Inflation targeting in a developing economy: policy rules, growth, and stability

Abstract

This paper aims to make a contribution to modeling monetary rules in open developing economies, in a context in which international capital flows are a force that has a decisive influence on the sustainable combination of the real exchange rate (RER) and the inflation rate. The intended contributions of the paper are twofold: it extends the Kaleckian model for an open economy to incorporate the effects of capital flows on the RER and interest rate, and it acknowledges the possibility of having different macroeconomic regimes that reflect different preferences for inflation and employment by the government. A monetary rule that considers its effects on both inflation and employment may be more conducive to stability than a regime that solely focuses on inflation. On the other hand, a regime that solely focuses on employment will be unstable if adaptive expectations prevail in the process of wage bargaining.

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