Real-Exchange-Rate-Adjusted Inflation Targeting in an Open Economy: Some Analytical Results
Policymakers in small open economies around the world are increasingly concerned about the undesirable consequences of sudden increases in U.S. interest rates. This paper demonstrates that in a small open economy a central bank can successfully ward off sudden changes in foreign interest rates and risk premium shocks – portfolio shocks - by choosing a core rate of inflation, real-exchange-rate-adjusted (REX) inflation, as its inflation objective and adding the real exchange rate to a Taylor-type rule. 1 The Taylor-type rule with a prescribed exchange rate response becomes a Monetary Conditions Index (MCI). From a welfare perspective the Taylor-type rule, with (the MCI) or without the exchange rate response, delivers welfare losses that are substantially greater than under optimal policy with commitment. But the performance of the properly designed MCI relative to other Taylor type rules improves with portfolio shocks becoming a more important source of disturbances.