The instrument problem under inflation targeting in an open economy: the case of Costa Rica
Since the early 1990s, an increasing number of central banks have adopted inflation targeting as the strategy to conduct their monetary policy. Most of the literature on this topic presupposes that the instrument of monetary policy should be the nominal interest rate. This dissertation revisits the instrument problem in the context of a small open economy that implements inflation targeting. It formulates a partial equilibrium monetary model that describes the inflation process. This model is used to analyze the interaction between the typical instruments of monetary policy, namely the nominal interest rate or a monetary aggregate, with particular exchange rate regimes. In an open economy, the issue is not what the best instrument to deliver the desired inflation rate is but, rather, what the best combination of a particular exchange rate arrangement and one of the two other policy instruments is. An analytical result is that inflation targeting is incompatible with a hard-peg exchange rate regime. The theoretical framework does not allow, however, a definitive answer about the most appropriate combination of policy instruments to reach a desired sustainable path for the inflation rate. Given that the choice of the optimum instrument is an empirical problem, the monetary model of inflation is estimated econometrically using annual data for the past 53 years for Costa Rica. The estimated parameters are used to compute expressions for the mean-squared error for the inflation rate under different policy instrument combinations. A ranking of the mean-squared errors shows that the instrument combination that minimizes the error in targeting a desired inflation rate, in the long run, is the nominal interest rate and a free exchange rate regime. The reason why, from the perspective of monetary policy, a free exchange rate regime is superior to other regimes is that the latter, in the presence of capital movements, requires some form of monetary sterilization, which in turn leads to debt accumulation. Eventually, this debt leads to central bank losses, which in the long run are a source of monetary expansion and thereby of inflationary pressures.
School:The Ohio State University
School Location:USA - Ohio
Source Type:Master's Thesis
Keywords:inflation targeting monetary policy instrument problem exchange rate small open economy costa rica
Date of Publication:01/01/2004