A model of inflation targeting in an open economy

This paper develops a model of inflation targeting in a small open economy under floating exchange rates. The central bank follows a simple Taylor rule to achieve a target inflation rate, and the inflation process itself is determined by an expectations augmented Phillips curve mechanism. The behaviour of the exchange rate is governed by uncovered interest parity as a benchmark case, and both exchange rate expectations and inflationary expectations are assumed to be held with perfect foresight. Finally, the level of output in the economy varies gradually in response to excess demand in the goods sector. The paper analyses the effects of two shocks, a reduction in the central bank's target inflation rate and a sudden increase in aggregate demand. The effects of these shocks in a large country engaged in inflation targeting on the outside world follow from these results. Copyright © 2004 John Wiley & Sons, Ltd.