Exchange rate intervention for a small open economy under managed floating and inflation targeting

Abstract

In this dissertation, the standard impulse control model of exchange rate intervention is modified to accommodate the managed floating regime and inflation targeting monetary policy. On the one hand, under managed floating regime, the central bank’s objective of exchange rate intervention is to stabilize international trade sector. On the other hand, the objective of inflation targeting is to stabilize domestic commodity prices and the real output. When these two policies are combined in the same model, the objective of exchange rate intervention is to choose the level of intervention in such a way that the economy as a whole can be stabilized. In this dissertation, the degree of openness of the country plays the key role in determining whether the exchange rate intervention is beneficial or harmful to the economy, given the transaction cost and the cost arising from inflationary pressure. It will be shown that, with high degree of openness, the managed floating regime will dominate, resulting in more intervention of exchange rate (that is, the exchange rate band will get narrower). On the contrary, with low degree of openness, the inflation targeting will dominate, resulting in less intervention of exchange rate (that is, the exchange rate band will get wider). These results can be explained intuitively as follow. With high degree of openness, significant portion of total national output and price is accounted for by international trade transactions. Therefore, the exchange rate intervention that is aimed towards stabilizing international trade sector will help stabilizing the whole economy as well. Hence, the exchange rate intervention will be beneficial and more intervention is expected for the case of high degree of openness. On the contrary, with low degree of openness, the international trade transactions constitute only small portion of total national output and price. Therefore, the exchange rate intervention will not help stabilize the whole economy. In this case, the intervention cost, particular the cost due to the distortion of domestic economic variables arising from the intervention itself, will outweigh the benefit from intervention. Therefore, with low degree of openness, the exchange rate intervention is undesirable and hence less intervention or more floating is preferred. In this dissertation, the model is applied to the case of Thai Baht/US dollar exchange rate. The simulation of various parameters was also performed so that the comparative static can be analyzed.