Review of Keynesian Economics

Is inflation targeting operative in an open economy setting?

Esteban Pérez Caldentey * * and Matías Vernengo * *

Keywords: inflation targeting, open economies, exchange rate


The justification for inflation targeting rests on three core propositions. The first is called ‘lean against the wind,’ which refers to fact that the monetary authority contracts (expands) aggregate demand below capacity when the actual rate of inflation is above (below) target. The second is ‘the divine coincidence,’ which means that stabilizing the rate of inflation around its target is tantamount to stabilizing output around its full employment level. The third proposition is that of stability. This means that the inflation target is part of an equilibrium configuration which generates convergence following any small disturbance to its initial conditions. These propositions are derived from a closed economy setting which is not representative of the countries that have actually adopted inflation targeting frameworks. Currently there are 27 countries, 9 of which are classified as industrialized and 18 as developing countries that have explicitly implemented a fully fledged inflation targeting regime (FFIT). These countries are open economies and are concerned by the evolution of the external sector and the exchange rate as proven by their interventions in the foreign exchange markets. We show that these three core propositions and the practice of inflation targeting are inoperative in an open economy context.

Author Notes

The opinions here expressed are those of the authors and may not coincide with those of the institutions with whom they are affiliated. The authors wish to thank Cecilia Vera for useful comments on an earlier version of this paper.

You are not authenticated to view the full text of this chapter or article.

Elgaronline requires a subscription or purchase to access the full text of books or journals. Please login through your library system or with your personal username and password on the homepage.

Non-subscribers can freely search the site, view abstracts/ extracts and download selected front matter and introductory chapters for personal use.

Your library may not have purchased all subject areas. If you are authenticated and think you should have access to this title, please contact your librarian.

Further information