Domestic or external policy targets? The case for having it both ways

Author(s): Crowe, Christopher (2001)

Created 22 Jul, 2001
Categories Working Papers
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Monetary policy making has become increasing dominated by the use of explicit targets. Targeting has been seen as one solution to the Kydland-Precott time inconsistency problem. However, in an environment characterised by uncertainty, targets are only effective if they are credible, and the interplay between targets and reputation is therefore critical. Although early work in the 1980s discussed issues of credibility and reputation when there is uncertainty over policy maker type, few researchers have developer explicit models uncovering the relationship between credibility and reputation within a targeting environment. Recent work by Cukierman (2000) develops a model of targeting and reputation, using a two-period policy game. However, Cukierman's research is based on a closed economy or an open economy with a flexible exchange rate regime. Many developing countries, particularly those with limited room for textbook monetary policy interventions, have chosen to implement a domestic policy target (monetary or fiscal) in tandem with and external (exchange rate) anchor. This paper extends Cukierman's model to the fixed exchange rate case, utilising insights from the first and second generation exchange rate crisis literature.

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