Targeting the Exchange Rate Under Inflation

The purpose of this paper is to implement empirically a variant of the new theory of exchange rate targeting, suitable for high inflation small open economies. We formulate an expectations induced relationship between the exchange rate and the fundamental subject to random shocks and target zone constraints on rates of depreciation. The empirical analysis provides estimates for the key parameters of the exchange rate dynamic equation, and thereby identifies the unique roles played by policy variables and market fundamentals in foreign exchange markets