Incentives from Exchange Rate Regimes in an Institutional Context

An open economy macromodel, calibrated to typical institutions and shocks of a populous emerging market economy, shows that a monetary stimulus preceding a supply shock can abort inflation at minimum output cost, since of the appreciation of exchange rates, accompanying a fall in interest rates and rise in output. Analytic results obtained for two periods are generalized through simulations and validated through estimation. One instrument achieves both domestic output and exchange rate objectives, partly since it creates correct incentives for foreign exchange traders. Strategic interactions imply supporting institutions are required to coordinate monetary, fiscal policy, and markets to the optimal equilibrium.