Predetermined exchange rate, monetary targeting, and inflation targeting regimes

• Date: 01 September 2016
• DOI: http://doi.org/10.1111/ijet.12092
• Published date: 01 September 2016
• Author: Shigeto Kitano

doi: 10.1111/ijet.12092

Predetermined exchange rate, monetary targeting, and

inflation targeting regimes

Shigeto Kitano∗

Many works analyzing the Mundell–Fleming dictum comparethe predetermined exchange rate

regime and the monetary targeting regime under flexible exchange rates. Reflecting on the fact

that many emerging market countries have shifted to the inflation targeting regime, this paper

aims to extend the literature toinclude the latter. The results of our analysis show that the interest

rule with an inflation target is superior (or at least equal) to the two above-mentioned regimes

in absorbing both real and monetary shocks.

Key wor ds optimal exchange rate regime, predetermined exchangerate, flexible exchange rate,

Mundell–Fleming dictum, small open economy

JEL classification E42, E58, F31, F41, O24

Accepted 10 March2015

1 Introduction

The choice of exchange rate regime has been one of the most important issues in open macroeco-

nomic policy analysis ever since Friedman (1953).1Accordingto the conventional wisdom, both the

flexible exchange rate regime and the predetermined exchangerate regime have their advantages and

disadvantages. If the internal prices are sticky,the predetermined exchange rate regime makes better

adjustments to monetary shocks, while the flexible exchange rate regime makes better adjustments

to real shocks.2V´

egh (2013, p. 1512) provides an excellent intuitive explanation of the conventional

wisdom. Real money balances play the key role of absorbing monetary shocks. Since, under flexible

exchange rates, policy-makers set the path of the money supply, real money balances are predeter-

mined (if internal prices are sticky). The economy thereforecannot absorb monetar y shocks through

the instantaneous adjustment of real money balances under flexible exchange rates. In contrast, un-

der predetermined exchange rates, policy-makers set the path of the nominal exchange rate. Since

real money balances are not predetermined in this case, the economy can absorb monetary shocks

(at least partially) through the adjustment of real money balances. On the other hand, the opposite

∗Research Institute for Economics and Business Administration (RIEB), KobeUniversity, Rokkodai, Nada, Kobe, Japan.

Email: kitano@rieb.kobe-u.ac.jp

Earlier versions of the paper were presented at Osaka University, Kobe University, and the JEA annual meeting in

Kumamoto. I thank Shinsuke Ikeda, Tatsuro Iwaisako, Takayuki Tsuruga, Hirokazu Ishise, Shingo Iokibe, and Takashi

Kamihigashi for valuable comments. I am extremely grateful to an anonymous referee for his/her careful reading and

helpful comments. Any remaining errors aremine. This work was suppor tedby Grants-in-Aid for Scientific Research.

1Friedman (1953) argued that if internal prices are sticky,the exchange rate regime matters and the flexible exchange rate

regime makes better adjustments in response to the changes in external conditions.

2Lahiri et al. (2006) refer to the conventionalw isdom as the Mundell–Flemingdictum.

International Journal of Economic Theory 12 (2016) 233–256 © IAET 233

International Journal of Economic Theory

Optimal exchange rate regimes Shigeto Kitano

is true for real shocks. The real exchange rate plays the key role of absorbing real shocks. Since

the real exchange rate is not predetermined under flexible exchange rates, the economy can absorb

real shocks (at least partially) through the adjustment of the real exchange rate. In contrast, under

predetermined exchange rates, the economy cannot absorb real shocks through the adjustment of

the real exchange rate, since the real exchangerate is predetermined (if the internal prices are sticky).

Hence, we can say that the predetermined exchange rateregime has an advantage in its flexibility to

absorb monetary shocks, while the flexible exchange rate regime has an advantage in its flexibility to

absorb real shocks.3

There have been many works on the optimal exchange rate regimes, and the advantages and

disadvantages of different exchange regimes have been extensively discussed.4For example, Lahiri

et al. (2007) revisited the issue of the optimal exchange rate regime in a model with flexible prices

and asset market frictions, arguing that the asset market frictions may be as prevalent as the goods

market frictions. They showed that in this case, contrary to the conventional wisdom, the flexible

exchange rates are optimal in the presence of monetary shocks, whereas the fixed exchange rates are

optimal in the presence of real shocks. They concluded that the choice of an optimal exchange rate

regime should also depend on the type of frictions as well as the type of shocks.5

In examining the conventional wisdom on predetermined and flexible exchange rates, rigorous

mathematical models assume that under the flexible exchange rates, policy-makers set a path of

money supply. In other words,the literature regarding the conventional wisdom has been concerned

mainly with the choice between the predetermined exchange rate regime and the monetary targeting

regime under flexible exchangerates. However, in reality,as argued by Frankel (2010), many countries

have shifted to the inflation targeting regime. Not only developed countries such as New Zealand,

Canada, the United Kingdom, and Sweden but also manyemerging market countries such as Brazil,

Chile, Colombia, Mexico,the Czech Republic, Hungary,Poland, Israel, Korea, South Africa, Thailand,

Indonesia, Romania, and Turkey shifted to the inflation targeting regime after (or in the middle of)

the series of currency crises in the emerging markets in East Asia and Latin America from the mid

1990s to the early 2000s.6This recent shift of many emerging market countries to the inflation

targeting regime provides the motivation for our paper.

Our paper is not the first to examinethese three cases. Indeed, for example, Mishkin and Savastano

(2001) already discuss the advantages and disadvantages of a hard exchange rate peg, monetary

targeting, and inflation targeting. However, they specifically focus on monetary policy strategies

in Latin America and are concerned with the advantages and disadvantages of the three regimes

from a more pragmatic perspective, taking into consideration the institutional environment or fiscal

situation in each Latin American country rather than developing a rigorous mathematical model.

On the other hand, as previously discussed, the literature concerned with rigorous mathematical

models, such as Helpman and Razin (1979, 1982), Helpman (1981), Calvo (1999), Devereux and

Engel (2003), C´

espedes et al. (2004), and Lahiri et al. (2007), only considers the predetermined

exchange rate regime and the monetary targeting regime when comparing exchange rate regimes.

Our paper aims to extend the literature on rigorous mathematical models regarding the Mundell–

Fleming dictum to include the inflation targeting regime. As such, we specifically consider nominal

3These results will be replicated in Sections 3.1, 3.2, 4.1, and 4.2.

4See, among others, Helpman and Razin (1979, 1982), Helpman (1981), Calvo (1999), Devereux and Engel (2003), and

C´

espedes et al. (2004).

5Lahiri et al. (2006) also obtained similar results using a perfect-foresight version of the stochastic model in Lahiri et al.

(2007).

6See Frankel (2010) for a comprehensive survey.

234 International Journal of Economic Theory 12 (2016) 233–256 © IAET