RDP 9807: Inflation Targeting in a Small Open Economy 1. Introduction
July 1998
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The practice of inflation targeting is becoming increasingly popular amongst central banks. Countries that currently have some form of inflation target include Australia, Canada, Finland, New Zealand, Spain, Sweden and the United Kingdom. The Reserve Bank of Australia (RBA) officially adopted an inflation target in 1993 with the stated objective of keeping underlying inflation between 2 and 3 per cent, on average, over the course of the business cycle (Grenville 1997).
The merits of inflation targeting are well documented in the literature.[1] Inflation targeting is said to impose discipline on central banks, promote policy transparency, and foster the credibility of the central bank. This serves to anchor private agents' inflation expectations, and can help to resolve the time inconsistency problems associated with monetary policy. For these reasons the central bank may be able to reduce inflation with less cost in terms of forgone output. In practice, inflation targets are accompanied by concern for output stability and perhaps interest-rate smoothing – in other words, the target is said to be flexible rather than strict. Strict inflation targeting may require large adjustments to the policy instrument. This is likely to induce extra volatility in output and interest rates, which can promote uncertainty and damage credibility. Flexible inflation targeting allows the central bank to maintain low, and relatively stable inflation, while promoting stability in product and financial markets.
Earlier work on inflation targeting was based on a closed economy framework where the central bank adjusts its policy instrument (usually the short-term nominal interest rate), to impact upon demand which in turn affects inflation.[2] More recent work by Svensson (1998) and Ball (1998) focuses on inflation targeting in an open economy, emphasising the importance of the exchange rate. Movements in the exchange rate occur in response to changes in interest rates, but also for speculative reasons. Changes in both interest rates, and the exchange rate, affect inflation indirectly via a lagged effect on demand. However, changes in the exchange rate also have a direct effect on the price of traded goods, and thus on aggregate inflation. Also, changes in the exchange rate may affect inflation expectations directly.
In this paper, we develop a model of a small open economy with traded and non-traded sectors. We investigate the implications of aggregate inflation targeting compared with targeting inflation of non-traded goods and services. Our model provides a description of an open economy which takes the world price of traded goods as given. In contrast to previous work, we distinguish between the consequences of different types of shocks by presenting variances of key macroeconomic variables, conditional on the type of shock hitting the economy.
The implications of inflation targeting in a small open economy are not as clear as in the case of a closed economy. For example, consider a shock that causes a persistent depreciation of the exchange rate which is not justified by fundamentals (such as a fall in the terms of trade). The immediate result is higher inflation in the traded goods sector. There will also be some inflationary pressure in the non-traded sector. Targeting aggregate inflation may involve substantial adjustment of the interest rate and subsequent volatility in output. One way of avoiding such an extreme outcome may be to target non-traded inflation. This would require less adjustment of the interest rate, and hence, less variability in output and non-traded inflation, at the cost of greater variability in the exchange rate and aggregate inflation. However, targeting non-traded inflation may produce undesirable outcomes when the economy is subject to shocks other than to the exchange rate. For example, in response to demand shocks, or shocks to non-traded inflation, a central bank with a non-traded inflation target is likely to restore equilibrium rapidly. This occurs through large adjustments in the interest rate, at the cost of greater volatility in the exchange rate and aggregate inflation.
The paper is structured as follows. Section 2 provides a brief review of the literature and discusses issues associated with inflation targeting in an open economy. We maintain that in the context of a small open economy there is a fundamental distinction between aggregate inflation and inflation in the non-traded sector. Section 3 presents empirical evidence that aggregate inflation behaves differently to non-traded inflation. Against this background, Section 4 presents a theoretical model of a small open economy with traded and non-traded sectors, and a forward-looking exchange rate. The model is used to compare aggregate versus non-traded inflation targeting. Simulation results are presented in Section 5 for the simplest version of the model with backward-looking inflation expectations. Section 6 presents some extensions to the basic model, including forward-looking inflation expectations, gradual exchange rate pass-through and discretionary policy. Section 7 summarises the main findings of the paper.