Exploring the Role of Exchange Rates in Inflation Targeting : Evidence from Thailand

Small open economies traditionally do not consider exchange rates explicitly when targeting inflation. However, the models used rely on various assumptions. To investigate this, we developed a small-scale, structural general equilibrium model for the Thai economy. Using Bayesian estimation, we evaluate the conduct of monetary policy under an inflationtargeting regime. Specifically, we focus on three main issues. First, we investigate whether exchange rate movements are incorporated in the monetary policy formulation. Second, we evaluated economic welfare under alternative monetary policy settings. Third, we explore how a varying degree of openness could affect the transmission mechanism. Using data over the past 20 years, we find that the Bank of Thailand adjusted policy interest rates in response to exchange rate movements and this helped to reduce both output and inflation fluctuations from global shocks and improve welfare. While a higher degree of openness is found to flatten the slope of the Phillips curve, it does not necessarily reduce monetary policy effectiveness. This is because openness also affects the policy coefficients in the central bank’s endogenous reaction function