Inflation Target In Emerging Countries: Modeling Exchange Rate Issues

Abstract

The idea of inflation targeting in emerging countries is not a new one. There have been papers that favor or reject the idea of implementing such a system in these countries for mainly institutional reasons. This paper does not deal with these normative arguments. Emerging countries are implementing IT regimes and therefore it is necessary to understand how it should be done and what problems can arise. Therefore this paper focuses on exchange rate issues for inflation targeting. These issues have their root in the basic relation that exists in emerging countries between inflation and the exchange rate, a relation known as the “pass through effect”. The simple setup used in this paper shows how the monetary authorities implementing an IT regime must intervene in the exchange rate market in order to comply with the inflation target. The central bank intervenes in order to avoid exchange rate movements that would affect the overall inflation rate through the pass-through effect. These results mean that the dirty floating or fear of floating hypothesis should be modified when applied to countries implementing IT, since their intervention (or dirty floating activities) may be justified.