The Role of Exchange Rate in Inflation Targeting
Takatoshi Ito *University of Tokyo
Post-Conference Version
Final, May 2007

Abstract. Issues related to compatibility of inflation targeting with managed exchange
rate regime are examined. The inflation targeting regimes in Asia are reviewed. The
correlation between the inflation rate and the exchange rate movement is reviewed. It
is argued that monetary policy actions in order to keep the inflation rate stable inresponse to an inflation shock will also offset the impact on the exchange rate from theinflation shock. Similarly, an exchange rate shock may be countered by monetary policythat will keep both the exchange rate and the inflation rate stable. Therefore, under usual
circumstances, inflation targeting and the exchange rate management are notinconsistent, especially when both targets have reasonably wide ranges.

JEL: E31, E52, F31
Keywords: inflation targeting; managed exchange rate; monetary policy; central
banking*

Professor, Graduate School of Economics and Graduate School of Public Policy, University ofTokyo. Views and Opinions expressed in this paper is the author’s and they do not necessarily
represent those of the official institutions that the author has been affiliated with in the past andpresent. The original version of this paper was prepared for the conference “Challenges to Inflation
Targeting in Emerging Countries,” at the Bank of Thailand on November 13, 2006. The author is
grateful to Drs. Khor Hoe Eee, Claudio Borio, Hans Genberg, Bandid Nijathaworn, Adam Posen,
and Pichit Patrawimolpon and other participants of the conference for their valuable comments.

1. Introduction
The exchange rate is an important variable for policy decisions, especially in a small
open economy. Prior to the Asian currency crisis, many central banks in East Asia, andother emerging market economies, had maintained the fixed exchange rate regime witha belief that exchange rate stability is essential for promoting trade and investment.
However, the fixed exchange rate regime had become difficult to maintain when thecapital accounts were liberalized. Some emerging market economies, including
Mexico and Thailand, first received large capital inflows followed by large outflows.
When the central bank, faced with massive outflows, tried to maintain the fixedexchange rate and exhausted the foreign exchange, the currency crisis resulted.
The fixed exchange rate with capital mobility meant the loss of control in monetary
policy. The impossibility of having capital mobility, the fixed exchange rate, andindependent monetary policy, is often called “impossible trinity.” After the Asiancrisis, the “two-corner solution” was advocated by the IMF and the United States. It
says that the stable exchange rate regime is either the hard peg (currency board or
dollarization) or free float. The intermediate regimes, such as the managed float or the
fixed exchange rate regime without a currency board arrangement, were regarded as
inherently unstable. (See Fischer (2001) for such a view.) However, free floating may
result in the loss of nominal anchor, or a guidance of monetary policy. Since 1998, theIMF has recommended to emerging market economies in addition to advanced countries
a combination of free float and inflation targeting in order to lessen the probability of acurrency crisis with stability of domestic prices.
The “two-corner solution” has become not so popular since the collapse of the currencyboard in Argentina. Even the currency board was not immune from the currency crisis,
because the domestic adjustment to avoid a currency crisis was not as automatic as
theory of currency board presumed.
Although one corner became not so popular, the other corner, the free float regime,
seemed to have gained more popularity, and so has inflation targeting. In East Asia,
Korea, Thailand, the Philippines, and Indonesia adopted inflation targeting since 1998.
Many emerging market economies have adopted, with or without recommendation of
IMF, the inflation targeting framework since 1998, some have not necessarily given up
on intervention in the foreign exchange market.

2

Time to time, the monetary authorities have intervened in the foreign exchange market,
and have attempted to influence the exchange rate movement. Inferring from thechanges in the foreign reserves, interventions have been rather large for some emerging
market countries.
Many inflation-targeting central banks of emerging market economies are believed tohave managed the exchange rate in an attempt to lessen the volatility of the exchange
rate. 1 This raises a question whether the managed exchange rate regime is compatible
with inflation targeting. A purist view is that an inflation targeting central bank should
not attempt to manage the exchange rate. The central bank should not pursue two
objectives. However, a more pragmatic view is that a managed exchange rate regime
and inflation targeting are compatible with each other most of the time. Those central
banks that practice both inflation targeting and substantial intervention are practicing apragmatic view.
Inflation targeting is a framework that the inflation rate is to be contained within anannounced range in the medium term. A fluctuation within the range is allowed
according to a shock to the economy. The demand or supply shock is partially
accommodated with a commitment that the inflation rate in the future will be kept or
brought back to the target range. With the medium term commitment to price stability,
expected future inflation rate would not change even with some shocks.
Suppose that both the inflation targeting and the exchange rate targeting aim at being
inside a range, and not pursuing a point. The question is how serious the defect is topursue two loose targets by one instrument. If responding to a shock in one variable
also contributes to keep the other variable stable, then pursuing two objectives iscompatible with each other.
The exchange rate fluctuations are one of the shocks to the economy. If it can beestablished that a natural response to the exchange rate shock may not jeopardize
inflation targeting, or even contribute to stabilizing prices, then pursuing the two targets
with one instrument may not be so bad. When the exchange rate appreciates, it tends
to have effects of lowering the inflation rate through two channels, lowering the cost of1

See Brash (2002) for the inflation targeting experiences of New Zealand, the first inflation
targeting country. It had a brief period of a mistake in paying too much attention to the exchange rateby putting too large a weight on the exchange rate in the rule of the interest rate response to thevarious economic conditions (the so-called Monetary Condition Index). .
3

imports and dampening the output by discouraging exports. Lowering the interest rate tostimulate the economy is an appropriate reaction in such a circumstance, unless the
inflation rate is too high to begin with.
Of course, excessive intervention to fix the exchange rate may result in amplifying
rather than moderating the inflation rate. Since the exchange rate is a noisy variable, an
excessive reaction to the exchange rate is not a wise idea.
The rest of the paper is organized as follows. Section 2 describes the combination of
the exchange rate regime and monetary policy framework, practiced by many countries.
Section 3 examines the experiences of the four Asian central banks that had adopted
inflation targeting. Section 4 examines the role of the exchange rate in inflation
targeting. Section 5 concludes the paper.
2. Exchange Rate Regime and Monetary Policy Framework
Countries have adopted various combinations of an exchange rate regime and amonetary policy framework. The exchange rate regime varies from the hard peg tofree float. The monetary policy framework ranges from no-independence to total
independence. The possible combination is shown in Table 1. The two corners withshades are the so-called the two corner solutions, a hard-peg and free float.
Table 1 about here
2.1 The currency board
The currency board theoretically works like the gold standard, but replacing gold withforeign reserves (that are maintained, in most cases, US Treasury papers). The monetary
authority holds foreign reserves as assets, and issue monetary base as liabilities. Whencapital inflows occur, the currency board monetary authority buys foreign currency at
the fixed exchange rate, expanding monetary base. The interest rate will be lowered
and capital inflows will be discouraged. Similarly, an increase in capital outflows
automatically lowers foreign reserves and monetary base, raising the interest rate. Thus
capital outflow will be discouraged. Therefore, the automatic adjustment mechanism isbuilt in. The interest rate is maintained at the rate when capital inflows and outflows
are balanced. If capital mobility is high, then the credible currency board will equate
the domestic interest rate with the one in the foreign country to which the peg ismaintained (in the case of Hong Kong, the US dollar).

4

Sterilization, or open market operations in general, is not possible because the monetary
authority is not allowed to hold domestic assets. Under the currency board, there is noroom for independent monetary policy, for better or worse.
The currency board has become popular when Argentina survived contagion from the
Mexican crisis of 1994-95 and the Asian crisis of 1997 and Hong Kong survived
contagion from the Asian crisis. However, as Argentina experienced the currency crisisand eventually de-peg from the US dollar in January 2002, the popularity was lost.
As the collapse of the currency board in Argentina shows, the currency board is notinvincible. 2 There were several external and internal shocks to Argentina. Depreciationof the Brazilian real and of the Euro vis-à-vis the US dollar (and the Argentinean peso)
from 1999 to 2001 had adverse impacts on the tradable sectors in Argentina. Domestic
price and wage adjustment could not neutralize the changes in the price competitivenessquick enough. Downward adjustment of prices and wages proved to be difficult.
Fiscal deficits also contributed to increasing volatility and fragility of the domestic
economy, raising the interest rate, inviting short-term capital inflows. When the capital
flows started to flow out as the economic conditions deteriorated, there was little choicethat the government could do to prevent further outflows. The currency board
collapsed in January 2002.
2.2 Free Float and Inflation Targeting
The other extreme of the two-corner solution is free float. The exchange rate is left tothe market force, while monetary policy is concentrated on the domestic price stability.
The central bank mandate is to keep the domestic price stability, and intervention into
the foreign exchange market is kept minimal, if at all. In this category, New Zealandstands out. It was the first country to adopt inflation targeting in 1990, and its authorities
have not intervened in the foreign exchange market since the late 1980s. Other countries
that have adopted inflation targeting after New Zealand have intervened in the foreignexchange market time to time. However, the frequency of interventions tends to havedecreased in many countries. Canada and Australia have adopted inflation targeting andthe frequency of interventions has declined substantially.
Three major economies—the US, the Euro land, and Japan—have adopted free floating,2

See Mussa (2002) and Dominguez and Tesar (2005) for the crisis in Argentina.
5

but not inflation targeting. The Federal Reserve Board (FRB) has achieved pricestability with discretionary monetary policy but with strong preference for price stability
since the mid-1980s. Mr. Greenspan has achieved substantial credibility for pricestability during his 18 year tenure at Chair of the FRB. Mr. Bernanke, who succeeded
Mr. Greenspan in February 2006, was an academic who advocated inflation targeting sothat a debate on adopting one in FRB may be stimulated. The US Treasury and FRB
have not intervened in the yen/dollar market since 1998, and the euro/dollar market
since 2000.
The European Central Bank since its establishment in 1999 has put emphasis on pricestability. It has announced “0-2% but close to 2%” as a reference range of price stability.
But it does not call the range as a target. It resisted a call for intervention during thesustained fall until the fall of 2000, although the Euro had depreciated from its
introduction in January 1999 to September 2000 by more than 30%. The G7 intervened
to support the Euro on September 22, 2000; and the ECB intervened on November 3,
2000. These are two occasions that the ECB and European national central banks
intervened for the Euro.
The Japanese authorities have intervened in the foreign exchange market more often
than the US and European counterparts. The intervention policy seemed to go through a
few stages. (See Ito (2004b) for descriptions of the Japanese intervention policy.) After
frequent interventions between 1991 and 1995, interventions had become very
infrequent between June 1995 and December 2002. However, frequent and massiveintervention occurred between January 2003 and March 2004. The Japanese
authorities, namely the Ministry of Finance, purchased 35 trillion yen worth of US
Treasury securities in the 15 months period. No intervention took place after March 16,
2004.
The Bank of Japan gained legal independence from the government in April 1998.
The independent monetary policy board, with nine members, can decide on monetary
policy without being pressured by the government. Since the exchange rate policy isdecided by the Ministry of Finance and monetary policy by the Bank of Japan, acoordination problem may occur if the two institutions have different assessment on theeconomy. .
The Bank of Japan has not adopted inflation targeting. When the Japanese economy

6

went through a long stagnation, from 1992 to 2002, the monetary policy set the policy
interest rate very low. In February 1999, the Bank of Japan introduced the zero interest
rate policy. Although the zero interest rate policy was lifted in August 2000, theeconomy turned downward again in the fall of 2000. The zero interest rate wasreinstated with additional feature of quantitative easing in March 2001. The unusual
policy of quantitative easing was maintained for five years. The Japanese economy wasin deflation, negative CPI inflation rate, from 1998 to 2005. Quantitative easing aswell as massive intervention, was one of the means to fight deflation and economic
stagnation. (See Ito (2004a) and Ito and Mishkin (2006) for assessment of monetary
policy by the Bank of Japan.)
In March 2006, the Bank of Japan announced that 9 members of the Board had
expressed their numerical “understanding” of price stability. They concluded that “It
was agreed that, by making use of the rate of year-on-year change in the consumer priceindex to describe the understanding, an approximate range between zero and two
percent was generally consistent with the distribution of each Board member's
understanding of medium- to long-term price stability. Most Board members' medianfigures fell on both sides of one percent.” (The Bank of Japan, “The Introduction of a
New Framework for the Conduct of Monetary Policy,” March 9, 2006.) However, thisis not regarded as an inflation targeting.
2.3 Intermediate Regimes
Countries that have adopted neither hard peg nor free float are said to maintainintermediate regimes. This includes a fixed exchange rate regime without a currencyboard, a pre-set crawl arrangement with or without a band, and managed float.
Managed float is also categorized into several variations. Some central banks operate
without explicit target on the exchange rate, but conduct intervention to moderate thespeed of changes. Other central banks implicitly target some range of the exchange
rate, and attempt to keep the exchange rate within the range. For a central rate of therange, some countries have implicit or explicit reference to the basket value of major
trading partners’ currencies. Some countries allow drift, while others try to keep thecentral rate stable. Many countries do have some band of tolerance, and interventions
are conducted to keep the exchange rate within the band. Most central banks under the
managed float, however, do not announce the central rate or a band that they have in
mind. Also, the central rate or a band would drift over time.

7

An intermediate regime seems to be compatible with various types of monetary policy
frameworks. Some central banks adopt inflation targeting while others do not announce
a numerical target for price stability.
Table 2 shows the variety of exchange rate regimes in Asia. Before the Asian crisis of
1997-98, most of the Asian currencies were de facto pegged to the US dollar. After the
Asian currency crisis, the variety has increased, and now they distribute over a wide
range of exchange rate regime.
Table 2 about here
2.4. Hungary
Hungary is unique in pursuing an announced fixed exchange rate with a band andinflation targeting. The objective of the central bank is to achieve and maintain pricestability, and the inflation targeting has been adopted since the summer of 2001. It issaid that the interest rate and exchange rate policies are subject to the inflation targeting
policy. The central bank issues inflation reports and the fan chart is produced—both ahallmark of an inflation targeting central bank. The target rates have been set once a
year with a reference period of two years ahead. 3 In August 2005, the government andthe central bank jointly adopted an explicit medium-term inflation target for the period
starting in 2007, with a target range of inflation rate at 3%, measured in CPI.
What is unique to Hungary is that the Central Bank Act requires that the bank is tomaintain the exchange rate within a certain band. 4 The central parity, a peg to the euro,
is 282.36 forint/euro. The market exchange rate may deviate from the parity within the3

The target range has been revised as follows: 7% plus/minus 1% point for the period ending in
December 2001 (set in June 2001); 4.5% plus/minus 1% point for December 2002 (set in June
2001); 3.5% plus/minus 1% point for December 2003 (set in December 2001); 3.5% plus/minus 1%
point for December 2004 (set in October 2002); 4% plus/minus 1 % point for December 2005 (set in
October 2003); and 3.5% plus/minus 1% point for December 2006 (set November 2004).
4
The central bank act (Article 11 (2)) states: “The Government, in agreement with the MNB, shalldetermine the exchange rate regime, and all parameters thereof, in particular the width of thefluctuation band, the central parity and the composition of the currency basket. Changes in theexchange rate system shall be made without prejudice to the primary objective of the MNB toachieve and maintain price stability.” See Magyar Nemzeti Bank homepage:
http://english.mnb.hu/Engine.aspx8

+/-15 percent fluctuation band, namely between 324.71 forint/euro and 240.01
forint/euro. The central parity was 276.1 forint/euro between 4th May 2001, thewidening of the band, and 4th June 2003. At the edges of the band, the central bankbuys or sells foreign exchange to prevent the further appreciation or depreciation of theforint. The minimum amount of intervention is 4 millions euro.
The exchange rate stability is important for Hungary because it aims at joining the euro
and the strategy requires the stability of the exchange rate. Spain also had inflation
targeting before jointing the euro. The stage of ERM-II, fixed exchange rate to the euro,
is important, and any inflation target has to be consistent with this aim. Currently at the
15% band around the central parity is considered to be wide enough a margin to pursue
both objectives.
For the purist of inflation targeting, the Hungarian arrangement is not a good form of
inflation targeting. The double objective of inflation targeting and exchange rate peg(with a band) may result in incompatible situations. At the floor or ceiling of theexchange rate band, the central bank will put its power toward maintaining the exchange
rate band. This may require compromising on the inflation front or resulting in thecurrency crisis.
However, from the Hungarian point of view, and any other EU-accessing countries that
aspire to adopt the Euro, pursuing both price stability and exchange rate stability
vis-à-vis the Euro is a necessary step. The narrow path of ERM-II has to be traveled
for at least two years before the Euro is adopted.
2.5. Indonesia
The Bank Indonesia Act states that “the ultimate goal of Bank Indonesia is to achieve
and maintain stability in the rupiah” (Article 7). The expression, “stability in therupiah,” needs to be elaborated, since it could mean both stability in domestic prices andstability in the exchange rate. The Bank Indonesia explains it as follows: “Stability inthe rupiah is reflected in the inflation rate and exchange rate. Inflation is reflected in theoverall increase in prices for goods. … Furthermore, the rupiah exchange rate isdetermined wholly by market supply and demand. However, BI is able to take someactions to keep the rupiah from undergoing excessive fluctuation.” 5 This is quite an
5

The following sentences that are in the original are omitted from the quoted paragraph in text:“The factors influencing inflation can be grouped into two broad categories: pressure from9

unclear statement as to the objective and ability of monetary policy with regard to theexchange rate movement. As the Indonesian Government mandates the inflation target
to the Bank Indonesia, the stated objective in the Act is rather confusing.
3. Experiences of the Asian Inflation Targeting
In East Asia, four countries have adopted inflation targeting. Korea adopted inflation
targeting in April 1998, followed by Indonesia in January 2000 and Thailand in April
2000. (See Ito and Hayashi (2004) for an early review of inflation targeting experiencesin Asia.) The Philippines adopted inflation targeting in January 2002. Although all ofthem can be regarded as genuine inflation targeting, the details differ among the four
countries. Table 3 shows the institutional and practical details of the inflation targetingin the four countries.
Table 3 about here
The target is set by joint efforts between the central bank and the government inThailand, Korea, and the Philippines, while the Government of Indonesia sets the target
for Bank Indonesia. The Thai target range between 0% and 3.5% is rather wide, but
the range has been maintained without any modification since its inception in 2000.
The central level of the target range in Korea started in 1998 at a very high rate, 9%, in
the wake of the currency crisis—probably expecting pass-through from a large
depreciation—but it was quickly lowered to 3% in 1999. The width of the range wasalso narrowed from 2% point to one percent point in 2004.
Bank of Thailand targets the inflation rate defined in terms of the core inflation rate. The
target range is wide, 0-3.5%, compared to any other inflation targeting countries in theworld. By taking the volatile items out and having the width of 3.5% points, Thailand
has been able to keep the inflation rate in the target range. This is shown in Figure 1.
Figure 1: Thailand

demand-pull inflation and cost-push inflation. Concerning this, BI is only able to influence pressure
from demand-pull inflation, while pressures from cost-push inflation (related to natural disasters,
droughts, distribution bottlenecks, etc.) are entirely outside BI's control. Therefore, to achieve andmaintain low, stable inflation, the cooperation and commitment of all economic players, including
government and private sector, is essential. Without this support and commitment, it will be difficult
to bring the current high rate of inflation under control.”10

Target ranges of the Bank of Korea have been frequently adjusted since its introductionin 1998. The central target rate started at 9% in 1998, but lowered to 3% in 1999, to2.5% in 2000. But the central target rate has been kept at 3% since 2001. The width of
the range was narrowed from 2% point to 1% point in 2004. As shown in Figure 2, theinflation rate was more or less within the target. The convergence to a low, stable, andnarrow range has been achieved in Korea.
Figure 2: Korea
Indonesia had a difficult time stabilizing the inflation rate, although it had adopted theinflation targeting in January 2000. As Figure 3 shows, the inflation rate was mostly
outside the target range. However, sudden inflation rate increases from October 2005
can be explained and excused by the regulatory changes in energy prices (reducing
subsidies). As the headline CPI has volatile components, the target range of 2% point
may be not wide enough for Indonesia.
Figure 3: Indonesia
Thailand, Korea, and Indonesia experience currency crises in 1997-98 as shown in
Figures 1-3 above. The exchange rate depreciated by 100% (the value was halved) in
Thailand and Korea at the worst point of the crisis, while the value of rupiah became theone-sixth at the worst point. The rupiah also stabilized at the much lower rate after thecrisis was over. The exchange rate depreciation had large impacts on the inflation rate
in 1998 in all three countries. However, the inflation rate was brought down very
quickly by end of 1999 in all three countries. During the more stable time between
2000 and 2006, there is a correlation between the exchange rate movement and theinflation rate. Depreciation is associated with a higher inflation, vice versa. This fact
points to importance of the exchange rate in forecasting inflation rate.
The Philippines adopted inflation targeting in January 2002. The target range is narrow,
1 % point, compared to other countries. The central bank has been missing the target,
most of the time. Due to the repeated fluctuations beyond the inflation target range,
credibility of having an inflation targeting framework is questioned.
The correlation between the inflation rate and the exchange rate is no so obvious in thecase of the Philippines. A large increase in inflation rate in 1997 and 1998 was in11

tandem with the exchange rate depreciation, partly due to the currency crisis. The
inflation rate came down very quickly in 1998-99, without any associated appreciationof the exchange rate. Although depreciation of 1999-2000 is associated withdepreciation, the decrease in inflation rate in 2000-2001 is not accompanied by theexchange rate movement. The inflation rate experienced a large increase in 2003, but
the exchange rate was rather stable.
Figure 4: the Philippines

4. The Exchange Rate in Inflation Targeting Theory
4.1. Compatibility of two goals in normal circumstances
Suppose that the central bank has both the inflation target, π*, and the exchange rate
target (equilibrium), e*, and that they are compatible when the output gap is zero, andthe expected inflation rate is also at the target, πe=π*. When the shock to the economy
disturbs the inflation rate and the exchange rate, what would be an appropriate responseof monetary policy?
Let us first consider a causal relationship from an exchange rate shock to inflation rate,
and an appropriate response to this shock. Suppose that the exchange rate suddenly
depreciates from the target (equilibrium) due to, for example, sudden withdrawal of
portfolio capital inflows. Depreciation affects the inflation process directly throughimport price inflation. The depreciation promotes also promotes exports, while lesscapital inflows dampens the capital markets. Higher output through competitive exports
will put inflationary pressure on domestic prices. These considerations justify
increasing the interest rate in response to the sudden exchange rate depreciation. Higher
interest rate also stimulate capital inflows and restore the exchange rate equilibrium.
The action of raising the interest rate is consistent with both the inflation and exchange
rate target. The case of sudden exchange rate depreciation is just the opposite—raising
the interest rate is an answer.
Let us consider the reverse causality, from inflation to the exchange rate, and an
appropriate response to the inflation shock. Suppose that the inflation rate increased
suddenly due to, for example, increased spending by households. Domestic inflation
tends to depreciate the exchange rate by making domestic products less competitive.
An appropriate response is to raise the interest rate that would dampen the aggregate

12demand and raise capital inflows. Thus, the inflation rate will become lower and theexchange rate will appreciate, both offsetting the initial shock.
In general, various combinations of shocks to the inflation rate and the exchange rate
are shown in Table 4. In the left-upper corner and right-lower corner, the monetary
policy response will be consistent in both targets. Monetary policy reactions may be
more complicated in the right-upper corner and left-lower corner.
Table 4 about here
In practice, as the inflation targeting has a range within which monetary policy has“constrained” discretion, and the managed exchange rate allows the exchange rate to
deviate from a target level for short-term, then monetary policy may be able to keep
both the inflation rate and the exchange rate within the respective range. Of course,
some large shocks, such as a currency crisis, will make the management of inflation andexchange rate much more difficult, and achieving both targets may be impossible.
So far, lags in the cause and effects are ignored. Even in pure theory, things becomemuch more difficult once lags and forecasts are introduced to derive an appropriate
policy. However, again, if shocks were relatively small, and the target ranges arereasonably wide, achieving two range objectives with one instrument may not be
impossible. In the next subsection, whether intervention was employed to keep theexchange rate relatively stable.
4.2. Demand Shock vs. Supply ShockIn the inflation targeting regime, the policy should forecast future inflation rate, andtake actions now as it takes time that monetary policy actions make effects on theeconomy, and inflation. Inflation targeting does not necessarily mean that the central
bank will target the inflation rate only. In the standard interpretation of inflation
targeting, such as Svensson (1997, 1999, 2000), the inflation targeting central bank may
minimize the loss function that has inflation gap and output gap as components.
When the economy is under demand shock, higher output (say, by an investment boom)
will produce higher inflation. Raising the interest rate will be an appropriate policy
response, to put brakes on the economy. With lags in the monetary policy transmission,
one is not hitting the inflation rate always, as forecast errors cannot be avoided. With13

inflation rate only targeter (narrow inflation targeting) may set the policy instrument sothat the expected inflation rate always equals the inflation target, while more “flexible”
inflation targeter will adjust the inflation rate toward the target gradually so that output
variability does not become too large. See Svensson (1997: Section 6).
In case of an adverse supply shock, such as an oil price increases, rising price isaccompanied by output decline. It is not so obvious how the monetary policy should
respond when the loss function includes output gap as well as inflation gap. If theinflation is expected to persist, then the interest rate should be raised to prevent higher
inflation rate to be engrained in the expectation. On the other hand, output decline
should be moderated by the accommodation in the interest rate. In general, monetary
policy response to a supply shock is more difficult than that to a demand shock. Thisdifficulty is independent from a question whether the central bank should pay attention
to the exchange rate in its policy making.
The exchange rate shocks act more like a demand shock in most of the times as
described in the preceding subsection. A Sudden depreciation (exchange rate shockunaccompanied by other real shocks) will raise the output by promoting exports andraise the domestic prices via imported inflation. Thus, the interest rate response isunambiguously in the direction of tightening. This is how the inflation targeting
framework works and it will bring back (partially) the exchange rate toward anequilibrium rate, so that it may look as if the central bank is chasing two goals with only
one instrument. It is fortunate that in this case chasing two goals are not so difficult,However, there are cases that exchange rate depreciation acts like a supply shock, sothat depreciation should be tolerated. There are two typical cases. First, suppose thattrading partners fall into a recession (foreign income shock) and reduce demand forexports from this country. Then reduction of exports (or expectation of such an eventin the future) will be most likely accompanied by the exchange rate depreciation. If theimported inflation overwhelms the price decline pressure due to lower demand, thenprices will be rising even during a recession. This was the case for Australia, New
Zealand, and other commodity exporters to Asia in 1998. The demand from Asia
collapsed and currencies of these countries depreciated.
Second, oil price increases for oil importing countries are another case of supply shocks.
Imported price increases will be direct. Energy-related inflation will cause output to14

decline. The combination of inflation and output declines will most likely induce
depreciation.
Therefore, when the central bank experiences exchange rate deprecation, it is mostimportant to examine what is causing the exchange rate depreciation in order todetermine an appropriate response. Depreciation is a sign of demand shock, if it isaccompanied by net export increases and domestic price increases. The appropriate
response to the demand shock is unambiguously an interest rate hike in order to offset(most of) the shock.
Depreciation is a sign of supply shock (such as oil price increases for importing
countries, and trading partners’ recession), if it is accompanied by net export declinesand domestic price increases. If it is a sign of supply shock, then the interest rate may
not be raised as much in the case of demand shock even if the experienced priceincrease is in the same magnitude, and depreciation may be left as is to help promote
exports.
Svensson (2000) is one of the few inflation targeting models that include explicitly theexchange rate. He built a model where the foreign shocks come through as exchange
rate disturbances. Inflation forecast targeting can produce a reaction function that takes
into account the exchange rate fluctuation. Our explanations above is consistent withwhat Svensson (2000) explains in a rigorous model.
4.3. Monetary Conditions Index
During the Asian crises, the exchange rates of commodity exporters depreciatedsubstantially. New Zealand tightened more than Australia, taking the exchange rate
depreciation as a sign of threatening inflation (demand shock), while it was actually adecline in trading partners’ income decline (supply shock).
The weighted average of the exchange rate and the interest rate constitute Monetary
Conditions Index (MCI), a concept developed by the Bank of Canada in the early 1990s,
but later abandoned. 6 This was used as a market signal that monetary stance is tight orloose. The popularity of MCI has declined after the Asian currency crisis. New
6

In Canada, the announcement of MCI has been discontinued at the end of 2006. The
Bank of Canada had not used MCI as an input into its monetary policy decisions.
http://www.bankofcanada.ca/en/rates/mci2.html.
15

Zealand did not loosen quickly enough and experience deeper recessions. It was said
that Reserve Bank had taken MCI mechanically and depreciation was considered to be apotential threat to inflation. Australia was more flexible, probably knowing that theshock was of a supply shock. 7
As explained in the previous subsection, depreciation can be either as a demand or
supply shock above points to a danger of reacting to the exchange rate changes
mechanically. One indicator that used the exchange rate was Monetary Conditions Index
4.4. PracticeAll the four inflation-targeting East Asian countries have intervened in the foreignexchange market at least occasionally. As mentioned above, the mandate for Bank
Indonesia contains reference to the exchange rate as well as the domestic inflation.
Other central banks have inflation target as a single objective, they have tried to avoid
wide fluctuations in the exchange rate. For example, the Bank of Thailand explains its
exchange rate policy as follows.
Thailand ‘manages’ the exchange rate by intervening in the foreign exchange
market from time to time in order to prevent excessive volatilities in themarkets, while fundamental trends are accommodated. … The managed-float
exchange rate regime together with the Inflation Targeting framework, which
was formally introduced in May 2000, with short-term interest rates as theoperating target has worked well for Thailand. The inflation target performs therole of a new nominal anchor for monetary policy while flexibility in exchange
rates helps absorb shocks to the economy. Since the adoption of the
managed-float exchange rate regime, the Thai Baht has generally moved in linewith the economic fundamental. However, extreme exchange rate movements
have occasionally occurred due to various causes. As a result, different
combinations of techniques and tactics were used depending on the market
conditions. Broadly speaking, the Bank of Thailand focuses on containing
excessive and persistent exchange rate volatility and intervenes when exchange
rates movements appear to be inconsistent with fundamental changes.
Short-term volatility is not a major concern unless it continues to persist and

See Brash (1998) and Stevens (1998) for comparison (and criticism) of how MCI wasused and contributed to policy decisions in New Zealand at the time.

7

16

become a threat to stability. 8
4.5. Foreign Exchange Interventions
This clearly states that the exchange rate fluctuations may be countered by foreignexchange interventions—an additional tool for exchange rate management. Thailand
pursues both inflation targeting and smooth movement of the exchange rate and seems
to be successful since 2000. It may be the key that interventions are limited to take out
extreme volatility rather than targeting a particular exchange rate level. By lowering
the medium-term volatility (amplitude) of the exchange rate, targeting a particular rangeof the inflation rate may become even easier than more difficult.
The exchange rate has an impact on the domestic inflation rate, the central bank should
pay attention to the movement in the exchange rate predicting the inflation rate in the
future. As explained above, a standard reaction of monetary policy instrument, theinterest rate, to the exchange rate shock was discussed. However, there is a limit that
one instrument can achieve in pursuit of two objectives, unless circumstances arefavorable (a demand shock case) that the interest rate action can contribute tostabilization of two objectives simultaneously. If the exchange rate is to be influenced
directly, foreign exchange market intervention (sales and purchases of foreign
currencies with intent to influence the exchange rate movements). Includingintervention in the menu of policy instruments, the policy question becomes richer. The
question is whether the central bank should change the interest rate in reaction and/orintervene in the foreign exchange market in order to change the course of the exchange
rate movement and whether the intent of influencing the exchange rate may be
inconsistent with inflation targeting.
There is a considerable controversy on the effectiveness of non-sterilized interventions,and intent and practices of the monetary authorities. Ito (2007) summarizes the literatureand concluded, based on the Japanese disclosed daily data, that the non-sterilizedinterventions can have impacts on the exchange rate movements if intervention amounts
are large and infrequent.
8“Foreign Exchange Policy and Intervention in Thailand” Paper prepared for the BIS Deputy

Governors’ meeting on “Forex Intervention: Motives, Techniques and Implications in Emerging
Markets”, BIS, Switzerland, 2-3 December 2004.
http://www.bot.or.th/bothomepage/BankatWork/FinMarketOpr/Download%20Articles/BIS%20FX%
20paper_Nov2004.pdf.
17

In the case of emerging market economies, the daily data of interventions are notdisclosed. Monthly movements of foreign reserves are used as proxies of intervention.
Whether the central bank intervened in reaction to the exchange rate movements is
examined for Thailand, Korea, Indonesia, and the Philippines, for the period of January
1999 to September 2006, in left panels of Figure 5. If the central banks tend to sellforeign reserves (to purchase the own currency) during the month when the exchange
rate depreciates, then the negative correlation should be found. This tendency is
confirmed in each country.
Whether the exchange rate changes (horizontal axis) resulted in CPI inflation (verticalaxis) is also examined for those four countries in the right panels of Figure 5. Bothvariables measured as annual changes (year on year). Positive correlation would be
evidence for pass-through of the exchange rate shocks to the domestic prices. Since
there are overlapping observations (monthly year-on-year data), a casual observation ismay be deceptive, but pass through were observed for Thailand, Korea, and thePhilippines.9
5. Concluding Remarks
This paper considers the interaction between the exchange rate and inflation targeting.
With a reasonable width of the inflation target range, and some fundamentallyconsistent exchange rate target with a range and a long-run drift for fundamental
changes, pursuing two targets with a single instrument is, most of the time, consistent.
The correlation between the inflation rate and the exchange rate movement is reviewed
for Asian inflation targeting countries. It was argued that monetary policy actions inorder to keep the inflation rate stable in response to an inflation shock will also offset
the impact on the exchange rate from the inflation shock. Similarly, an exchange rate
shock may be countered by monetary policy that will keep both the exchange rate andthe inflation rate stable. Therefore, under usual circumstances, inflation targeting andthe exchange rate management are not inconsistent, especially when both targets havereasonably wide ranges. The experiences of Thailand and Korea in particular seem tosupport this view.

For a rigorous study of the pass-through effects among the Asian countries, see Itoand Sato (2006).

918

References:
Brash, Donald (1998), “Reserve Bank Forecasting: Should We Feel Guilty?” Speech attheNew
ZealandSocietyofActuaries,
October21.
http://www.rbnz.govt.nz/speeches/0067862.html
Brash, Donald T., (2002), "Inflation targeting 14 years on", Reserve Bank of New
Zealand Bulletin, Vol. 65. No.1. March 2002, pp.58-70.
Dominguez, Kathryn M.E. and Linda L. Tesar, 2005. “International Borrowing andMacroeconomic Performance in Argentina,” NBER working paper no. 11353, May.
Fischer, Stanley, (2001). “Exchange Rate Regimes: Is the Bipolar View Correct?”Journal of Economic Perspectives, vol. 15, no.2, Spring: 3-24.

Ito, Takatoshi (2004a). “Inflation Targeting and Japan: Why has the Bank of Japan not
adopted Inflation Targeting?” in Christopher Kent and Simon Guttmann (eds.) The
Future of Inflation Targeting, August 2004: 220-267.Reserve Bank of Australia
Ito, Takatoshi (2004b). “The Yen and the Japanese Economy, 2004.” C. F. Bergsten and
J. Williamson, (eds.) Dollar Adjustment: How Far? Against What?, ch.8, Washington,
D.C.: Institute for International Economics: 171-196.
Ito, Takatoshi, 2007. “Myths and reality of foreign exchange interventions: An
application to Japan”, International Journal of Finance & Economics, Volume 12, Issue
2, April: 133-154 .
Ito, Takatoshi and Tomoko Hayashi, 2004, Inflation Targeting in Asia Hong Kong:
Hong Kong Institute for Monetary Research, Occasional Paper, No. 1, March.
Ito, Takatoshi and Frederic S. Mishkin. (2006) “Two Decades of Japanese Monetary
Policy and the Deflation Problem,” in T. Ito and A. Rose, (eds.) Monetary Policy with
Very Low Inflation in the Pacific Rim, NBER-University of Chicago Press: 131-193
Ito, Takatoshi and Kiyotaka Sato (2006), “Exchange Rate Changes and Inflation in
Post-Crisis Asian Economies: VAR Analysis of the Exchange Rate Pass-Through”
RIETI discussion paper, April 2006 06-E-018
http://www.rieti.go.jp/jp/publications/dp/06e018.pdf
19

Mussa, Michael, 2002. Argentina and the Fund: From Triumph to Tragedy, Washington,
DC: Institute for International Economics, July.
Stevens, Glenn, 1998, "Pitfalls in the Use of Monetary Conditions Indexes," Reserve
Bank of Australia Bulletin (August): 34-43.
Svensson, Lars, E.O. 1997. “Inflation Forecast Targeting: Implementing and Monitoring
Inflation Targets,” European Economic Review, vol. 41, 1111-1146.
Svensson, Lars, E.O., 1999. “Inflation Targeting as a Monetary Policy Rule,” Journal of
Monetary Economics, vol. 43: 607-654.
Svensson, Lars, E.O., 2000. “Open-Economy Inflation Targeting”, Journal ofInternational Economics, Vol. 50 : 155-183.

20

File: InflTargetExRateRegime.xls
Table 1: Exchange Rate Regime and Monetary Policy Framework
Exchange Rate Regime↓

Exchange Rate Anchor

No monetary Policy(Dollarized or otherarrangements)

Ecuador, Panama, Marshall Islands,
Western African countries in the
CFA Franc zone

Currency Board

Hong Kong, Brunei, Estonia,
Lithuania, Argentina(1994-2002)

Fixed Exchange Rate
(Announced and De
facto)

Bangladesh, Nepal, Butan, Jordan,
Macedonia, Maldive, China(19942005), Thailand (-June 1997)

Basket Peg

Botswana, Fiji, Kuwait, Morocco,
Seychell, Indonesia (-1997)

Peg with a band

Denmark, Cyprus, Egypt

Crawling Peg

Bolivia, Costa Rica, Nicaragua,
Solomon Islands
Belarus, Romania, Uruguay,
Venezuela

Band crawling

Monetary Policy Framework
Money Supply Targeting
Inflation Targeting

Euro Area countries (within
the Area)

Hungary

IsraelManaged Float (limited China, Malaysia, Thailand (-1997)
fluctuation)

Ghana, Guinea, Jamaica,
Mongolia, Slovenia

Managed Float (Basket
Band)
Free Float

Thailand (July 1997-May
2000); Indonesia (19971999)
Peru

Algeria, India, Slovak Rep.
Thailand (May 2000-)

Singapore

Australia, Brazil, Canada, Japan, US, Euro Area
Chile, Columbia, Czech(collectively), Papua New
Rep., Iceland, Indonesia
Genea, Haiti, etc.
(Jan 2000-), Korea (April
1998-), Mexico, New
Zealand, Norway, Poland,South Africa, Sweden, U.K.,
Philippines, Turkey（Source）IMF, International Financial Statistics April 2003, various central bank home pages and Author's judgment（Notes）The classification is based on the de facto regimes.

OthersTable 2

Exchange Rate Regimes in Asia
Inflation Targeting
Not Inflation Targeting
Narrow Band
Currency Board
Multiple exchange rates

Thailand, Korea, Indonesia, Philippines
Managed Float
Viet Nam, Taiwan, Singapore
China, Malaysia
Hong Kong, Brunei
Fixed Exchange Rate
Myanmar (2)De facto Dollarlization
Cambodia, Lao Rep., Viet Nam(1) China and Malaysia moved to the managed float system on July 21, 2005.
(2) Myanmar officially adopts a fixed exchange rate to SDR, but de facto multiple exchange rate system

File: InflTargetExRateRegime.xls (page 2)

22

Table 3: Inflation Targeting Framework in Asia
Inflation Targeting
Framework in Asia
Introduction

Bank of Thailand
2000, April

Index

Core CPI, quarterly ave.

Target Range

0-3.5%

Horizon

8 quarters ahead

Escape Clause
Setting a goal

None
Gov't and BOT
Monetary Policy Comm.
Monetary Policy instrument 7members
Independence of central
No (Governor can be replacedbank
at will)
Accountability, if target is
Explanation to the public
not achieved
Transparency

Quarterly Inflation Report

Bank of Korea
Bank Indonesia
1998, April
2000, January
Headline CPI in 1998-99; Core CPI without regulated prices,
CPI, 20002000-01; Headline CPI 20029-10% in 2002; 9±1% in 2003;
9±1% in 1998, 3±1% in 1999 5.5±1% in 2004
2.5±1% in 2000, 3±1% in
6±1% in 2005; 5.5%±1% in
2001-03; 2.5-3.5% in 2004-06 2006; 5±1% in 2007
One year
One to two years

The Philippines central bank
2002, January
Headline CPI
5-6% in 2002; 4.5-5.5% in
2003; 4-5% in 2004-05

4-5% in 2006-07
2 yearschanges in tax reform andNone except natural disastersubsidies; price changes inNone& tax reform in 1999
fresh food
BOK with consultation with Gov't since 2005 Gov't and central bankMonetary Policy Comm. 7
Moneary Policy Comm. 7
Monetary Policy Comm.
members
members
Yes (no dismissal of
Yes (no dismissal of Governor) Yes (no dismissal of Governor) Governor)
Governor sends letter toExplanation to the public
NA
PresidentMonthly Review; Quarterly
Quarterly Bulletin
Quarterly Inflation Report
Reports

Source: Ito and Hayashi (2004)

23

Table 4:

Interest rate responses to shocks in inflation and exchange ratehigh
π > π*Inflation
just right
π = π*

low
π < π*

high interest rate

slightly high interest rate

uncertain

slightly high interest rate

neutralslightly low interest rate

uncertain

slightly low interest rate

low interest rate

Exchange Ratee > e* (depreciation)e = e*e < e* (appreciation)

File: InflTargetExRateRegime.xls (page 2)

24

Figure 1

File: Thailand(InflTarget).xls

Core CPI Inflation rate(%、 Year on Year)

Figure 1: Thailand: Inflation Targeting, Inflation Rate, and Inflation

Baht/Dollar rate

10.00

60
Core CPI Inflation rate (left scale)
Baht/Dollar rate (right scale)

8.00

50

6.00

40
Inflation Target

4.00

30

2.00

20

0.00

10

-2.00

1997

1998

1999

2000

2001

2002

2003

2004

Source: IMF, International Financial Statistics; and Bank of Thailan for core inflation rate

25

2005

2006

0

Figure 2
Figure 2: Korea, Inflation Targeting, Inflation rate and the Won/Dollar rate

CPI Inflation Rate(%、Year on year)
12.00

Won/Dollar Rate
1800
1600

Won/Dollar Rate(right scale)

10.00

1400
8.00

1200
Inflation Rate
(left scale)

Inflation Rate

6.00

1000
800

4.00

600
400

2.00
200
0.00

0
1997
2005
2006

1998

1999

2000

2001

2002

Source: IMF, International Financial Statistics

File: Korea(InflTarget).xls

26

2003

2004

Figure 3
Inflation Rate(%、Year on Year)

Figure 3, Indonesia, Inflation Targeting, Inflation Rate, and the Exchange Rate

90.00
80.00

Rupiah/Dollar Rate
(rupiah/dollar)
16000

Inflation Rate
(left scale)

14000

70.00
12000

Rupiah/Dollar Rate
(Right scale)

60.00

10000

50.00
40.00

8000

30.00
Target
(4～6%)

20.00

Target(9～10%)Inflation Target(3～5%)

6000
Target(8～10%)

Target
(4.5～6.5%)

Target
(5-7%)
4000

10.00
2000

0.00
-10.00

1997
1998
1999
2000
2001
Source: IMF, International Financial Statistics

2002

2003

File: Indonesia(InflTarget).xls

27

2004

Target(4.52005 6 5%)2006

0Figure4 File: Philippines(InflTarget)V2.xls
CPI Inflation rate(%、Year 0n Year)

Figure 4: The Philippines: Inflation Targeting, Inflation Rate and the Exchange Rate
Peso/Dollar rate

12.00

60.00
Peso/Dollar rate

10.00

50.00

8.00

40.00

Inflation
target

6.00

30.00

4.00

20.00

CPI Inflation rate
2.00

0.00

10.00

1997
1998
1999
2000
2001
2006
Source: IMF, International Financial Statistics

2002

28

2003

2004

2005

0.00

Figure 5::(1) Thailand
Intervention when the exchange rate moves?
Negative correlation
if depreciation led to selling of the local currency

Did inflation rate tend to increase when the exchange rate depreciate?
Positive correlation
if depreciation led to inflationΔe (horizontal) & ΔFR(vertical）1999:01-2006:09

Δe & Δπ （year on year), 1999:01-2006:09
8

7

6

6
5

4

4
2
3
0
2
-2
1
-4

0

-6

-1

-8
-4

-2

0

2

4

6

-2
-40

-30

-20

29

-10

0

10

20

30

(2) Korea
Intervention when the exchange rate moves?
Negative correlation
if depreciation led to selling of the local currency

Did inflation rate tend to increase when the exchange rate depreciate?
Positive correlation
if depreciation led to inflationΔe (horizontal) & ΔFR(vertical）1999:01-2006:09

Δe & Δπ （year on year), 1999:01-2006:09
9

6

8
5

7
6

4

5
4

3
3
2

2

1
0

1

-1
-2
-6

-4

-2

0

2

4

6

0
-40

-30

-20

30

-10

0

10

20

30

(3) Indonesia
Intervention when the exchange rate moves?
Negative correlation
if depreciation led to selling of the local currency

Did inflation rate tend to increase when the exchange rate depreciate?
Positive correlation
if depreciation led to inflationΔe (horizontal) & ΔFR(vertical）1999:01-2006:09

Δe & Δπ （year on year), 1999:01-2006:09
15

80
70

10
60
5

50
40

0
30
-5

20
10

-10
0
-15
-20

-15

-10

-5

0

5

10

15

-10
-60

-40

-20

31

0

20

40

60

(4) The Philippines
Intervention when the exchange rate moves?
Negative correlation
if depreciation led to selling of the local currency

Did inflation rate tend to increase when the exchange rate depreciate?
Positive correlation
if depreciation led to inflationΔe (horizontal) & ΔFR(vertical）1999:01-2006:09

Δe & Δπ （year on year), 1999:01-2006:09
14

14

12
12
10
10

8
6

8

4
6

2
0

4

-2
2
-4
-6
-6

-4

-2

0

2

4

6

0
-20

-10

0

10

Data: International Monetary Fund, International Financial Statistics, On-line December 2006.

32

20

30