band, the policy reaction function can be represented as follows:20

where:

θ=0if|q^t|<q

θ0if|q^t|q

q’ is half the width of the exchange rate band.

Within the band, the approach works essentially like the open-economy inflation-targeting approach, but once the edge of the band is reached, the inflation objective is overridden by the exchange rate objective.21 Clearly, if the exchange rate band is wide relative to the typical magnitude of exchange rate changes, then the band is rarely binding and the approach is similar to open-economy inflation targeting. If the band is relatively narrow, however, the regime may appear similar to an exchange rate peg (a crawling peg if the equilibrium exchange rate is moving over time or some kind of peg to a composite if the real effective exchange rate is used). The nonlinearity of the policy response to exchange rate movements that is implied by this framework is difficult to incorporate in a simple model, and for this reason it is not included in the model simulations.

Several countries have used this approach, especially to transition to inflation targeting. Chile (1990–99) and Israel (1992–96) used this framework in their transitions from relatively high-inflation, exchange-rate-based regimes to low-inflation, full-fledged inflation-targeting frameworks.22 Recent examples include Hungary (until early 2008) and the Slovak Republic.

Exchange-Rate-Based Inflation Targeting

The exchange rate rather than an interest rate can be used as the operating instrument or proximate target for monetary policy. In this case, the central bank’s policy reaction function can be described as follows:

As in the plain vanilla and open-economy approaches, the coefficient on the inflation objective, α, must be high enough to ensure that inflation is brought back to target over the medium term. In principle, this approach could be implemented directly through unsterilized intervention in the foreign exchange market. Alternatively, the central bank could use a very short-term domestic interest rate to move the exchange rate to the desired level.23

To date, only two countries have used the exchange-rate-based approach: New Zealand during the early 1990s and Singapore currently.24 In both cases, use of the exchange rate as the operational target substantially reflected the openness of the economies and consequently the importance of the exchange rate relative to interest rates in the monetary policy transmission mechanism.25

Evaluation of Alternative Inflation-Targeting Approaches

In this subsection, a small open-economy model is used to evaluate the performance of alternative inflation-targeting approaches in financially robust advanced economies and financially vulnerable emerging economies. The analysis begins with a brief description of the model, focusing on structural differences between the stylized advanced and emerging economies. This is followed by a discussion of the results of the model simulations, which compare how different policy rules perform in the different types of economies and in response to different kinds of economic disturbances.

The main purpose of the analysis is to provide a more systematic comparison of the performance of alternative approaches. In most studies, alternative rules are compared in the context of a particular type of economy or shock (see, for example, Batini, Harrison, and Millard, 2001; Cavoli and Rajan, 2006; McCallum, 2006; and Ravenna and Natalucci, 2008). Other studies compare the performance of particular rules across economies but do not specifically address the issue of the benefits of including the exchange rate in the reaction function (for example, Morón and Winkelried, 2005). Finally, the range of shocks used to evaluate different rules and different economies varies considerably from study to study. This analysis compares the performance of a range of simple policy rules in both financially robust economies and financially vulnerable economies and in response to a standard set of shocks.

Model Characteristics

The analysis is based on a conventional, small, open-economy model. Standard features of such models include forward-looking optimizing behavior by households and firms, together with nominal and real rigidities that generate sluggish adjustments to economic disturbances. These rigidities provide scope for monetary policy to have real effects in the short term but not over the long term. The open-economy nature of the model is reflected both through the importance of international trade in aggregate demand and by the effects of international trade and financial flows on interest rates and the exchange rate. The model is discussed in greater detail in Appendix II, but some important features are particularly relevant:

  • Aggregate demand includes domestic and foreign demand components; higher real interest rates dampen demand, whereas a weaker currency boosts demand.
  • Firms use labor and imported inputs in production. Real wages are procyclical so that stronger aggregate demand increases production costs. A weaker currency also boosts production costs and induces substitution toward the use of more labor and fewer imports in production.26
  • Inflation is largely determined by the price-setting behavior of firms. Prices are adjusted periodically and reflect past changes and forward-looking expectations about costs.
  • The relationship between the exchange rate and the interest rate comprises (1) a conventional uncovered interest parity (UIP) condition that links domestic risk-free interest rates to foreign rates and to the expected change in the exchange rate; (2) a risk premium reflecting the current account balance; (3) the level of external debt relative to GDP; and (4) the vulnerability of corporate balance sheets to exchange rate movements.

Two versions of the model are calibrated to create stylized representations of a financially robust advanced economy and a financially vulnerable emerging economy. The main differences between the stylized economies reflect the following:

  • Domestic financial system development: In the emerging economy, interest rates are assumed to be less effective in influencing demand than in the advanced economy, reflecting a less developed financial system.
  • External financial vulnerability: In the emerging economy, the differential between domestic and foreign interest rates is assumed to be more sensitive to the evolution of external debt and the current account balance than in advanced economies, consistent with less stable capital mobility and asset substitutability.27 In addition, the emerging economy is assumed to have a high proportion of financial liabilities denominated in foreign currency, making it vulnerable to strong balance sheet effects resulting from exchange rate changes. These balance sheet effects are assumed to outweigh the more conventional macroeconomic effects of exchange rate changes.28
  • Policy credibility: In the emerging economy, price setting by firms is assumed to be more backward looking than in the advanced economy. This reflects weaker policy credibility as a legacy of higher inflation and more limited central bank independence.29

Model Simulations

Three kinds of model simulations are conducted, with each focused on a slightly different question:

  • How do different roles for the exchange rate affect the trade-off between the variability of inflation and output?
  • How do changes in the weight placed on the exchange rate in the policy reaction function affect the variability of inflation and output?
  • How do different roles for the exchange rate affect the variability of a wider range of macroeconomic and financial variables?

How do different roles for the exchange rate affect the trade-off between the variability of inflation and output?

The simulations distinguish between different economic structures in the financially robust advanced economy and the financially vulnerable emerging economy and different types of economic shocks, including demand shocks, cost-push shocks, and risk-premium shocks.30

The variability of output and inflation and the tradeoffs between them differ substantially according to the nature of the shocks and the structure of the economy. Figure 4.1 shows policy trade-offs for plain vanilla inflation targeting in robust advanced economies and vulnerable emerging economies. The curves, or frontiers, show the combinations of inflation and output variability achievable by varying the relative weights on inflation and output in the plain vanilla inflation targeting policy rule (see Equation 4.1).

Figure 4.1.Plain Vanilla Inflation Targeting in a Robust Advanced Economy and a Vulnerable Emerging Economy

Source: IMF staff estimates.

The volatility of output and/or inflation is typically significantly higher in the vulnerable emerging economy than in the robust advanced economy for comparably sized shocks of all kinds, reflecting differences in economic structure.31 In both types of economies, the scope for a trade-off between inflation and output variability depends greatly, and in a broadly similar way, on the nature of the economic disturbances:

  • In the case of demand disturbances, the “L” shaped trade-off curves indicate that there is only a limited trade-off between inflation and output variability, especially in the robust advanced economy. Indeed, in the advanced economy, a portion of the slope becomes positive, indicating that putting a very high weight on dampening inflation and a very low weight on stabilizing output may lead to higher volatility in both variables, rather than to a trade-off. Essentially, in the event of demand disturbances, reducing output volatility tends to dampen inflation volatility and vice versa. In both types of economies, reducing the volatility of inflation beyond some point typically leads to sharp increases in output volatility, and vice versa. This finding supports the view that putting some weight on smoothing deviations between actual output and potential output, in addition to countering deviations of projected inflation from the target, is sensible in both advanced and emerging economies.
  • In the case of risk-premium disturbances, there is likewise only limited scope for a trade-off between inflation and output variability in either the advanced or the emerging economy. But there is clearly a significant difference between the impact that risk-premium disturbances have on the levels of inflation and output variability in the two types of economy.
  • In the case of cost-push disturbances, the lengthy downward-sloping efficiency frontiers show that there is much more scope for a trade-off between output and inflation variability. In the case of the advanced economy, the steep slope indicates that putting a fairly heavy weight on stabilizing output comes at relatively little cost in terms of higher inflation variability. With relatively well-anchored inflation expectations, the central bank can afford to largely “look through” transient cost-push shocks. In the emerging economy, however, with weaker policy credibility, cost-push shocks tend to feed into ongoing inflation so that the trade-off is more evenly balanced, making it more costly in terms of inflation variability for the central bank to focus on stabilizing output.

Differences between the various inflation-targeting frameworks can have a significant impact on the inflation output trade-off. Figure 4.2 compares the performances of alternative policy reaction functions in the robust advanced and vulnerable emerging economies. For the advanced economy, the plain vanilla approach performs best in handling demand shocks, but some dampening of exchange rate changes is better in handling cost-push and risk-premium shocks. Responding to the level of the exchange rate, however, performs poorly when coping with demand or risk-premium shocks.

Figure 4.2.Alternative Policy Rules and the Variability of Inflation and Output in Advanced and Emerging Economies1

Source: IMF staff estimates.

1 Frontiers are derived by varying the relative weights of inflation and output objectives in the policy reaction function while holding the coefficient on the exchange rate objective at 0.3 and the coefficient on instrument smoothing at 0.7.

2 IT = inflation targeting.

3 focused on changes in the exchange rate (XR).

4 Splits weight between change in and the level of the exchange rate.

These results are generally consistent with conventional views about the best inflation-targeting framework for an advanced economy. Ragan (2005) observes that exchange rate movements associated with disturbances that directly affect demand tend to offset the output and inflation effects of the shock. Consequently, rules that dampen exchange rate adjustments to demand disturbances tend to be counterproductive. In the case of risk-premium shocks, the exchange rate movements are destabilizing, so that including some dampening of exchange rate changes in the rule outperforms the plain vanilla approach. This is consistent with Ragan’s argument that, in the case of risk-premium shocks, an inflation-target-oriented monetary policy should aim to offset the induced demand effects of the shock in order to dampen the inflation consequences. This can be achieved by allowing the interest rate to rise just enough to offset the demand stimulus of a weaker currency.32 Including the exchange rate in the rule works in this direction and thus outperforms the plain vanilla approach.

For the financially vulnerable emerging economy, an open-economy inflation-targeting approach appears to perform about as well as plain vanilla inflation targeting. This result appears to stem primarily from the perverse demand effects of exchange rate changes that are associated with a high degree of liability dollarization. In these circumstances, exchange rate changes associated with demand shocks do not have the stabilizing effect on demand described by Ragan (2005). Consequently, some exchange rate dampening tends to yield better outcomes than plain vanilla inflation targeting in the event of both demand and risk-premium shocks. Moreover, the more L-shaped frontiers associated with the open-economy inflation-targeting framework also indicate that the rule tends to reduce the scope for a trade-off between output and inflation volatility, making them more complementary as objectives, as in the robust advanced economy.

The open-economy inflation-targeting approaches that work best in a robust advanced economy appear to differ in an important way from those that work best in a vulnerable emerging economy. In the advanced economy, the open-economy rule that works best focuses on dampening exchange rate changes, and performance is worsened by including the level of the exchange rate, such as the “half-and-half” rule (which puts equal weight on changes in and the level of the exchange rate). Conversely, in the emerging economy, putting some weight on the level of the exchange rate greatly improves the performance of the open-economy approach. The key difference between these rules is the persistence of the policy response to an exchange rate movement. The rule that focuses only on exchange rate changes results in a much briefer policy response than a rule focusing on the level of the exchange rate. It appears that a more sustained response to exchange rate movements is needed in the vulnerable emerging economy than in the advanced economy, perhaps reflecting the more backward-looking process of price setting.33

In the vulnerable emerging economy, incorporating the exchange rate into the policy rule also affects the trade-off between output and inflation in the event of supply shocks. As discussed previously in the context of plain vanilla inflation targeting, emerging economies tend to face a higher cost in terms of inflation volatility when they seek to dampen output volatility associated with supply shocks. Active exchange rate policy frameworks appear to tilt the trade-off somewhat further in this direction, suggesting that if the exchange rate is included in the policy framework, it may also be appropriate to increase the weight placed on inflation relative to output smoothing.

The analysis in this section suggests that the plain vanilla rule, which performs well in advanced economies primarily affected by demand shocks, may not perform as well as a default rule in many emerging economies. The choice of policy rule should reflect the predominant kinds of shocks to which the economy is exposed, as well as the structure of the economy. In reality, monetary policymakers are faced with an array of different kinds of shocks of different magnitudes that may occur simultaneously. Moreover, there is often substantial uncertainty surrounding the nature of the shocks. In such circumstances, it makes sense for the central bank to have a “default” rule that is likely to perform reasonably well in response to the types of disturbances to which the economy is typically exposed.

How do changes in the weight placed on the exchange rate affect the variability of inflation and output?

If the exchange rate is taken explicitly into account in an inflation-targeting framework, an important issue is how much weight to put on the exchange rate relative to inflation and output objectives. In the preceding simulations, the weight placed on the exchange rate was fixed. The second set of simulations focus on how the variability of inflation and output is affected by changing the weight given to the exchange rate while holding fixed the weights given to the inflation and output objectives.

Figure 4.3 shows how the policy trade-off—the variability in inflation and output—shifts as the weight on the exchange rate is increased. The starting point for each curve is the plain vanilla rule, with a weight of zero on the exchange rate. In the case of the open-economy inflation-targeting framework, the rule focusing on exchange rate changes is used for the advanced economy, while the half-and-half rule, with equal weight on the change in and the level of the exchange rate, is used for the emerging economy (reflecting the results of the previous simulations). The curves in the panels basically trace how the inflation-output volatility trade-off shifts as the weight on the exchange rate in the policy rule increases. In other words, they show whether the trade-off curves in Figure 4.2 move closer to or further away from the origin as the exchange rate objective increases in importance. In the first panel of Figure 4.3, for example, the curve for the advanced economy shows that as the weight on the exchange rate is increased from zero (the plain vanilla rule), the volatility of output rises quite rapidly, while inflation volatility increases only slightly. The curve for the emerging economy shows that increasing the weight on the exchange rate from zero first leads to a decline in inflation volatility and a slight increase in output volatility, but later raises the volatility of both inflation and output. The results suggest that, even when it is beneficial to include the exchange rate in the reaction function, the weight placed on it should be quite small:

  • In the vulnerable emerging economy, putting a small weight on the exchange rate (around 0.3, compared with weights of 0.5 on output and 1.5 on inflation) tends to dampen inflation volatility while slightly increasing output variability in the event of demand and risk-premium shocks. If more than a small weight is placed on the exchange rate, however, both output and, especially, inflation performance deteriorate substantially. In the event of cost-push shocks, there is a more sustained trade-off, with the efficiency frontier shifting toward greater inflation volatility and less output volatility as the weight placed on the exchange rate in the policy rule increases.
  • In the robust advanced economy, putting any weight on the exchange rate worsens performance in the event of demand disturbances. In the event of cost-push disturbances, however, putting some weight on the exchange rate reduces inflation variability with virtually no impact on output variability. With risk-premium disturbances, placing a small weight on the exchange rate slightly reduces output volatility and increases inflation volatility, but as the weight on the exchange rate is increased, both output and inflation volatility increase.

Figure 4.3.The Impact of an Exchange Rate Objective on the Variability of Inflation and Output in Robust Advanced and Vulnerable Emerging Economies1

Source: IMF staff estimates.

1 Frontiers are derived by varying the coefficient on the exchange rate objective between zero (plain vanilla inflation targeting) and 3 while holding weights on inflation and output objectives at 1.5 and 0.5, respectively.

2 For the advanced economy, the open-economy inflation-targeting rule includes the change in the exchange rate; for the emerging economy, the rule includes the “half and half” rule of weight on change in and level of the exchange rate.

The results also suggest that exchange-rate-based inflation targeting should only involve a moderate degree of exchange rate smoothing. For the exchange-rate-based inflation-targeting framework, increasing the degree of exchange rate smoothing raises the volatility of inflation and especially output in both advanced and emerging economies. However, as long as the degree of smoothing is fairly low (a smoothing parameter of less than about 0.6), the deterioration in output and inflation performance is very limited.

How do different roles for the exchange rate affect the variability of a wider range of macroeconomic and financial variables?

Although inflation-targeting central banks may be principally concerned with stable inflation and growth, they also typically seek to avoid inducing high variability in interest rates, the exchange rate, and international trade performance. The third set of simulations therefore focuses on the impact of alternative frameworks on the volatility of a wider range of variables than just output and inflation. In these simulations, the weights placed on the inflation, output, and exchange rate objectives use the combination of weights shown in the previous simulations to minimize output and inflation volatility.34

The results suggest that inflation-targeting frameworks with an active role for the exchange rate may significantly reduce financial and external volatility in financially vulnerable emerging economies but offer little benefit to robust advanced economies. The “cobweb” charts in Figure 4.4 show the variability in output and inflation, real interest rates, the real exchange rate, and the real trade balance for different inflation-targeting rules in advanced and emerging economies.

  • The vulnerable emerging economy is characterized by significantly higher macroeconomic and financial volatility than the robust advanced economy. This applies even more to real interest rates, the real current account balance, and especially the real exchange rate than to inflation and output (see Figure 4.1).
  • In the vulnerable emerging economy, the open-economy half-and-half rule and the exchange-rate-based inflation-targeting approach both lead to sharp reductions in exchange rate volatility compared with the plain vanilla approach, as well as more modest reductions in interest rate and trade volatility. These reductions in volatility are also associated with a slight decrease in inflation variability and a slight increase in output variability in the event of demand or risk-premium shocks (see Figure 4.3). In the event of cost-push shocks, output variability is reduced and inflation variability increases relative to the plain vanilla rule.
  • In the advanced economy, including the exchange rate shows no significant benefit in terms of macroeconomic or financial performance relative to the plain vanilla inflation-targeting framework. Indeed, the exchange-rate-based approach and the half-and-half open-economy approach lead to a slight worsening of performance in most dimensions.

Figure 4.4.Performance of Alternative Policy Rules on Macroeconomic and Financial Volatility in Advanced and Emerging Economies1

Source: IMF staff estimates.

1 Based on weights on inflation, output, and exchange rate objectives of 1.5, 0.5, and 0.3, respectively.

2 IT = inflation targeting.

3 Focused on change in the exchange rate (XR).

4 Splits weight between change in and the level of the exchange rate.

General Assessment

The simulations support the conventional wisdom that financially robust advanced economies have relatively little to gain by including the exchange rate directly in the policy reaction function. If the economy is mainly affected by demand shocks, a plain vanilla approach outperforms the alternatives. However, if the economy is vulnerable to cost-push and risk-premium shocks, an active role for the exchange rate may be preferable. In these circumstances, the analysis suggests that the focus should be on dampening changes in the exchange rate, not on its level.

At the same time, the analysis suggests that financially vulnerable emerging economies might benefit by including the exchange rate in the reaction function in a limited way. An active role for the exchange rate may lead to slightly better output and inflation performance than a plain vanilla approach. Putting weight on the exchange rate appears to offer more substantial benefits by reducing volatility in the exchange rate, interest rate, and trade balance, particularly in the event of cost-push and risk-premium disturbances. Because these countries may be much more exposed to such disturbances than financially robust advanced economies, this is an important advantage.

Nonetheless, the analysis also suggests that the weight put on the exchange rate should be small relative to the weights given to inflation and output. The simulations indicate that putting more than a modest weight on dampening exchange rate volatility is likely to significantly worsen macroeconomic performance.35

The analysis suggests that an exchange-rate-based approach to inflation targeting may work almost as well as an open-economy approach in financially vulnerable emerging economies, particularly by lowering the volatility of the exchange rate, interest rate, and trade balance. However, the analysis also indicates that a high degree of exchange rate smoothing is likely to harm macroeconomic performance. In addition, such a framework may be problematic from an operational perspective. In particular, the framework could be prone to speculative pressures in advance of periodic resets of the exchange rate, resulting in high interest rate volatility, pressure on foreign exchange reserves, or both.

For inflation-targeting emerging economies that are in a relatively robust financial position, a framework with an active role for the exchange rate is likely to be less beneficial than in more vulnerable economies. In many emerging economies, dollarization is limited, so that the net impact on demand of exchange rate changes is in the same direction as in an advanced economy.36 Under these circumstances, the case for an exchange rate role is weaker than in more financially vulnerable economies. However, such economies may still be more exposed than most advanced economies to cost-push and risk-premium shocks, and these are the types of shocks for which plain vanilla inflation targeting may be outperformed by the alternatives. Moreover, the best inflation-targeting rule may be different in a robust emerging economy than in a robust advanced economy. In particular, if inflation expectations are less well anchored, the best approach may be to put some weight on the level as well as on the change in the exchange rate.

Caveats

As for any small model, the one used in this analysis has important limitations. These constrain the kind of questions or issues that can be addressed and also mean that caution is warranted in drawing firm conclusions on the generalizability of the results. Indeed, the analysis itself points to the need for caution, because there can be substantial differences in the effects of various types of shocks and in the implications of variations in economic structure or policy rules. Some important issues that are not addressed within the model include the following:

  • Policy credibility: The representation of policy credibility in the model is highly simplified. Because credibility is set exogenously, it is not possible to evaluate how different policy rules affect policy credibility, and vice versa.37 In this regard, endogenizing credibility would facilitate examination of two issues of particular interest: whether including the exchange rate in the policy rule undermines policy credibility, and how credibility affects exchange rate pass-through effects.
  • The long-run equilibrium, or steady state, of the economy: In this model, the steady state of the economy is exogenous. Consequently, the model cannot readily compare the performance of alternative policy frameworks in handling changes in the steady state of the economy, nor can it assess possible effects of different policy approaches on the steady state. A particular example concerns possible hysteresis effects of real exchange rate movements on potential output, implying that temporary shocks can have permanent effects. It is not clear, however, whether such limitations of the model would, on balance, strengthen the case for whether and how to include the exchange rate in the monetary policy reaction function.
  • Uncertainty regarding the steady state: Because the model is specified in terms of deviations of variables from steady-state values, it implicitly assumes that the steady-state values are known. Errors in estimating steady-state values will result in policy mistakes and greater macroeconomic volatility. However, it is not clear that this is an argument for excluding the exchange rate from the reaction function. There has been extensive analysis of an analogous issue—the implications of misestimating potential output. In general, research on this issue indicates that even if potential output is misestimated, it is better to include the output gap in the policy reaction function.38 An additional consideration is whether errors in the estimates of the steady-state values of the real interest rate, real exchange rate, and output gap are likely to be correlated with one another. In principle, at least, inclusion of the exchange rate in the reaction function might improve policy if errors in measuring the steady state of the output gap typically offset errors in measuring steady-state values of the other variables.
  • Uncertainty regarding the correct model of the economy: Although there is always uncertainty about how best to model the economy, the problem may be more acute in emerging economies undergoing extensive structural change, and for which data availability and quality may be weaker, than in more advanced economies. In this case, it is desirable to have policy rules that are robust to modeling errors. In this regard, Wollmershäuser (2006) finds that an open-economy inflation-targeting rule is more robust than a plain vanilla rule to a range of errors in specifying the correct model of the exchange rate.39
  • Linearity of the model: This is a standard property of most models but has some important implications for this analysis. In particular, it means that the model cannot take into account threshold effects or asymmetries that may be important in transmission of financial disturbances or exchange rate movements. It also limits the ability to deal with the implications of uncertainty for the design and choice of a policy framework. In particular, the model is not really able to address the consequences for different policy rules of uncertainties regarding different shocks or the steady state of the economy.
  • Model parameters: The model parameters are imposed rather than estimated. Although most parameters are drawn from the relevant literature, the two country models are deliberately intended to highlight differences. Thus the emerging economy model is calibrated to ensure financial vulnerability. In view of this, the findings of the analysis should not be seen as prescriptions for policy in any particular economy. To translate the analysis into policy, the kind of policy rules examined in this analysis would need to be adapted to reflect the structure of specific economies.
9See Roger, Restrepo, and Garcia (2009) for a full description of the model and analysis in this section and Appendix II.
10Essentially, this requires that the policy instrument reacts strongly enough to a gap between the inflation forecast and the target to ensure that inflation will return to the target rate over the long term.
11In this context, it is important to distinguish clearly between targets and objectives. The central bank has a target for the steady-state level of inflation, but it has no target for either output or the exchange rate (either level or rate of change). The inflation target is distinct from the objective of minimizing variations in inflation around the target and variations in output, interest rates, and the exchange rate from their steady-state values.
12See, for example, Mishkin (2000) and Truman (2003) for overviews of the framework and Svensson (2000) for a model-based analysis of policy formulation.
13See, for example, Brook (2001), Ragan (2005), and Taylor (2001).
14The distinction between “strict” and “flexible” inflation targeting discussed in Svensson (2000) partly hinges on whether α is much greater than β.
15Caution is needed in interpreting the weights in the reaction function. These do not necessarily reflect the central bank’s preferences regarding stable inflation versus other objectives. For example, even if the central bank has no interest in stabilizing output per se, it might put some weight on dampening output volatility if this contributed to stabilizing inflation.
17Note that the steady-state value of the real exchange rate may have an upward or downward trend over time, particularly in emerging economies that experience significant structural change.
18Of course, this applies equally to dampening fluctuations in the actual level of output relative to the estimated level of potential output.
21As long as the deviation of the real exchange rate from the steady-state equilibrium, q^t, is less than some amount q then policy is based on an open-economy inflation-targeting approach (or a plain vanilla approach if the exchange rate coefficient γ is set to zero). However, if the exchange rate reaches the q threshold, then the interest rate response to further exchange rate deviation, (y– 8), is much stronger, overriding the inflation objective.
23In this case, the exchange rate can be described as a proximate or operational target, intermediate between the operating instrument and the inflation objective.
24The classification of the monetary and exchange rate framework in Singapore is somewhat uncertain. One study, by Parrado (2004a), estimates that there is a very high degree of exchange rate smoothing, which may not be fully consistent with inflation targeting. Moreover, the Singapore authorities themselves do not describe their framework as an inflation-targeting regime.
26The model does not include direct exchange rate pass-through from foreign to domestic prices. Pass-through is indirect via the cost of imported goods used in production. The magnitude of pass-through therefore depends on the openness of the economy (the share of imported inputs in production) as well as the extent to which changes in costs can be passed on to consumers.
27In other words, the risk premium depends partly on the external-debt-to-GDP ratio and on the current external balance, and in the financially vulnerable economy the coefficients on these terms are assumed to be larger than in the financially robust economy.
28This approach to modeling external financial vulnerability follows Céspedes, Chang, and Velasco (2004) and Morón and Winkelried (2005).
29Rudebusch and Svensson (1998) argue that backward-looking expectations may be an appropriate specification in the early stages of inflation targeting when agents are still learning about the regime.
30Details of the simulation methodology are described in Appendix II.
31In particular, the ability of the central bank in the advanced economy to achieve low inflation and output volatility is facilitated by the more forward-looking behavior of agents and the greater effectiveness of the interest rate and exchange rate channels of transmission.
32This is precisely the logic underlying the design and use of a Monetary Conditions Index (MCI), which was designed to offset the impact of exogenous exchange rate shocks on aggregate demand, with the relative weights in the index reflecting the relative importance of interest rate and exchange rate changes in affecting aggregate demand.
33Wollmershäuser (2006) also finds that a mixed rule outperforms alternatives, even with forward-looking expectations. He attributes the superior performance of this type of rule to the fact that both the current and the previous value of the exchange rate contain useful forward-looking information that is not being captured in the central bank’s incorrect model of the economy.
34Specifically, the weights used in the simulations are 1.5 for inflation, 0.5 for output, and 0.3 for the exchange rate objective. The coefficient on instrument smoothing is 0.7.
35In the model, macroeconomic performance tends to deteriorate significantly if the weight put on exchange rate smoothing is more than about half the weight placed on output smoothing. This is consistent with the results in Ravenna and Natalucci (2008), who find that putting a large weight on exchange rate smoothing is disadvantageous in handling sectoral productivity shocks. It may be noted that in their model, the “flexible” exchange rate rule uses a weight on the exchange rate of 0.1, relative to weights of 0.4 on output and 1.0 on inflation.
36See, for example, Tovar (2006), who finds that for the Korean economy, the stimulative effects of devaluation outweigh balance sheet effects.
37Céspedes and Soto (2005) find that, in a model with endogenous policy credibility, weak credibility tends to shorten the effective policy horizon as well as to decrease policy aggressiveness.
39Moreover, the rule that performs best is a mixed rule that puts some weight on both the level of and the change in the exchange rate.

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