Notes on "Two targets, two instruments: Monetary and exchange rate policies in emerging market economies" (Ghosh, Atish R. ; Ostry, Jonathan D. ; Chamon, Marcos)

Two targets, two instruments: Monetary and exchange rate policies in emerging market economies 

Ghosh, Atish R. ; Ostry, Jonathan D. ; Chamon, Marcos

Journal of International Money and Finance [Peer Reviewed Journal]

Two instruments to stabilise inflation and output while attenuating disequilibrium currency movements:

the policy interest rate

sterilised foreign exchange market intervention

inflation targeting is appropriate for emerging market economies(EMEs) that lack other nominal anchors, but it should be supplemented by judicious foreign exchange intervention, especially in the face of volatile capital flows

most EME central banks - even those with formal IT frameworks - appear to care about exchange rate volatility, adjusting the policy interest rate in response to exchange rate movements and undertaking sterilised interventions:

sterilised intervention is more likely to effective in EMEs than in advanced economies

using a simple open economy model with imperfect capital mobility. while discretionary monetary policy allows the central bank to better respond to domestic and foreign shocks - and this is welfare-enhancing when the central bank cares about exchange volatility - it may also impart an inflationary bias to the economy when the central banks i contending with time consistency or credibility problems

FX intervention is fully consistent with the central bank meeting its inflation target under IT, and is welfare enhancing provided the central bank indeed penalises exchange rate volatility. the model further implies that there will be a larger gain to adding FX intervention to the toolkit when the central bank has IT framework than when it sets discretionary policies, and that the gains from adding the second instrument to an IT framework are larger than the exchange rate stabilisation gains of switching to discretionary policies.

FX intervention is more likely to play an important role when the interest rate sensitivity of capital flows with respect to the return differential is low (in the limit where that sensitivity goes to infinity and Uncovered Interest Parity holds, FX intervention will have no traction). Assuming that FX intervention is costly, it is also more likely to play am ore important role in smoothing temporary shocks, playing a relatively minor role is the case of more persistent shocks.

with the credibility of most EME central banks not yet fully established, discretionary monetary policies would not be appropriate even though they allow the central bank to better respond to shocks that ternate costly exchange rate movements. Rather, by adding FX intervention to their arsenal, EME central banks with IT frameworks can capture much of the currency stabilisation gains that discretionary policies afford—without jeopardising the hard-won credibility about their commitment to maintain low inflation. Indeed, not only is FX intervention fully consistent with inflation targeting, it may actually enhance the credibility of the central bank's inflation target.