The authors study a wide range of hybrid inflation-targeting (IT) and managed exchange rate regimes, analysing their implications for inflation, output and the exchange rate in the presence of various domestic and external shocks. To this end, the chapter presents an open economy New Keynesian model featuring sterilized interventions in the foreign exchange (FX) market as an additional central bank instrument operating alongside the Taylor rule, and affecting the economy through portfolio balance sheet effects in the financial sector. The chapter shows that there can be advantages to combining IT with some degree of exchange rate management via FX interventions. Unlike ‘pure’ IT or exchange rate management via interest rates, FX interventions can help insulate the economy against certain shocks, especially shocks to international financial conditions. However, managing the exchange rate through FX interventions may also hinder necessary exchange rate adjustments, e.g., in the presence of terms of trade shocks.
The Impossible Trinity: Inflation Targeting, Exchange Rate Management and Open Capital Accounts in Emerging Economies
