INFLATION TARGETING, PATTERN OF TRADE, AND ECONOMIC DYNAMICS

Abstract

This paper develops an analytically tractable, two-country, two-traded-good dynamic general-equilibrium model of money to examine the long-run and short-run effects of a temporary change in the domestic inflation target on the trade pattern, the terms of trade, the foreign exchange rate, and the capital accumulation of each country and of the world economy. We find that such a temporary monetary innovation can generate permanent effects on the world distribution of capital and the pattern of trade, resulting in nonneutrality in an otherwise money-neutral cash-in-advance setting. This change also leads to very rich transitional dynamics that we fully characterize analytically. In particular, endogenous responses in transition can be monotone or nonmonotone and can exhibit over-shooting. Our analytic findings and quantitative results help explain some noticeable changes in the capital accumulation, output, and bilateral trade of several countries adopting inflation targeting. Since the permanent effects of a temporary change in the domestic inflation target on the pattern of international trade and the performance of the macroeconomy are driven by a new channel through the world distribution of capital, we add new insights to the literature.