Inflation targeting when devaluations are contractionary

Abstract

In the New Consensus model, when monetary policy is sufficiently sensitive to changes in the rate of inflation, a standard Taylor rule can effectively pin down inflationary expectations and stabilize the economy at practically no output cost. It is often believed that assuming an open or a closed economy does not matter. This view is incorrect, and the result depends critically on the nature of devaluations. When devaluations are contractionary, standard Taylor rules do not work. This result holds in a standard New Consensus model and in an amended version of it. We suggest that a successful inflation-targeting regime for an open economy cannot rely only on the manipulation of a short-term interest rate.