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

Journal: Efil Ekonomi Araştırmaları Dergisi (Vol.5, No. 1)

Publication Date:

Authors : ;

Page : 24-62

Keywords : Open Economy Macroeconomics; Inflation Targeting Monetary Policy; Fear of Floating; Difference-Differential Equation Systems; Simulation.;

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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.

Last modified: 2022-03-24 18:23:35