The international transmission of inflation in a managed float regime
The small open economy model predicts that inflation can be transmitted from a large economy to a small open economy in a fixed exchange regime but not in a flexible regime. Empirical studies, however, have shown contrasting results with some studies arguing that transmission has occurred in flexible regimes. I choose 30 countries with different regimes and find that, in general, countries with flexible exchange rate are indeed insulated from foreign price shocks while countries with fixed regime are not insulated. Countries which are officially under managed float regime, on the other hand, have been mixed where the majority enjoys price shock insulation. Acknowledging that few studies have been conducted with managed float regimes, I then constructed a model of inflation transmission in an exchange rate target zone by incorporating a discrete time version of Krugman's exchange rate target zone in a small open economy model. The results show that within the band, foreign shocks do not affect local prices while at the edge of the band, foreign shocks do affect local prices. Near the edge of the band, the central bank has to intervene to stop the exchange rate from further sliding to the edge. My model predicts that if the interventions are robust, then the exchange rate is mean reverting and in the long run, an exchange rate target zone can insulate an economy from foreign price shocks. I test my model using five European countries which adopted a target zone under the Exchange Rate Mechanism and find that these economies are indeed insulated from foreign price shocks. Price shocks from the large economy had transitory effect but no permanent effect on the small open economies with target zones.^
Chua, Kevin C, "The international transmission of inflation in a managed float regime" (2013). ETD Collection for Fordham University. AAI3588208.