Real exchange rates, growth, and inflation targeting

Under inflation targeting, central banks should set the short-term interest rate according to the deviation of expected inflation from the government’s target. In mainstream models, variations in the real exchange rate can lead to monetary policy changes through its impact on expected inflation. Still, the effect tends to cease as the real exchange rate’s value stabilizes at a new level, given by the country’s and the rest of the world’s technology and preferences. In post-Keynesian models, the exchange rate also has transitory impacts on inflation, but the story does not end there. The level at which the real exchange rate stabilizes may have permanent effects on the structure of the economy, which can alter its trend growth rate of productivity and generate multiple equilibria. Based on this view, this chapter presents a model of inflation and growth in which there can be more than one level of the real exchange rate that is compatible with the inflation target. The theoretical model is also applied to Brazil, where there seems to be a nonlinear relationship between inflation, growth, and the real exchange rate.