Credible Monetary Policy When Output is Persistent: Exchange Rate and Nominal Income Targeting

Abstract

Distortions introduced by targeting nominal income growth, or an exchange rate peg, in the trade-off between inflation and output in the stabilization of shocks to supply and terms of trade cannot be eliminated simultaneously. If supply shocks are optimally stabilized, targeting an exchange rate peg yields relatively less bias in shocks to the terms of trade if the economy is relatively open. Optimal degree of conservativeness depends on shock selected for stabilization and on policy regime. Targeting a weighted sum of change in real exchange rate and nominal income growth is shown to replicate the optimal equilibrium without resort to a state-contingent rule.