Inflation Targeting in a Small Open Economy*

Abstract

AbstractIn this paper we offer a justification for the observed wide variation in monetary practices across industrial countries. We claim that differences in the monetary policy rule adopted may simply reflect differences in economic structure and, in particular, in the types of shocks encountered and nominal rigidities present in various countries. We find that a case for inflation targeting can be made when external shocks are the prevalent source of volatility in the economy – a likely scenario for a small open economy. A policy of strict inflation targeting performs best when the main source of nominal rigidity is to be found in the labour market, while a policy of flexible inflation targeting that also puts some emphasis on exchange rate volatility has superior performance when the main source of nominal rigidity is in the goods market. Domestic supply shocks, on the other hand, call for greater tolerance of short‐run inflation movements, especially in the presence of nominal wage rigidities.