The Effects of Capital Market Openness on Exchange Rate Pass-through and Welfare in an Infl ation-Targeting Small Open Economy

Working papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded offi cial Federal Reserve Bank of Cleveland publications. The views stated herein are those of the authors and are not necessarily those of the Federal Reserve Bank of Cleveland or of the Board of Governors of the Federal Reserve System. This paper analyzes the impact of capital market openness on exchange rate pass-through and subsequently on the social loss function in an infl ation-targeting small open economy under a pure commitment policy. Applying the intuition behind the macroeconomic trilemma, the author examines whether a more open capital market in an infl ation-targeting country improves the credibility of the central bank and consequently reduces exchange rate pass-through. First, the effect of capital openness on exchange rate pass-through is empirically examined using a New Keynesian Phillips curve. The empirical investigation reveals that limited capital openness leads to greater pass-through from the exchange rate to domestic infl ation, which raises the marginal cost of deviation from the infl ation target. This subsequently worsens the infl ation output-gap trade-off and increases the social loss of the infl ation targeting central bank under pure commitment. However, the calibration results suggest that the infl ation output-gap trade-off improves and the social loss decreases even in the presence of larger exchange rate pass-through if the capital controls are effective at insulating the exchange rate from interest rate and risk-premia shocks. and the participants at the SCIIE Conference for their suggestions.