RDP 2002-01: Inflation Targeting and the Inflation Process: Some Lessons from an Open Economy 1. Introduction

Inflation targeting in an open economy has a number of additional complexities compared with inflation targeting in a closed economy. One of these is that central banks in open economies have to decide how to respond to changes in the exchange rate. Pitchford (1993), Svensson (1998) and Ball (1998) examined this issue theoretically, and, in broad terms, reached the conclusion that in the presence of exchange rate shocks, central banks should consider targeting a measure of non-traded, or ‘domestic’, inflation rather than the aggregate inflation rate. The implication of their analysis is that central banks should respond to developments in the exchange rate, but only to the extent that the shocks to the exchange rate stimulate output growth in the economy or affect aggregate inflation expectations.

In the broader discussion of optimal policy-making under an inflation target, several papers have used the Ball-Svensson framework to explore the impact of including non-traded rather than aggregate inflation in the central bank's objective or policy reaction function[1] and have investigated how the specifics of the exchange rate pass-through process affect the monetary policy decision.[2] In many cases, these issues are discussed in the context of policy reaction functions that are variants of the Taylor rule.

In this paper, we summarise the essential features of an economy that affect the choice between targeting aggregate and non-traded inflation, and examine the issue empirically. The empirical part of this paper has two components. First, in Section 3, we use an empirical model of the Australian economy to illustrate the choice between targeting aggregate inflation rather than a measure of non-traded inflation and some of the aspects of the economy that affect that choice.

We examine the trade-off both in the context of optimal policy-making and assuming policy-makers use a Taylor-type rule to set interest rates.

These results, however, depend on our understanding of the inflation process. In Section 4 of the paper, we thus examine how the inflation process in Australia has changed over the last two decades, using reduced-form price equations that are often used for forecasting. We examine how the influence on the inflation rate of exchange rate shocks and deviations of output from potential have changed over time, as well as how the persistence of the inflation process has changed. The results for Australia are compared with those for the US, the UK, Canada and New Zealand.


Bharucha and Kent (1998) and Ryan and Thompson (2000). [1]

Cunningham and Haldane (1999). [2]