Carlos Rondón Moreno, Banco Central de Chile

Paper: Capital Controls and the Optimality of Inflation Targeting in Emerging Economies with Downward Wage Rigidities

Abstract: Large external shocks put Central Banks in emerging economies with inflation targeting regimes at a crossroads. On the one hand, an inflation targeting regime allows room for movements in the exchange rate to cushion the effects of such shocks by relocating resources away from the tradable sector towards the nontradable sector. On the other hand, large movements in the exchange rate can compromise achieving the inflation target, forcing the central bank to assume a more contractionary monetary policy. In this paper, we use a non-linear monetary small open economy model to evaluate the optimality of the inflation targeting (IT) regime when the economy faces adverse external shocks and wages are downwardly rigid. Our results show that the strict IT regime is close to the optimal exchange rate regime for a plausible calibration of terms-of-trade and interest rates shocks. In particular, the lifetime consumption equivalent welfare cost in the IT regime is 0.3\% (vs 3.4\% in a currency PEG). The average unemployment rate of the economy under IT is six times lower than that of an economy under a currency peg.