The effects of capital market openness on exchange rate pass-through and welfare in an inflation targeting small open economy

Mukherjee, Sanchita (2011): The effects of capital market openness on exchange rate pass-through and welfare in an inflation targeting small open economy. Unpublished.

Abstract

This paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss in an inflation targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, I examine whether a more open capital market in an inflation targeting country improves the credibility of the central bank and consequently reduces exchange rate pass-through. First, I empirically examine the effect of capital openness on exchange rate pass-through using a New Keynesian Phillips curve. The empirical investigation reveals that limited capital openness leads to greater pass-through from the exchange rate to domestic inflation, which raises the marginal cost of deviation from the inflation target. This subsequently worsens the inflation output-gap trade-off and increases the social loss of the inflation targeting central bank under pure commitment. However, the calibration results suggest that the inflation output-gap trade-off improves and the social loss decreases even in the presence of larger exchange rate pass-through if the capital controls are effective at insulating the exchange rate from interest rate and risk-premia shocks.

• Item Type: MPRA Paper
• Language: English
• Keywords: Monetary policy; Inflation Targeting; Exchange rate pass-through; Capital account openness; Small open economy
• Subjects: E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects); F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F47 - Forecasting and Simulation; F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy

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