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Overshooting Meets Inflation Targeting

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  • Jose De Gregorio
  • Eric Parrado

Abstract

This paper revisits Dornbusch’s overshooting model; first, to discuss the conditions of overshooting and undershooting, extending the model to consider monetary policy rules and imperfect capital mobility. And second, to outline Dornbusch’s representation in the context of a simple dynamic neo-Keynesian model that can be used to analyze the impact of persistent changes in monetary policy, among other shocks. The model considers inflation targeting in a small open economy setup, which is characterized by imperfect competition and short-run price rigidity. The main findings of the paper are consistent with the original contribution where the exchange rate overshoots its long run equilibrium. We also show that flexible exchange rates dominate managed exchange rates in terms of output and inflation volatility in the presence of real shocks, while for nominal shocks the reverse is true.

Suggested Citation

  • Jose De Gregorio & Eric Parrado, 2006. "Overshooting Meets Inflation Targeting," Working Papers Central Bank of Chile 394, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:394
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_394.pdf
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    References listed on IDEAS

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    Cited by:

    1. Volker Wieland, 2009. "Learning, Endogenous Indexation, and Disinflation in the New-Keynesian Model," Central Banking, Analysis, and Economic Policies Book Series, in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.),Monetary Policy under Uncertainty and Learning, edition 1, volume 13, chapter 11, pages 413-450, Central Bank of Chile.
    2. Luis F. Céspedes & Claudio Soto, 2007. "Credibility and Inflation Targeting in Chile," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 14, pages 547-578, Central Bank of Chile.
    3. Stepahnie Schmitt-Grohé & Martín Uribe, 2007. "Optimal Inflation Stabilization in a Medium-Scale Macroeconomic Model," Central Banking, Analysis, and Economic Policies Book Series, in: Frederic S. Miskin & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Se (ed.),Monetary Policy under Inflation Targeting, edition 1, volume 11, chapter 5, pages 125-186, Central Bank of Chile.
    4. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," NBER Working Papers 12163, National Bureau of Economic Research, Inc.
    5. Valdivia, Daney & Loayza, Lilian, 2010. "Adopción de metas de inflación y su impacto en las expectativas de inflación y volatilidad del crecimiento económico: evidencia empírica para Bolivia [Inflation targeting and its impact on the infl," MPRA Paper 37328, University Library of Munich, Germany, revised 25 Aug 2011.

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