Inflation targets and real exchange rate: volatility, stabilization and credibility

Abstract

In this paper we develop a small open economy model, in which output depends on both interest rate and real exchange rate. Our results show that: a) output may be volatile in response to exogenous shocks, both external and domestic; b) the relative responsiveness of output to interest rate and real exchange rate in the short run will be determinant of equilibrium output. In turn, we show that, depending on this relative responsiveness, a credible central bank that follows an explicit inflation objective can improve economic results in the long run