FIN-01-065

Inflation Targeting and Exchange Rate Regimes: Evidence From The Financial Markets

November 2001

Menachem Brenner and Meir Sokoler

ABSTRACT

Inflation targeting is gaining popularity as a framework for conducting monetary policy. At the same time many countries employ some sort of foreign exchange intervention policy assuming that these two policies can coexist. This paper attempts to show that both policies are not sustainable. The potential conflict between the two policies is costly to the economy and will eventually result in the abandonment of one of these policies. Israel is a classic test case for two reasons. First, in the past six years Israel has struggled to maintain both policies. Second, it has a variety of financial instruments which provide a rich source of information. We test our hypothesis using information from the financial markets. The results support the hypothesis that both policies cannot be sustained in the long run. The conclusion is that a credible monetary policy aimed at inflation targets must be conducted in a free floating exchange rate regime.

Classification: G13, E52, E58, F31

Menachem Brenner
Institution: Leonard N. Stern School of Business, New York University
Telephone: 212-998-0323
Fax: 212-995-4233
Email: mbrenner@stern.nyu.edu
Home Page: http://www.stern.nyu.edu/~mbrenner

Meir Sokoler
Institution: Bank of Israel

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