Open-Economy Inflation Targeting

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Abstract
The paper examines inflation targeting in a small open economy with forward-looking aggregate supply and demand with microfoundations, and with stylised realistic lags in the different monetary-policy transmission channels. The paper compares strict and flexible targeting of CPI and domestic inflation and inflation-targeting reaction functions and the Taylor rule. Flexible CPI-inflation targeting does not only limit the variability of CPI inflation but also the variability of the output gap and the real exchange rate. Negative productivity supply shocks and positive demand shocks have similar effects on inflation and the output gap and induce similar monetary policy responses.

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