Monetary policy and exchange rate targeting in open economies

We develop an institutional framework for central banks that try to pursue a stability-oriented monetary policy in open-economies by directly targeting the exchange rate. Our main intention is to design a framework which avoids excessive capital inflows that can be regarded as a main cause of the crises in Asia, Latin America, Eastern and Central Europe and of the ERM I. In an open economy policy makers can target two interrelated variables: the interest rate and the exchange rate. These two operating target have to fulfil two different conditions. On the one hand they have to create monetary conditions that are consistent with the domestic economic situation. On the other hand they have to be compatible with a risk-premium adjusted uncovered interest parity condition (UIP). It is obvious that both conditions are difficult to met. In our view sustained violations of the second condition provide an important explanation for the problem of speculative capital inflows under a fixed nominal peg. We show that an adjustable nominal peg is in most cases a better solution to the dual requirement of UIP and adequate monetary conditions. This leads to a new solution for the inconsistency triangle: a central bank can combine an autonomous domestic interest rate policy with capital mobility and a floor for the target path of the exchange rate.