Inflation Targeting and Sudden Stops

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Abstract
Underlying weaknesses in the domestic financial sector and limited integration with world financial markets make emerging market economies vulnerable to “sudden stops” of capital inflows. Without much warning, the capital flows that support a boom may come to a halt, exposing the country to an external crisis. Monetary policy in this context has often been seen as an additional source of problems rather than as a remedy. This chapter shows how inflation targeting should be adapted to countries whose primary macroeconomic concern is the presence of sudden stops in capital inflows. It uses a model that provides a natural motivation for both centralized holding of reserves and holding reserves in the form of dollars. However, it demonstrates that a central bank that cannot commit will be too aggressive in injecting dollar reserves during a crisis. To better understand monetary policy in emerging markets, the chapter models the presence of two distinct financial constraints: one between domestic agents and one between domestic agents and foreign investors.

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