NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Inflation Targeting and Sudden Stops

Ricardo J. Caballero, Arvind Krishnamurthy

NBER Working Paper No. 9599
Issued in April 2003
NBER Program(s):   CF   EFG   IFM

Emerging economies experience sudden stops in capital inflows. As we have argued in Caballero and Krishnamurthy (2002), having access to monetary policy during these sudden stops is useful, but mostly for insurance' rather than for aggregate demand reasons. In this environment, a central bank that cannot commit to monetary policy choices will ignore the insurance aspect and follow a procyclical rather than the optimal countercyclical monetary policy. The central bank will also intervene excessively to support the exchange rate. These inefficiencies are exacerbated by the presence of an expansionary bias. In order to solve these problems, we propose modifying the central bank's objective to (i) include state-contingent inflation targets, (ii) target a measure of inflation that overweights non-tradable inflation

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Published: Inflation Targeting and Sudden Stops, Ricardo J. Caballero, Arvind Krishnamurthy, in The Inflation-Targeting Debate (2005), University of Chicago Press (p. 423 - 446)

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