Foreign exchange intervention and inflation targeting: The role of credibility

Abstract

We develop a small open economy model where the central bank operates under a flexible inflation targeting regime, i.e., monetary policy is aimed at stabilizing output and inflation. In this theoretical framework, we analyze to what extent foreign exchange intervention (FXI) can contribute to the central bank goals for different degrees of credibility. We find two key results. First, in a baseline scenario where the central bank is perfectly credible, FXI can improve macroeconomic outcomes by successfully stabilizing both output and inflation in response to foreign disturbances. Second, when central bank lacks credibility, FXI policies entail a trade-off by reducing output volatility at the expense of inducing higher inflation volatility. In this scenario, FXI policies prevent the central bank from achieving the goal of price stability. These results suggest that FXI is more likely to support an inflation targeting regime when the credibility of the central bank is high.