The Advantages of Targeting the Real Exchange Rate

This paper uses a simple open-economy macroeconomic framework to explore the implications of real exchange rate targeting for the behavior of real output, the domestic real interest rate, trade account, net foreign asset holdings, and the inflation rate. It finds that a more depreciated level of the real exchange rate decreases the domestic real interest rate and net foreign debt, and leads to a higher level of output and net exports. For inflation control, given price stick iness real exchange rate targeting may not lead to higher rates of inflation. The results are consistent with the after-effects of EMS currency re-alignment. They also imply that a "real targets approach" to exchange rate policy rather than a "nominal anchor approach" may be more appropriate for the European Union inflation-prone countries and the high inflation developing countries.