DP2011-25

Predetermined Exchange Rate,
Monetary Targeting, andInflation Targeting Regimes
Shigeto KITANO

Revised March 12, 2015

Predetermined Exchange Rate, Monetary Targeting, andInflation Targeting Regimes∗
Shigeto Kitano
Kobe University †Abstract
Many works analyzing the Mundell-Fleming dictum compare the predetermined exchange rate regime and the monetary targeting regime under flexible
exchange rates. Reflecting on the fact that many emerging market countries
have shifted to the regime of inflation targeting, this paper aims to extend
the literature to include the inflation targeting regime. The results of ouranalysis show that the interest rule with an inflation target is superior (or atleast equal) to the two abovementioned regimes in absorbing both real andmonetary shocks.

Keywords: optimal exchange rate regimes, predetermined exchange
rate, flexible exchange rate, the Mundell-Fleming dictum, small open
economyJEL Classification: E42, E58, F31, F41, O24.

∗

Earlier versions of the paper were presented at Osaka University, Kobe University, and the JEA
annual meeting in Kumamoto. The author thanks Shinsuke Ikeda, Tatsuro Iwaisako, Takayuki Tsuruga, Hirokazu Ishise, Shingo Iokibe, and Takashi Kamihigashi for valuable comments. The author
is extremely grateful to an anonymous referee for his/her careful reading and helpful comments.
Any remaining errors are mine. This work was supported by Grants-in-Aid for Scientific Research.
†
Research Institute for Economics & Business Administration (RIEB), Kobe University, 2-1
Rokkodai, Nada, Kobe 657-8501, JAPAN, E-mail: kitano@rieb.kobe-u.ac.jp, Tel/Fax:+81-78-8037009.

1

1

Introduction

The choice of exchange rate regime has been one of the most important issues inopen macroeconomic policy analysis ever since Friedman (1953).1 According to theconventional wisdom, both the flexible exchange rate regime and the predeterminedexchange rate regime have their advantages and disadvantages. If the internal prices
are sticky, the predetermined exchange rate regime makes better adjustments tomonetary shocks, while the flexible exchange rate regime makes better adjustments
to real shocks.2 Végh (2013) provides an excellent intuitive explanation of theconventional wisdom (chapter 11, page 512). Real money balances play the key roleof absorbing monetary shocks. Since under flexible exchange rates, policy makers set
the path of money supply, real money balances are predetermined (if internal prices
are sticky). The economy therefore cannot absorb monetary shocks through the
instantaneous adjustment of real money balances under flexible exchange rates. In
contrast, under predetermined exchange rates, policy makers set the path of nominal
exchange rate. Since real money balances are not predetermined in this case, theeconomy can absorb monetary shocks (at least partially) through the adjustmentof real money balances. On the other hand, the opposite is true for real shocks.
The real exchange rate plays the key role of absorbing real shocks. Since the realexchange rate is not predetermined under flexible exchange rates, the economy canabsorb real shocks (at least partially) through the adjustment of real exchange rate.
In contrast, under predetermined exchange rates, the economy cannot absorb realshocks through the adjustment of real exchange rate, since the real exchange rate
is predetermined (if the internal prices are sticky). Hence, we can say that thepredetermined exchange rate regime has an advantage in its flexibility to absorb
monetary shocks, while the flexible exchange rate regime has an advantage in its
flexibility to absorb real shocks.3
There have been many works on the optimal exchange rate regimes, and the advantages and disadvantages of diﬀerent exchange regimes have been still discussed.4
For example, Lahiri et al. (2007) revisited the issue of the optimal exchange rate
regime in a model with flexible prices and asset market frictions, arguing that theasset market frictions may be as prevalent as the goods market frictions. They
showed that in this case, contrary to the conventional wisdom, the flexible exchange
rates are optimal in the presence of monetary shocks, whereas the fixed exchange
rates are optimal in the presence of real shocks. They concluded that the choice ofan optimal exchange rate regime should also depend on the type of frictions as wellas the type of shocks.5
In examining the conventional wisdom on the predetermined and flexible ex1

Friedman (1953) argued that if internal prices are sticky, the exchange rate regime matters andthe flexible exchange rate regime makes better adjustments in response to the changes in external
conditions.
2
Lahiri et al. (2006) refer to the conventional wisdom as the Mundell-Fleming dictum.
3
These results will be replicated in Sections 3.1, 3.2, 4.1, and 4.2.
4See, among others, Helpman and Razin (1979), Helpman (1981), Helpman and Razin (1982),
Calvo (1999), Devereux and Engel (2003), and Céspedes et al. (2004).
5
Lahiri et al. (2006) also obtained similar results using a perfect-foresight version of the stochastic model in Lahiri et al. (2007).

2

change rates, the rigorous mathematical models assume that under the flexible exchange rates, policy makers set a path of money supply. In other words, the literature
regarding the conventional wisdom has been concerned mainly with the choice between the predetermined exchange rate regime and the monetary targeting regime
under flexible exchange rates. However, in reality, as argued by Frankel (2010),
many countries have shifted to the regime of inflation targeting. Not only developed countries such as New Zealand, Canada, the United Kingdom, and Sweden but
also many emerging market countries such as Brazil, Chile, Colombia, Mexico, theCzech Republic, Hungary, Poland Israel, Korea, South Africa, Thailand, Indonesia,
Romania, and Turkey shifted to the regime of inflation targeting after (or in the
middle of) the series of currency crises in the emerging markets in East Asia andLatin America from the mid 1990s to the early 2000s.6 This recent shift of many
emerging market countries to the regime of inflation targeting motivates our paper.
Our paper is not the first to examine these three cases. Indeed, for example,
Mishkin and Savastano (2001) already discuss the advantages and disadvantages ofa hard exchange rate peg, monetary targeting, and inflation targeting. However,they specifically focus on monetary policy strategies in Latin America and are concerned with the advantages and disadvantages of the three regimes from a more
pragmatic perspective, taking into consideration the institutional environment or
fiscal situation in each Latin American country rather than developing a rigorous
mathematical model. On the other hand, as previously discussed, the literature comprised of rigorous mathematical models, such as Helpman and Razin (1979), Helpman (1981), Helpman and Razin (1982), Calvo (1999), Devereux and Engel (2003),
Céspedes et al. (2004), and Lahiri et al. (2007), only consider the predeterminedexchange rate regime and the monetary targeting regime when comparing exchange
rate regimes. Our paper aims to extend the literature of rigorous mathematical models regarding the Mundell-Fleming dictum to include the inflation targeting regime.
As a paper considering the inflation targeting regime, we specifically consider nominal interest rate rules with an inflation target. For example, Reinhart (1992), Végh(2001), and Calvo (2007) develop models comprising the nominal interest rate rulewith an inflation target. Reinhart (1992) shows that the introduction of a nominalinterest rate rule with an inflation target into a macro model can avoid the indeterminacy problems identified by Sargent and Wallace (1975). Végh (2001) showsthat under certain conditions, some equivalences exist among the three regimes: (a)a “k-percent” money growth rule, (b) a nominal interest rate rule with an inflation
target, and (c) a real interest rate rule with an inflation target. Calvo (2007) examines the role of a nominal interest rate rule with an inflation target in the context
of an imperfectly credible stabilization program and shows that the resulting transitional dynamics in the case of this interest rate rule are opposite to those in the caseof an exchange rate-based stabilization program. This paper introduces a nominalinterest rate rule with an inflation target developed by the abovementioned authors
into the literature of rigorous mathematical models regarding the Mundell-Fleming
dictum.
We develop a small open economy model with a cash-in-advance constraint andexamine the economy’s responses to real shocks and monetary shocks, respectively.
6

See Frankel (2010) for a comprehensive survey.

3

First, we replicate the well-known results regarding the diﬀerence between the economy’s responses to each shock in the predetermined exchange rate regime and in
the monetary targeting regime under flexible exchange rates. It is shown that in response to a real shock, consumption fluctuates less in the monetary targeting regime
under flexible exchange rates than in the predetermined exchange rate regime. In
this case, the real exchange rate, which is not a predetermined variable in the monetary targeting regime, plays the key role of absorbing the real shock. In contrast,
in response to a monetary shock, consumption fluctuates less in the predeterminedexchange rate regime than in the monetary targeting regime under flexible exchange
rates. In this case, real money balances, which is not a predetermined variable in thepredetermined exchange rate regime, plays the key role of absorbing the monetaryshock.
Next, we consider how the economy’s responses to each shock in an inflation
targeting regime diﬀer from those in either the predetermined exchange rate regime
or monetary targeting regime. We consider a specific form of the interest rate rulewith an inflation target, such as the one employed by Calvo (2007), as an inflation
targeting regime. According to this rule, policy makers increase (decrease) the levelof the nominal interest rate if the actual inflation level is above (below) the target
level set in advance by policy makers. This construction allows the nominal interest
rate to jump on impact. We focus on the case in which policy makers adjust thenominal interest rate such that the Taylor principle is fulfilled. That is, the nominalinterest rate will be adjusted such that the real interest rate increases (decreases) in
the face of an increase (decrease) in inflation. We refer to this type of interest rate
rule as the interest rate rule incorporating the Taylor principle.
Then, we examine the economy’s response to real shocks and monetary shocks,
respectively, under the inflation targeting regime. It is shown that in response toreal shocks, consumption fluctuates less in the inflation targeting regime than in
the predetermined exchange rate and monetary targeting regimes. In addition, theinflation targeting regime is shown to be superior (or at least equal) to the predetermined exchange rates and monetary targeting regimes in absorbing monetaryshocks. Under the inflation targeting regime, both the real exchange rate and realmoney balances play key roles in absorbing real and monetary shocks, respectively,
since neither the real exchange rate nor real money balances are predetermined.
Therefore, the economy can make better (or at least equivalent) adjustments toboth real and monetary shocks under the inflation targeting regime compared withthe predetermined exchange rates and monetary targeting regimes.
To demonstrate that our results are robust, we include an appendix where we
examine the economy’s responses to real and monetary shocks under another type ofinterest rate rule with an inflation target, such as that employed by Reinhart (1992)
and Végh (2001). According to this policy rule, policy makers increase (decrease) therate of change, and not the level, of the nominal interest rate if the actual inflationlevel is above (below) the target level set by policy makers in advance. This type ofinterest rate rule implies that the nominal interest rate is a predetermined variable
and moves in a sticky way. We refer to this type of interest rate rule as the sticky
interest rate rule. The results obtained under the sticky interest rate rule in response
to both real and monetary shocks are exactly the same as those obtained in the case4

described earlier in the main text.
The remainder of the paper is organized in four sections. In section 2, we present
a basic model to analyze the impact of real and monetary shocks on the economy
under alternative regimes. Section 3 compares how the economy’s response to realshocks varies under predetermined exchange rates, monetary targeting, and inflation
targeting. Section 4 compares the economy’s response to monetary shocks under thediﬀerent regimes. Section 5 concludes.

2

Model

Consider a small open economy that is perfectly integrated with the rest of theworld in goods and capital markets. The free movement of goods implies that thelaw of one price holds for the tradable good: P T (t) = E(t)P ∗ (t), where E(t), P T (t),and P ∗ (t), respectively, denote the nominal exchange rate, the domestic price of the
tradable good, and the foreign price of the good at time t. For simplicity, we assume
that P ∗ (t) = 1, so that there is no foreign inflation. Perfect capital mobility implies
that the interest parity condition holds:
i(t) = r + ε(t),(1)

where i(t) is the domestic nominal interest rate, r is the (constant) world real interest˙E(t)rate, and ε(t)(≡ E(t)) is the rate of devaluation (or depreciation).

2.1

Consumers

The economy is inhabited by a large number of identical, indefinitely living individuals. The representative household’s instantaneous utility depends on the consumption of tradables cT (t) and non-tradables (or home goods), cN (t). The lifetime
utility as of time 0 can therefore be written as follows:∫ ∞0{γ log(cT (t)) + (1 − γ) log(cN (t)) } e−βt dt,(2)where β(> 0) is the rate of time preference. An individual holds assets in the formof foreign bonds, B(t), and domestic money, M (t). The individual’s financial wealth(in nominal terms of the domestic price of tradables) is denoted by A(t) and is givenbyA(t) = M (t) + E(t)B(t).

(3)

Dividing equation (3) by P T (t), we obtain
A(t)
M (t)
E(t)B(t)
= T
+
.
T
P (t)
P (t)
P T (t)(4)

Since the law of one price holds (i.e., P T (t) = E(t)P ∗ (t)), we also obtain
B(t)E(t)B(t)=.
P T (t)P ∗ (t)5(5)

Hence, from equations (4) and (5), we obtaina(t) = m(t) + b(t),

(6)

M (t)
B(t)
where a(t)(≡ PA(t)T (t) ), m(t)(≡ P T (t) ), and b(t)(≡ P ∗ (t) ) denote the individual’s real
financial wealth, real money balances, and real foreign bond holdings, respectively.
The individual has a constant endowment flow of tradables, y T , while the output
of non-tradables, y N (t), is demand-determined. The individual’s lifetime constraint
is given by

a0 +

∫ ∞(
0

(

)

)

∫ ∞
y N (t)cN (t)y +cT (t) ++ τ (t) e−rt dt =+ i(t)m(t) e−rt dt, (7)
e(t)
e(t)
0

(

T

T

)

is the real exchange rate (i.e., the relative price of tradables inwhere e(t) ≡ PP N (t)(t)
terms of non-tradables) and τ (t) denotes the government lump-sum transfers.
We assume that transactions require holding cash in advance:()

cN (t)
m(t) = α c (t) +, α > 0.
e(t)
T

(8)

By maximizing the lifetime utility (2) subject to the individual’s budget constraint (7) and the cash-in-advance constraint (8), the following first-order conditions are obtained:7γ= λ (1 + αi(t)) ,
(9)
T
c (t)
and
(1 − γ)λ (1 + αi(t))
=
,
N
c (t)
e(t)

(10)

where λ is the Lagrange multiplier. From (9) and (10), we can express the realexchange rate as(e(t) =γ
1−γ)

cN (t).
cT (t)(11)

Following Calvo and Végh (1999) and Calvo (2007), we assume that the nontradables sector operates under the sticky price setting and the output of nontradables is demand determined. Formally, we adopt the sticky price model in
Calvo (1983) that implies that the rate of change in the inflation rate is a negative
function of excess demand:8)(π̇(t) = −θ y N (t) − ȳ N , θ > 0,
7

(12)

In order to abstract from the intrinsic sources of an economy’s dynamics, the model assumes
that β = r. The intrinsic source causes movement even when all exogenous variables that aﬀect theeconomy remain constant forever. The model therefore focuses on the extrinsic dynamic behavior
caused by real or monetary shocks. This distinction between intrinsic and extrinsic dynamics
is made by Obtsfeld and Stockman (1985). Samuelson (1947) refers to this distinction as thedistinction between “causal” and “historical” dynamic systems.
8
See Calvo (1983) and Végh (2013) for the derivation of equation (12). This type of sticky pricemodel is also employed in Calvo and Végh (1993).

6

(

N

)

where π(t) ≡ ṖP N (t)is the inflation rate of non-tradable goods and ȳ N can be(t)interpreted as the “full employment” level of output.
By substituting (11) into (8), we obtain( )α Tc (t).
γm(t) =

(13)
)

(

.
Let us denote the real money balances in terms of non-tradable goods as n(t) ≡ PMN(t)(t)
T

It follows from the definition of e (i.e., e ≡ PP N (t)) that the real exchange rate can(t)be rewritten ase(t) =

n(t)
.
m(t)

(14)

From (11), (13), and (14), we have(n(t) =

2.2)

αcN (t).
1−γ(15)Government

The government’s intertemporal constraint is given by∫ ∞0τ (t)e−rt dt = h0 +∫ ∞(ṁ(t) + ε(t)m(t)) e−rt dt,

(16)

0

where h0 is the initial stock of international reserves. The quantity ṁ(t) + ε(t)m(t)˙is equal to PMT(t)and indicates revenues from money creation (i.e., seigniorage flow).
(t)
Equation (16) indicates that the government must finance the present discounted
value of transfers using the initial assets and seigniorage revenues.

2.3

Equilibrium conditions

Equilibrium in the non-tradable goods sector requiresy N (t) = cN (t).

(17)

By combining the consumer’s constraint (7) and the government’s constraint (16),and using (1) and (17), we obtain this economy’s resource constraint:
∫ ∞
yT
k0 +
=
cT (t)e−rt dt,
r
0

(18)

where k0 (≡ b0 + h0 ) denotes the economy’s net stock of foreign assets (at time 0).

7

3Real shocks

In this section, we analyze how the economy responds to real shocks under diﬀerent
exchange rate regimes. Following Végh (2013), we consider a shock that shifts
demand from non-tradables to tradables as a real shock. Formally, we assume that
there is an unanticipated and permanent increase in γ as shown in Panel A of Figure
2.
We first replicate the well-known results about the diﬀerence between the economy’s response to real shocks in the predetermined exchange rate regime and that in
the monetary targeting regime under flexible exchange rates, and will then comparethem with that in the inflation targeting regime.9

3.1

Predetermined exchange rates

Under predetermined exchange rates, policy makers set the path of nominal exchange
rate E(t). We assume that the devaluation rate is set at a constant level: ε̄. Fromthe interest parity (1), the nominal interest rate is therefore constant over time
(Panel B in Figure 2):i(t) = r + ε̄.

(19)Considering that i(t) is constant and the consumer’s first-order condition (9), we
can get that the consumption of tradables will be constant along a perfect foresightequilibrium path. From the economy’s resource constraint, we obtain the constantlevel of tradables consumption:cT (t) = rk0 + y T .

(20)Using (11) and (17), we can rewrite (12) as
{

}

)
1−γ (
π̇(t) = θ ȳ −rk0 + y T e(t) .
γ
N

(21)
T

From the definition of the real exchange rate (i.e., e(t) ≡ PP N (t)) and P T (t) = E(t),(t)
we haveė(t) = e(t) (ε̄ − π(t)) ,(22)

under predetermined exchange rates.
Equations (21) and (22) constitute a system of diﬀerential equations in π and e.
In the steady state, we have(es =πs = ε̄,
γ
1−γ

)(

N

ȳ
rk0 + y T

9

(23)

)

,

(24)

The model, which is used to replicate the well-known results, heavily draws on Végh (2013)(subchapter 11.4). While Végh (2013) employs a money-in-the-utility-function model, we considera cash-in-advance economy.

8where πs and es denote the steady state levels of π(t) and e(t), respectively.10 By
linearizing the system comprising (21) and (22) around the steady state, we have
[

π̇(t)
ė(t)

]

[

=

0 θ
−es

(

1−γ
γ

)(

rk0 + y T0

) ][π(t) − πse(t) − es].

The determinant of the matrix on the right-hand side is denoted as ∆ and has thevalue∆ = −θȳ N < 0.
(T

Around the steady state, the system is saddle-path stable. Note that e(t) ≡ PP N (t)= PE(t)N (t)(t)
is a predetermined variable, since we have predetermined exchange rates E(t) andthe sticky price of non-tradables P N (t). Figure 1 shows the corresponding phase
diagram. The initial steady state is at point A. The new steady state associatedwith a higher value of γ becomes point C. On impact, the system jumps from point
A to point B and then converges to point C along the saddle path.
Figure 1: Increase in γ under predetermined exchange ratesπtπ̇ = 0Aė = 0C

Bet
The paths of the main variables are illustrated in Figure 2. Figure 2 is obtained
based on the Mathematica program in Chapter 11 of Végh (2013). Following Végh(2013), the parameter values are set as follows: r = 0.05, k0 = 0, y¯T = 1, ȳ N =1, θ = 0.5, ε̄ = 0.5, and α = 1. The shock consists of an increase in γ from 0.5 to
0.6. The path of π(t) and that of e(t) are straightforward from Figure 1 (Panels C
and D in Figure 2). From the path of e(t), equation (11), and the fact that tradables
consumption, cT (t), is constant, we obtain the path of non-tradables consumption,cN (t), as shown in Panel E in Figure 2.

10

Hereafter, in this paper, a variable with the suﬃx s denotes its steady state level.

9)A. Increase in Γ

B. Interest rate
i

Γ
0.65

0.70
0.65

0.60

0.60
0.55

0.55
0.50

0.50

0.45
t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55
0.50
0.45
0.40
0.35
0.30

1.4
1.2
1.0
0.8
t
-2

0

2

4

6

8

10

t
-2

0

2

4

6

E. Non-tradables consumption
cN
1.1
1.0
0.9
0.8
0.7
t
-2

0

2

4

6

8

10

Figure 2: Real shock under predetermined exchange rates

10

3.2

Monetary Targeting

In the monetary targeting regime under flexible exchange rates, policy makers( set the)Ṁ (t)
path of money supply M (t). We assume that the rate of money growth µ(t) ≡ M(t)(t)
is set at a constant level: µ̄. From the definition of m(t)(≡ PMT(t)=M), it follows
(t)
E(t)
that

ṁ(t)
= µ̄ − ε(t).
m(t)

(25)

From the interest parity (1), equation (25) can be rewritten asṁ(t)= r + µ̄ − i(t).
m(t)

(26)

ṁ(t)
ċT (t)
= T .
m(t)
c (t)

(27)

It follows from (13) that

By diﬀerentiating both sides of equation (9) with respect to time, we obtainαċT (t)=i̇(t).
− Tc (t)1 + αi(t)(28)

By combining (26), (27), and (28), we obtaini̇(t) =

1 + αi(t)(i(t) − r − µ̄) .
α(29)Using (15) and (17), we can rewrite (12) as{π̇(t) = θ ȳ N −
(

(

)

}

1−γ
n(t) .
α(30)), we have
From the definition of n(t) ≡ PMN(t)(t)ṅ(t) = n(t) (µ̄ − π(t)) .

(31)

Equations (29), (30), and (31) constitute a system of diﬀerential equations in i,π, and n. In the steady state, we haveis = r + µ̄,
πs = µ̄,
α N
ȳ .
ns =
1−γ

(32)
(33)
(34)

By linearizing the system comprising (29), (30), and (31) around the steady state,
we have










1+αis
0
0
i(t) − is
i̇(t)
α



1−γ  π(t)− πs 00−θ=.
 π̇(t) α n(t) − ns
0
−ns
0
ṅ(t)

11

The determinant of the matrix on the right-hand side is denoted as ∆ and has thevalueθ (1 − γ) (1 + αiss ) nss
∆=−
< 0.
α2
The trace of the matrix on the right-hand side is denoted as T r and has the valueTr =1 + αiss> 0.
αTherefore,we) get that there exist one negative and two positive roots. Note that(M (t)n(t) ≡ P N (t) is a predetermined variable, since M (t) is predetermined under monetary targeting and the price of non-tradables P N (t) is sticky. Since the number ofnegative roots is equal to the number of predetermined variables (i.e., n(t)), we canpin down the saddle path converging to the steady state for a given value of i0 , π0 ,and n0 .11
Let δ1 denote the negative root. Let h1j , j = 1, 2, 3 denote the elements of theeigenvector associated with the root δ1 . By setting the constants corresponding to
the two unstable roots as zero, we can express the solution of this dynamic systemasi(t) − is = ω1 h11 exp(δ1 t),π(t) − πs = ω1 h12 exp(δ1 t),n(t) − ns = ω1 h13 exp(δ1 t),

(35)
(36)
(37)

where ω1 is the constant associated with the root δ1 . To obtain h1j , j = 1, 2, 3, wesolve 1+αi



From

(

1+αis
− δ1
α

)

s

α

0
0

− δ1









0
0
h11
0



h
0 
−δ1 −θ 1−γ
=




.
12
α
h13
0
−ns −δ1> 0, we have thath11 = 0(38)h12
θ(1 − γ)
=−
> 0.
h13
αδ1

(39)

and

From (35) and (38), we can get that i(t) remains at the initial steady state. Equations (36), (37), and (39) imply that π(t) and n(t) will converge to their steady statevalues from the same direction.12
Figure 3 illustrates the paths of the main variables. As argued above, i(t) remains at the steady state (Panel B in Figure 3). π(t) and n(t) converge to their
11

For details on the analysis of the system with three roots, see, for example, Végh (2001) orVégh (2013) (subchapter 8.5.2).
12
We can pin down ω1 by setting h13 = 1, since n0 is its initial steady state value and ns is its
new steady state value. (Note that n(t) is a predetermined variable.)12

steady state values from the same direction (Panels C and E in Figure 3). From(15), we can obtain the path of cN (t) (Panel F in Figure 3). Considering that i(t) isconstant and the consumer’s first-order condition (9), the consumption of tradables
is constant along a perfect foresight path equilibrium (i.e., cT (t) = rk0 + y T ). Thus,
from the path of cN (t) and (11), the path of e(t) must look as in Panel D of Figure
3. Note that under monetary targeting, the real exchange rate e(t) is not predetermined and can jump on impact. From (11) and the fact that the consumption of
tradables is constant along a perfect foresight path equilibrium, we can know thatthe real exchange rate e(t) plays the role of absorbing the real shock. That is, theconsumption of non-tradables fluctuates less under monetary targeting than underpredetermined exchange rates.

3.3

Inflation targeting

We now consider nominal interest rate rules with an inflation target. Policy makers
announce a target level of inflation π̄. We consider the interest rate rule incorporating the Taylor principle as follows:i(t) = r + π̄ + ϕ (π(t) − π̄) , ϕ > 1.

(40)

This rule is employed in, for example, Calvo (2007). We will focus on the case where
policy makers adjust the nominal interest rate in such a way that the Taylor principle
is satisfied.13 The condition ϕ > 1 is the so-called Taylor principle. According tothis policy rule, policy makers increase (reduce) the level of the nominal interest rate
if the actual inflation level is above (below) the target level set by the policy makers
in advance. In this set-up, by construction, the nominal interest rate can jump on
impact. That is, the nominal interest rate will be adjusted such that the real interest
rate is increased (reduced) in the face of an increase (decrease) in inflation.
In order to analyze the dynamic adjustment of this economy under the nominal()
λ
interest rate rule, we follow Calvo (2007) and introduce another variable x(t) ≡ e(t)into the system. Using the variable x(t) and (10), we havecN (t) =1−γ.
(1 + αi(t)) x(t)(41)

By combining (17), (40), and (41) with (12), we obtain
}

{

1−γ
.
π̇(t) = θ ȳ −[1 + α {r + π̄ + ϕ (π(t) − π̄)}] x(t)
N

(

(42)

)

λ
From the definition of x(t) ≡ e(t)and e(t) = PE(t)N (t) , we have

ė(t)
ẋ(t)
=−
= −ε(t) + π(t).
x(t)
e(t)
From the interest rate parity (1), we obtainẋ(t) = (r + π(t) − i(t)) x(t).
13

For the Taylor principle, see, for example, Galı́ (2008).

13

(43)

A. Increase in Γ

B. Interest rate
i

Γ
0.65

0.70
0.65

0.60

0.60
0.55

0.55
0.50

0.50

0.45
t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55
0.50
0.45
0.40
0.35
0.30

1.4
1.2
1.0
0.8
t
-2

0

2

4

6

8

t

10

-2

E. Real money balances

0

2

4

6

F. Non-tradables consumption

n

cN
1.1

2.6
2.5

1.0

2.4
2.3

0.9

2.2

0.8

2.1
0.7

2.0
t
-2

0

2

4

6

8

10

t
-2

0

2

4

Figure 3: Real shock under monetary targeting
14

6

8

10

By substituting (40) into (43), we obtainẋ(t) = x(t) {(1 − ϕ) (π(t) − π̄)} .

(44)

Equations (42) and (44) constitute a system of diﬀerential equations in π and x. In
the steady state, we have
πs = π̄,1−γxs =.
{1 + α(r + π̄)} ȳ N

(45)
(46)

By linearizing the system comprising (42) and (44) around the steady state, we have
[

π̇(t)
ẋ(t)

]

[ θ(1−γ)=xs

αϕ{1+α(r+π̄)}2

xs (1 − ϕ)

θ(1−γ){1+α(r+π̄)}x2s0][π(t) − πsx(t) − xs].

The trace of the matrix on the right-hand side is denoted as T r and has the valueTr =θ(1 − γ)αϕ> 0.
xs
{1 + α(r + π̄)}2The determinant of the matrix on the right-hand side is denoted as ∆ and has thevalue{θ (1 − ϕ) (1 − γ)
> 0 if ϕ > 1,∆=−=
≤ 0 if ϕ ≤ 1.
{1 + α (r + π̄)} xs
The Taylor principle implies that there are two positive roots in this system. Notethat neither π(t) nor x(t) are predetermined. Therefore, as argued in Calvo (2007),
we need two positive roots so that the system has a unique equilibrium around thesteady state.14 Figure 4 shows the corresponding phase diagram. The initial steadystate is at point A. The new steady state associated with a higher value of γ becomespoint B. On impact, the system jumps from point A to point B.
Figure 5 shows the paths of the main variables. An increase in γ does not change
the steady state level of π(t). Thus, there is no change in π(t) on impact (Panel C in
Figure 5). From (40), i(t) remains at its initial steady state level (Panel B in Figure5). x(t) falls to its new steady state level on impact (Panel F in Figure 5). The
amounts of change in the steady state levels of x(t), λ(t), and e(t) due to an increasein γ are explained in Appendix A2. From the paths of γ, x(t), and i(t), and equation(41), we obtain the path of cN (t) (Panel E in Figure 5) (as explained in Appendix
A2). It turns out that the consumption of non-tradables remains unchanged overtime.
To show the robustness of our results, Appendix A1 presents another interest
rate rule as follows:i̇(t) = ϕ (π(t) − π̄) ,which is employed in Reinhart (1992) and Végh (2001). As mentioned in the introduction, we refer to this type of interest rate rule as the sticky interest rate rule,since this type of interest rate rule implies that the nominal interest rate is a predetermined variable that moves in a sticky way. In Appendix A1.1, we show that thereal shock considered in this section causes the exact same dynamics as all of theendogenous variables shown in Figure 5.
14

If ϕ < 1, we have the saddle-path stability that implies indeterminacy in the system with two
non-predetermined variables.

15

Figure 4: Increase in γ under the interest rate rule with the Taylor principleπtπ̇ = 0Aπ̄ẋ = 0B

xt

3.4

Comparison of the response to real shocks under alternative regimes

We have analyzed the economy’s response to real shocks under alternative regimes.
As a benchmark case, we first replicated the well-known results about the diﬀerencein the economy’s response to real shocks under predetermined exchange rates andmonetary targeting. By comparing Panel E in Figure 2 and Panel F in Figure 3, we
can confirm that in response to the real shock, the consumption of non-tradables
fluctuates less under monetary targeting than under predetermined exchange rates.
As argued by Végh (2013), Chapter 11, this is because under monetary targeting,the real exchange rate serves as a cushion against real shocks (as is clear from thecomparison of Panel D in Figure 2 and Panel D in Figure 3). By comparing Panel
E in Figure 5 with Panel E in Figure 2 and Panel F in Figure 3, we can say thatthe inflation targeting regime is more optimal in making adjustments to real shocks.
The reason why the inflation targeting regime can make better adjustments thanthe predetermined regime is that the real exchange rate under the inflation targeting
regime is not predetermined and plays the role of absorbing real shocks as undermonetary targeting. In addition, under the inflation targeting regime, real money
balances are not predetermined either, and play the role of a shock absorber, in
addition to the real exchange rate. It should be noted that even though the real exchange rate is not predetermined, if real money balances are predetermined, (whichis the case in monetary targeting), an immediate adjustment to the consumption of
non-tradables is impossible (as is clear from equation (15)).15

15Since the real (monetary) shock does not change the steady state level of the consumptionof non-tradables in this model, the immediate adjustment implies that there is no convergenceprocess to the steady state after the shock (i.e., non-tradables consumption remains unchanged on
impact).

16

A. Increase in Γ

B. Interest rate
i

Γ
0.65

0.70
0.65
0.60
0.55
0.50
0.45

0.60
0.55
0.50
t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55
0.50
0.45
0.40
0.35
0.30

1.4
1.2
1.0
t
-2

0

2

4

6

8

0.8
t

10

-2

0

E. Non-tradables consumption

2

4

6

8

10

8

10

F. xH=ΛeL

cN
1.1

x
0.35

1.0
0.9

0.30

0.8
0.25
0.7
t

t
0

-2

2

4

6

8

10

-2

0

2

4

6

G. Lagrange multiplier
Λ
0.40
0.38
0.36
0.34
0.32
0.30
0.28
t
-2

0

2

4

6

8

10

Figure 5: Real shock under the interest rate rule with the Taylor principle
17

4

Monetary shocks

In this section, we analyze how the economy responds to monetary shocks under thediﬀerent regimes. Following Végh (2013), we consider a change in money demand
as a monetary shock. Formally, we assume that there is an unanticipated andpermanent increase in α as shown in Panel A of Figure 6.
We first replicate the well-known results about the diﬀerence in the economy’s
response to monetary shocks under predetermined exchange rates and monetary
targeting, and will then compare them with the economy’s response to monetaryshocks under inflation targeting.16

4.1

Predetermined exchange rates

As argued in Section 3.1, equations (21) and (22) constitute the dynamic system
under predetermined exchange rates. Note that e(t)(= PE(t)N (t) ) is the only predetermined variable under predetermined exchange rates. From (24), we know that ashift in α does not change es . Therefore, there is no adjustment in response to themonetary shock. Each variable except for real money balances remains at its initialsteady state level (Panels B to D and F in Figure 6). From (15) ((13)), n (m) jumps
to its new steady state level on impact. That is, under predetermined exchange
rates, the monetary shock changes only the real money balances.

4.2

Monetary Targeting

As argued in Section 3.2, equations (29), (30), and (31) constitute the dynamic) is the only predetermined
system under monetary targeting. Note that n(t)(≡ PMN(t)(t)
variable under monetary targeting. From (34), we know that an increase in α willraise ns . Therefore, we can get that there is adjustment due to the monetary shock.
The adjustment process of n to its new steady state level is shown in Panel E in
Figure 7. From (15), we can know the path of cN (t) (Panel F in Figure 7). As shownin Section 3.2, π(t) converges to its steady state level from the same direction as n(t)(Panel C in Figure 7), while i(t) remains at its initial steady state (Panel B in Figure7). Considering that i(t) is constant and the consumer’s first-order condition (9),the consumption of tradables is constant along a perfect foresight path equilibrium(i.e., cT (t) = rk0 + y T ). Thus, from the path of cN (t) and (11), we get that the pathof e(t) would be as in Panel D of Figure 7.

4.3

Inflation targeting

We now analyze how the economy responds to the monetary shock under the inflation targeting regime. As shown in Section 3.3, equations (42) and (44) constitutethe dynamic system under the interest rate rule with the Taylor principle. Since wehave no predetermined variables and the system is unstable around the steady state,
16

As in the case of real shocks, the model here, which is used to replicate the well-known resultsin the case of monetary shocks, heavily draws on Végh (2013) (subchapter 11.4). While Végh(2013) employs a money-in-the-utility-function model, we consider a cash-in-advance economy.

18

A. Increase in Α

B. Interest rate
i

Α
0.65
1.3
0.60

1.2

0.55

1.1

0.50

1.0

t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55
0.50
0.45
0.40
0.35
0.30

1.4
1.2
1.0
0.8
t
-2

0

2

4

6

8

t

10

-2

E. Real money balances

0

2

4

6

F. Non-tradables consumption

n

cN
1.1

2.6
2.5

1.0

2.4
2.3

0.9

2.2

0.8

2.1
0.7

2.0
t
-2

0

2

4

6

8

t

10

-2

0

2

4

6

Figure 6: Monetary shock under predetermined exchange rates
19

8

10

A. Increase in Α

B. Interest rate
i

Α
0.65
1.3
0.60

1.2

0.55

1.1

0.50

1.0

t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55

1.4

0.50
0.45

1.2

0.40
1.0

0.35
0.30

0.8
t
-2

0

2

4

6

8

t

10

-2

E. Real money balances

0

2

4

6

F. Non-tradables consumption

n

cN
1.1

2.6
2.5

1.0

2.4
2.3

0.9

2.2

0.8

2.1
0.7

2.0
t
-2

0

2

4

6

8

10

t
-2

0

2

Figure 7: Monetary shock under monetary targeting
20

4

6

8

10

there is no adjustment in response to the monetary shock. From (46), an increasein α will reduce xs . Similarly as in Figure 4, the system jumps to its new steadystate like point B.
Figure 8 shows the paths of the main variables. Since an increase in α does notchange the steady state level of π(t) (from (45)), π(t) remains unchanged on impact(Panel C in Figure 8). x(t) falls to its new steady state level on impact (Panel G in
Figure 8). From (40), i(t) remains at its initial steady state level (Panel B in Figure8). The new steady state levels of x, λ, and e due to an increase in α are explained
in detail in Appendix A3. From the paths of α and i(t) and by substituting (A21)
into (41), we can get that the new steady state level of cN (t) is equal to its initiallevel (Panel F in Figure 8). From the path of cN (t) and (15), therefore, the steadystate level of real money balances n(t) increases on impact (Panel E in Figure 8).
To demonstrate the robustness of our results, we include Appendix A1.2, in
which we also examine the case with a sticky nominal interest rate. It is shown thatthe monetary shock considered in this section causes the exact same dynamics as
all the endogenous variables shown in Figure 8.

4.4

Comparison of the response to monetary shocks underalternative regimes

As a benchmark case, we first replicated the well-known results about the diﬀerencein the economy’s response to monetary shocks under predetermined exchange rates
and monetary targeting. As is clear from Panel F in Figures 6 and 7, we can confirm
the well-known result that in response to monetary shocks, the predetermined exchange rate regime is more optimal than the monetary targeting regime. As argued
by Végh (2013), Chapter 11, this is because under predetermined exchange rates,
the real money balances serve as a cushion against monetary shocks (as is clear fromthe comparison of Panel E in Figures 6 and 7). Note that if the real money balances
are predetermined, which is the case in monetary targeting, the consumption of
non-tradables would have an adjustment (convergence) process to its steady state(from (15)). By comparing Panel F in Figure 8 with Panel F in Figures 6 and 7,
we can get that in terms of adjustments to monetary shocks, the inflation targeting regime is more optimal than the monetary targeting regime, and as optimal as
the predetermined exchange rate regime. The reason why the inflation targeting
regime is more optimal than the monetary targeting regime is that the real money
balances under the inflation targeting regime are not predetermined and play therole of absorbing monetary shocks as under predetermined exchange rates.

21

A. Increase in Α

B. Interest rate
i

Α
0.65

1.3

0.60

1.2

0.55

1.1

0.50

1.0

t

t
-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

D. Real exchange rate

C. Inflation rate
e

Π
1.6

0.60
0.55
0.50
0.45
0.40
0.35
0.30

1.4
1.2
1.0
t
-2

0

2

4

6

8

0.8
t

10

0

-2

E. Real money balances

2

4

6

8

10

F. Non-tradables consumption

n

cN
1.1

2.6
2.5
2.4
2.3
2.2
2.1
2.0

1.0
0.9
0.8
0.7
t
-2

0

2

4

6

8

t

10

0

-2

G. xH=ΛeL

2

4

6

8

10

H. Lagrange multiplier

x

Λ
0.40
0.38
0.36
0.34
0.32
0.30
0.28

0.35
0.30
0.25
t
-2

0

2

4

6

8

10

t
-2

0

2

4

6

8

10

Figure 8: Monetary shock under the interest rate rule with the Taylor principle
22

5Conclusion

Although there have been many works on the conventional wisdom on predetermined and flexible exchange rates, existing studies have been mainly focused on the
choice between predetermined exchange rates and monetary targeting under flexible exchange rates. The aim of our study is to extend the literature regarding theMundell-Fleming dictum to include the inflation targeting regime. After replicating the well-known results about the diﬀerence in the economy’s response to theshocks under predetermined exchange rates and monetary targeting, we have compared them with the economy’s response to the shocks under the inflation targeting
regime.
The results of our analysis show that the inflation target regime is superior (or atleast equal) to predetermined exchange rates and monetary targeting in absorbing
real and monetary shocks, respectively. The intuitive explanation for this result is
as follows. The real exchange rate plays the key role of absorbing real shocks. Since
the real exchange rate is predetermined under predetermined exchange rates, thepredetermined exchange rate regime is not as optimal as the monetary targeting
regime in the presence of real shocks. On the other hand, the real money balances
are the key shock absorber to monetary shocks. Since the real money balances arepredetermined under monetary targeting, the economy under monetary targeting
cannot make immediate adjustments to monetary shocks. In contrast, under theinterest rate rule with an inflation target, neither the real exchange rate nor realmoney balances are predetermined. Hence, the economy under inflation targetingcan make better (or at least equivalent) adjustments to both real and monetaryshocks as compared to under predetermined exchange rates and monetary targeting.

Appendix
A1

Sticky interest rate rule

In this appendix, we consider the nominal interest rate rule as follows:i̇(t) = ϕ (π(t) − π̄) .

(A1)

According to this policy rule, policy makers increase (reduce) the rate of change (notthe level) of the nominal interest rate if the actual inflation level is above (below)
the target level set by the policy makers in advance.17 This type of nominal interest
rate rule implies that the nominal interest rate is a predetermined variable, andsticky.
By substituting (17) and (41) into (12), we obtain
}

{

1−γ
.
π̇(t) = θ ȳ −(1 + αi(t)) x(t)N

(A2)

Similarly, as in Section 3.3, we haveẋ(t) = (r + π(t) − i(t)) x(t).
17Végh (2013) explains this type of interest rate rule in detail (chapter 9, page 438).

23

(A3)

Equations (A1), (A2), and (A3) constitute a system of diﬀerential equations in i, π,
and x. In the steady state, we haveis = r + π̄,πs = π̄,1−γxs =.
{1 + α(r + π̄)} ȳ N

(A4)
(A5)
(A6)

By linearizing the system comprising (A1), (A2), and (A3) around the steady state,
we have






0
ϕ
i̇(t)
 αθ(1−γ) π̇(t)  = 
 xs (1+αis )2 0
ẋ(t)
−xs
xs





i(t) − isθ(1−γ)
π(t)− πs 
.
(1+αis )x2s 
x(t) − xs00

The determinant of the matrix on the right-hand side is denoted as ∆ and has thevalueϕθ (1 − γ)∆=−
< 0.
(1 + αis ) xs
The trace of the matrix on the right-hand side is denoted as T r and has the value
T r = 0.
The determinant and the trace imply that there exist one negative and two positiveroots. Note that i(t) is a predetermined variable. Since the number of negativeroots is equal to the number of predetermined variables (i.e., i(t)), we can pin down
the saddle path converging to the steady state for a given value of i0 , π0 , and x0 .
Let δ1 denote the negative root. Let h1j , j = 1, 2, 3 denote the elements of theeigenvector associated with the root δ1 . By setting the constants corresponding to
the two unstable roots as zero, we can express the solution of this dynamic systemasi(t) − is = ω1 h11 exp(δ1 t),π(t) − πs = ω1 h12 exp(δ1 t),
x(t) − xs = ω1 h13 exp(δ1 t),

(A7)
(A8)
(A9)

where ω1 is the constant associated with the root δ1 . To obtain h1j , j = 1, 2, 3, we
solve


−δ1

 αθ(1−γ) xs (1+αis )2

−xs

ϕ
−δ1
xs



0







0
h
  11 θ(1−γ)
(1+αis )x2s   h12  =  0  .
h13
0
−δ1

It follows that
h12
δ1
=
<0
h11
ϕ
and
h13
=
h11

(

(A10)

)

1
1
−
xs > 0.
ϕ δ1
24

(A11)

A1.1

Real shocks

Equations (A7), (A8), and (A10) imply that i(t) and π(t) will converge to theirsteady state values from opposite directions. Equations (A7), (A9), and (A11)
imply that i(t) and x(t) will converge to their steady state values from the same
direction. However, we should note that the real shock of an increase in γ does notchange the steady state level of i(t). Since i(t) is the only predetermined variable inthis system, we do not observe an adjustment process along the saddle path due tothe real shock. Hence, as depicted in Figure 5, i(t) remains at its initial steady statelevel (Panel B in Figure 5). π(t), too, remains at its initial steady state level (Panel
C in Figure 5). From (A6), we know that x(t) has a new lower steady state value
due to an increase in γ. Since, as argued above, an increase in γ does not resultin an adjustment process along the saddle path, x(t) jumps to its new steady statelevel on impact (Panel F in Figure 5). Similarly, as in Section 3.3, the changes inthe steady state levels of x(t), λ(t), and e(t) due to an increase in γ are explainedin Appendix A2. From the paths of γ, x(t), and i(t), and equation (41), we obtain
the path of cN (t) (Panel E in Figure 5) (as explained in Appendix A2). It turns outthat the consumption of non-tradables remains unchanged over time.

A1.2

Monetary shocks

As argued in Section A1, equations (A1), (A2), and (A3) constitute the dynamic
system under the sticky interest rate rule. We should note that the monetary shock
does not change the steady state level of i(t). Since i(t) is the only predeterminedvariable in this system, we do not observe an adjustment process along the saddle
path. Hence, i(t) remains at its initial steady state level (Panel B in Figure 8). From
(A5), π(t), too, remains at its initial steady state level (Panel C in Figure 8). From
(A6), we get that x(t) has a new lower steady state value due to an increase in α.
Since, as argued above, an increase in α does not result in an adjustment process
along the saddle path, x(t) jumps to its new lower steady state level on impact(Panel G in Figure 8). Similarly as in Section 4.3, the new steady state levels ofx, λ, and e due to an increase in α are explained in detail in Appendix A3. Fromthe paths of α and i(t) and by substituting (A21) into (41), we can get that the
new steady state level of cN (t) is equal to its initial level (Panel F in Figure 8) (asexplained in Appendix A3). From (15), the steady state level of real money balancesn(t) increases on impact (Panel E in Figure 8).

A2

Shifts in x, λ, and e due to an increase in γ

Let γ ′ denote a higher level of γ (i.e., γ → γ ′ ). Correspondingly, we denote theinitial steady state levels of x(t), λ(t), e(t) and cN (t) as x, λ, e, and cN , and denote′their new steady state levels as x′ , λ′ , e′ , and cN . We now show how their steadystate levels change (or does not change) in response to the increase in γ in Sections
3.3 and A1.1.

25

From equation (A6) (equation (46)), the following must holdx′ =1 − γ′,{1 + α(r + π̄)} ȳ N

(A12)in the new steady state. Then, we havex′
1 − γ′=(< 1).
x
1−γ

(A13)

Substituting the definition of x(≡ λe ) into (A13) givesx′ =1 − γ′ λ
.
1−γ e

(A14)

The substitution of (24) into (A14) gives18(

1 − γ′
x =λ
γ

)(

′

rk0 + y T
ȳ N

)

.

(A15)

′

From the definition of x(≡ λe ), we also have x′ = λe′ . Using (24) again, we obtain
(
′

x =λ

′

1 − γ′
γ′)(

rk0 + y T
ȳ N

)

.

(A16)

Hence, it follows from (A15) and (A16) thatλ′γ′=(> 1).
λγ(A17)From the definition of x(≡ λe ) and (A13), equation (A17) implies thate′λ′ xγ ′ (1 − γ)==(> 1).
eλ x′
γ (1 − γ ′ )(A18)From equations (41), (A13), and the fact that i remains unchanged, we can confirm
thatcN = cN

A3

′

(

)

= ȳ N .

(A19)

Shifts in x, λ, and e due to an increase in α

In this appendix, we show how x, λ, e, and cN change (or does not change) in
response to the increase in α in Sections 4.3 and A1.2.
From equation (A6) (equation (46)), the following must hold
x′ =
18

1−γ
,
{1 + α′ (r + π̄)} ȳ N

Equation (24) holds under both interest rate rules.

26

(A20)

in the new steady state. Then, we havex′
1 + α (r + π̄)=(< 1).
x
1 + α′ (r + π̄)(A21)

From equation (11), we have
(
′

e=e =

γ
1−γ
(

)(

ȳ N
rk0 + y T

)

)

.

(A22)

′

By substituting the definition of x ≡ λe (x′ (≡ λe′ )) into (A21) and using (A22), wehave
λ′1 + α (r + π̄)=(< 1).
λ1 + α′ (r + π̄)(A23)

From equations (41), (A21), and the fact that i(= r + π̄) remains unchanged, we
can confirm thatcN = cN′()= ȳ N .

(A24)

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