Optimal Inflation Targeting in a Dual-Exchange Rate Oil Economy

This paper develops a DSGE model for a small open oil economy which has two rates at official and free (unofficial) markets for foreign currency. In this model, government has access to foreign currency by supplying oil in international markets. Using the oil revenue, the government provides the Central Bank and essential imported goods with foreign currency at the official rate; Other goods are imported at the unofficial rate. The CB’s objective is to minimize the difference between nominal free and official exchange rates. To do so, the CB uses three policy instruments: i) either holds foreign currency as financial assets or sells it to the free market at the unofficial rate, ii) nominal monetary base growth rate and iii) nominal depreciation of official exchange rate. These instruments are applied in this paper in four scenarios of CPI targeting and PPI targeting in both dual and unified exchange rate regimes. Through a welfare analysis, this paper indicates that PPI targeting works better than CPI targeting in this economy. As well, this paper illustrates that PPI targeting under unified system considerably increases welfare. In addition, the interaction between fiscal and monetary policy is assessed. The results show that monetary and exchange rate policies are also more effective when fiscal authority follows a procyclical fiscal rule.