Exchange Rate – Price – Output Dynamics in an Inflation Targeting Small Open Economy: Analysis with A Modified Dornbusch Model

For the countries that apply inflation targeting monetary policy to maintain price stability the exchange rate pass-through effect on the inflation rate arises as a serious issue. Countries with a high import dependency in manufacturing and with high foreign debt stocks cannot leave exchange rates to market dynamics; therefore, their central banks use policy interest rates to control their exchange rates with fear of floating. In this study, a dynamic model based on the dynamic versions of the Mundell – Fleming and Dornbusch models is developed to analyze the dynamic behavior of output, price, and exchange rate in an inflation-targeting small open economy. The steady-state and simulation results suggest that central banks with a fear of floating cannot determine their inflation target independently of the foreign interest rates. There is a unique value of the fear of floating parameter that can keep the economy stable.