Assessing the Impacts and Policy Alternatives
Edited by Gerald A. Epstein and A. Erinc Yeldan
Chapter 3: Inflation Targeting and the Real Exchange Rate in a Small Economy: A Structuralist Approach
3. Inflation targeting and the real exchange rate in a small economy: a structuralist approach Jose Antonio Cordero INTRODUCTION 3.1 In the past few years several nations, especially encouraged by the International Monetary Fund (IMF), have decided to move into a monetary regime based on explicit inflation targets. This regime has been strongly recommended to economies that were struggling to bring their inflation rates down to the level of the more advanced countries. The application of this regime has been very effective in reducing inflation but, as argued in Epstein and Yeldan (2008), the final effects on employment and economic growth are not so clear. A rigorous analysis of the consequences of inflation targeting in open economies requires a formal model exploring the interaction among money, the foreign sector, output and employment. Within the structuralist tradition several models have been developed in order to examine growth and distribution in open economies. These works, however, do not always include the monetary sector and, when they do, they rarely establish the links between the latter and the balance of payments; they are not designed to examine the association between the monetary regime and the foreign exchange rate system. This chapter attempts to fill that void by means of a framework that allows comparing two alternative monetary regimes: one resulting from inflation targeting, and another resulting from real exchange rate targeting. The model allows formalizing the adjustment process in three periods: first, output and employment vary with given prices, second, inflation clears an...
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