This paper presents a model of an economy that uses nominal exchange rate policy to keep the real exchange rate constant at a certain target level, under the assumption that domestic and foreign assets are imperfect substitutes. The paper discusses the determinants of inflation under such a policy and examines the consequences of exogenous and policy-induced shocks on inflation, the external accounts, and the fiscal accounts.
The paper concludes that under real exchange rate targeting, there seems to be a trade-off between external trade performance and inflation. The more ambitious the external trade objectives, and thus the more depreciated the real exchange rate target, the higher the resulting rate of inflation.
How fiscal tightening affects inflation depends on the instrument that is used. An increase in taxes or a reduction in public sector expenditure on nontraded goods would reduce inflation in both the short run and the long run. A reduction in public sector expenditure on traded goods, on the other hand, would have no effect on inflation. The consequences of fiscal tightening for the trade balance are also instrument-specific. While reducing public sector expenditure on traded goods would improve the trade balance by the same amount, increasing taxes would have no effect on the trade balance as private sector expenditure would remain constant due to reduced inflation tax payments. Furthermore, a reduction in public sector expenditure on nontraded goods would cause the trade balance to worsen; the decline in inflation tax payments would cause private expenditure to rise by more than the reduction in public expenditure.
The model indicates that high domestic interest rates brought about by open market sales of domestic bonds can be effectively used to contain inflation, but only in the short term. Eventually, private sector demand will expand owing to increased real interest receipts on private sector holdings of domestic bonds, thereby generating higher inflation.
This pattern also has implications for designing a response to exogenous changes in world financial markets. For example, a fall in foreign interest rates in the absence of a policy response would induce capital inflows, a decline in domestic interest rates, and higher inflation in the short run. Eventually, however, lower real interest receipts by the private sector would lead to lower private expenditure and, in turn, to lower inflation. If the monetary expansion resulting from the capital inflows were sterilized by sales of domestic bonds, the authorities would be able to contain the initial increase in inflation but would forfeit (at least part of) the fall in inflation that would follow if sterilization did not occur.