Inflation targeting and exchange rate volatility smoothing: A two-target, two-instrument approach

Abstract

This paper introduces a strategy to model a small open economy, whose central bank has established two simultaneous policy objectives: an inflation target, and a maximum limit for nominal exchange rate volatility. In line with the Tinbergen–Aoki condition, the monetary authority establishes two policy instruments, one for accomplishing each target: the monetary policy rate, and the stock of foreign exchange reserves. Monetary policy analysis is built around a non-microfounded augmented New Keynesian DSGE model estimated through Bayesian techniques for the Guatemalan economy. It is found that each instrument is efficient in accomplishing its own target. Nevertheless, a coordinated effort is required for central bank policymakers before employing both instruments simultaneously, in order to avoid sending mixed signals to economic agents about its monetary policy stance, and endanger the achievement of its inflation target.