The role of exchange rate in the open economy model: Exchange rate pass-through and simple policy rules

Many developing countries are considering following the practice of some industrial countries to adopt policies of inflation targeting. For many developing countries, open economy aspects of inflation targeting are especially important. Changes in the exchange rate can have substantial effects on inflation, which can complicate the design of monetary policy strategies. While there is a large literature on inflation targeting in general, only recently have studies began to incorporate an open economy aspect. One key issue is the quantitative effects of exchange rate changes on inflation. A second is the design of policy rules that take these feedbacks into account. These questions are the basis of this dissertation. While the primary focus is an application to Indonesia, the estimation issues raised have general relevance and are investigated for Brazil as well.; Previous empirical works analyzing nominal exchange rate pass-through to inflation have reached biased results because they used open economy Phillips Curve equations that ignored multicolinearity problems.; The results show that the Lucas Critique holds; all parameters of the explanatory variables significantly differ across exchange rate regimes. The pass-through coefficients of the nominal exchange rate often change when exchange rate policy changes. Because of multicolinearity, some recent models for open economy Phillips Curve could not be generally applied. Sensitivity analysis indicates that in observed emerging market countries, the parameters of the independent variables are more sensitive to changes when the nominal exchange rate is removed from the base equation. Whether one should use the real exchange rate in deviation or level form in an open economy Phillips Curve equation depends on the purpose of the regression analysis because the parameters of other independent variables do not change much, especially the pass-through coefficients of the nominal exchange rate change.; With respect to the choice of simple policy rules, Ball suggests that when there is a shock to net foreign investment, a monetary condition index target that includes the exchange rate as well as the interest rate keeps output more stable than just an interest rate target, and if there is a shock to net exports, an interest rate target keeps output more stable than an MCI target. This question is investigated for Thailand, Brazil, and New Zealand and only in a certain period in New Zealand, does Ball's hypothesis hold.