Inflation Targeting and Sudden Stops

Ricardo J. Caballero and Arvind Krishnamurthy

in The Inflation-Targeting Debate

Published by University of Chicago Press

Published in print February 2005 | ISBN: 9780226044712
Published online February 2013 | e-ISBN: 9780226044736 | DOI:
Inflation Targeting and Sudden Stops

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Underlying weaknesses in the domestic financial sector and limited integration with world financial markets make emerging market economies vulnerable to “sudden stops” of capital inflows. Without much warning, the capital flows that support a boom may come to a halt, exposing the country to an external crisis. Monetary policy in this context has often been seen as an additional source of problems rather than as a remedy. This chapter shows how inflation targeting should be adapted to countries whose primary macroeconomic concern is the presence of sudden stops in capital inflows. It uses a model that provides a natural motivation for both centralized holding of reserves and holding reserves in the form of dollars. However, it demonstrates that a central bank that cannot commit will be too aggressive in injecting dollar reserves during a crisis. To better understand monetary policy in emerging markets, the chapter models the presence of two distinct financial constraints: one between domestic agents and one between domestic agents and foreign investors.

Keywords: inflation targeting; sudden stops; capital inflows; emerging markets; financial constraints; domestic agents; foreign investors; monetary policy; dollar reserves

Chapter.  8605 words. 

Subjects: Financial Markets

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