Exchange Rate Pegs and Inflation Targetting:

modeling the exchange rate in reduced form New

Keynesian models
(Preliminary Draft)

Jaromı́r Beneš, Jaromı́r Hurnı́k and David Vávra∗

March 19, 2008

Abstract

This paper introduces a strategy of modelling the exchange rate when

the monetary authority targets inflation, while also managing the ex-
change rate using interventions. It does so in the framework of a standard
reduced form new keynesian model of monetary transmission mechanism,
used in many institutions for research, forecasting and monetary policy
analysis purposes. We propose a micro-founded modification to a UIP
condition that allows for modeling of informal exchange rate bands. Our
modeling strategy is useful for most hybrid IT regimes, including those
with imperfect control over market interest rates.

∗ Corresponding author: David Vávra (IMF Consultant, dvavra@imf.org), Jaromı́r Beneš

(jaromir.benes@rbnz.gov.nz) is Research Advisor in the Reserve Bank of New Zealand, and

Jaromı́r Hurnı́k (jaromir.hurnik@cnb.cz) is Advisor to the Board in the Czech National Bank.
The views expressed in this paper are solely the responsibility of the authors and should not be
interpreted as reflecting the views of institutions they represent or any other person associated
with them.

1
1 Introduction

Modeling of transmission mechanisms when monetary policy engages in both

inflation targeting (IT) as well as some forms of exchange rate management is
an important issue for many central banks. The mix of the fixed exchange rate
and IT regimes calls for adequate forecasting and modelling capacities, similar
to those required by a full fledged IT.

Various central banks are in a need of such forecasting capacities. For instance,
there are countries with a fixed or strongly managed exchange rate regimes con-
templating a gradual transition towards a more flexible exchange rate regime.
Among others, Botswana, Belarus, Egypt or Ukraine may well serve as an exam-
ple. Although they peg their currencies either to a single foreign currency or to
a basket of international currencies, they simultaneously attempt to implement
elements of inflation targeting by controlling the deviation of inflation from the
target through adjustments of short run interest rates.

On the other hand, there are IT (or close to) countries with flexible ex rate,
which have gradually approached an exchange rate peg within the ERM II
framework (Slovakia for instance) or will do it in the future, such as the Czech
Republic. Its almost free float1 will be at certain time constrained by its entering
into the ERMII with a tight fluctuation band, only to be entirely removed by
joining the EMU later. The freedom of the central bank to choose targets and
interest rates to achieve them will thus gradually be reduced.

However, many other countries would find such capacity useful too, as the phe-
nomenon of coexistence of the two regimes is more or less present in any IT
country. All of them, at times, attempt to control excessive ex rate fluctua-
tions by interventions of various forms (e.g. sterilization of inflows). Some of
them (e.g. Hungary) even recognize two explicit targets: in terms of ex rate
and inflation bands. Indeed, the coexistence of the two intermediate targets
is not incongruent (e.g. Mishkin and Savastano, 2001) - in theory there is no
difference between Inflation and Exchange rate targeting, as long as the targets
are defined consistently with each other2 .

This paper introduces a strategy how to model the behaviour of the exchange
rate when the monetary authority attempts to control both exchange and in-
flation rates, each with a different instrument: inflation by interest rates and
exchange rates through interventions3 . It does so in the framework of a simple
reduced form new Keynesian model of monetary transmission mechanism, used
1 See Geršl and Holub(2006) for a discussion of exchange rate interventions undertaken

recently by the CNB.

2 It is the practice of the two regimes which marks the difference. In pegged regimes,

central banks are punished for their mistakes by financial markets that act swiftly and with a
force hard to balance. On the other hand, mistakes in IT regimes are punished by consumers
(and public in general) through their expectations, which evolve only gradually, however. In
practice, then, the monetary policy has many more opportunities to correct for their mistakes
when targeting inflation rather then exchange rate. For IT, it is enough when the policy is
correct on average, for a peg, a single mistake can have devasting consequences.
3 There is a widespread consensus that interventions are an effective tool to control exchange

rate volatility even in the IT regimes, see Geršl and Holub (2006) among others.

2
in many institutions for research, forecasting and monetary policy analysis.

Our strategy differs from other approaches that combine inflation targeting with
a partial control over the exchange rate in that it uses exchange rate as an op-
erational rather than intermediate target. The exchange rate thus complements
the interest rate as the monetary policy instrument rather than inflation as
the intermediate target. This is a more relevant approach in the cases, when
the control over money market interest rates is not yet perfectly established,
or when changing interest rates is for some reason insufficient to achieve the
intermediate inflation target and the central banks resorts to interventions. In
addition to a pure IT, our strategy encompasses hybrid IT regimes of informal
exchange rate corridors, pegged exchange rates or using exchange rate as the
only instrument to target inflation.

The paper first discusses why the modelling of the exchange rate management
through interventions (as opposed to interest rate changes) is more relevant for
the purposes of such countries like menitoned above. It then explores mod-
elling requirements of the extreme case with the simultaneous coexistence of
an exchange rate peg and interest rate management (inflation targeting). In
a subsection, model responses to shocks are contrasted to responses of an IT
model with flexible exchange rate. In the next section the model is made more
general to encompass intermediate cases when exchange rate is partially flexible.
To accomplish that, a modified uncovered interest rate parity condition (UIP)
is proposed, loosely based on systematic interventions of a central bank. It is
shown how the desired extent of the exchange rate flexibility (e.g. in a form
of a target band) can be mapped to the parameters of this equation. Finally,
the model is extended to encompass for other hybrid IT cases, including those
involving both exchange and interest rates corridors. The last section presents
conclusions.

2 Institutional Setting

The coexistence of inflation targeting and exchange rate management can be

achieved in two institutionally different ways; each with different modelling
implications. In one the monetary authority affects the exchange rate solely
through manipulation of interest rates, and the exchange rate then responds to
interest rate differentials according to interest rate parity arbitrage. In the other,
the authority conducts exchange interventions independently from their interest
rate management; violating the arbitrage of interest rate parity, if necessary.

In reality, both practices are common, and often are used concurrently. For
instance, the interest rates in Hungary (explicitly following both exchange and
interest rate targets) are set accounting that the exchange rate does not escape
its bands. If so happens, however, the central banks intervenes to keep the ex-
change rate target. Also in other cases interventions are supported by dramatic
changes in interest rates to preserve the exchange rate targets (whether explicit
or implicit), as happened, for instance, during the speculative attacks on the
ERM in 1992.

3
Both practices have different modelling requirements. When the exchange rate
is managed through interest rates simultaneously with inflation, the monetary
authority has to consider both inflation and exchange rates in its interest rate
rule as intermediate targets. Less flexible exchange rate regimes are represented
by a high weight on the deviation of the exchange rate from the desired level,
as in Parrado (2004a) or Natalucci and Ravenna (2002). The exchange rate
itself is then modelled via a conventional uncovered interest rate parity (UIP)
arbitrage relationship, and the exchange rate fluctuations remain confined by
the appropriate management of policy rates.

Modelling of the situation when both exchange rate and interest rates are man-
aged independently is more challenging and not well explored in the literature.
In such a case, interest rates are set with respect to the inflation target, while
the role of UIP in determining the exchange rate must be reduced (depending on
the flexibility of the exchange rate regime). As a special case, both interest and
exchange rates may be used as independent instruments in targeting inflation.

Although modelling of both practices is important, this paper focuses only on

the exchange rate interventions independent of the interest rate management.
It is for two reasons. First, managing the ex rate via interest rate does not
permit the analysis of a simultaneous functioning of a fixed exchange rate and
inflation targeting regimes, because in that case the interest rate arbitrage fixes
policy rates at a parity implied by foreign interest rates.

Second, the case of targeting exchange rate through interest rates is relatively
well developed in the literature (see Parrado (2004a) or Natalucci and Ravenna
(2002)).

Third, using interest rates in targeting exchange rate is not an adequate tool
for modelling of simultaneous coexistence of IT and managed exchange rates.
The latter requires handling of interventions and (at least periodical) violation
of the interest rate parity condition. It has been argued (e.g. Krugman, 1991,
Sarno and Taylor, 2001) the existence of exchange rate bands acts as a signal
altering the sensitivity of the exchange rate to its fundamentals (i.e., in this case
the interest rate differential).

3 A Common New Keynesian Model of Trans-

mission Mechanism

In this section we present a common reduced-form New Keynesian model that

is widely used for forecasting and policy analysis among the central banks and
other institutions like the IMF4 . More detailed description including the ratio-
nale behind the model equations can be found for instance in Bulı́ř and Hurnı́k
(2006) who used similar model (without the proposed extension of UIP ) for
analysis of disinflation costs in several EU member countries as well as in Berg,
Laxton and Karam (2006a) and (2006b).
4 See Berg, Laxton and Karam (2006a) and (2006b) for the reference.

4
We start our discussion with presenting the model in the form adequate for a
full-fledged IT country that leaves the exchange rate to float freely. In addition,
we first propose the exchange rate equation to take the form of purely forward
looking uncovered interest rate parity equation (UIP), while later we modify the
exchange rate equation in a way allowing for certain persistence in the exchange
rate movement as proposed by Beneš, Vávra and Vlček (2002). Only then we
in next section discuss extensions required for coexistence of IT and exchange
rate management.

The model consists of six behavioral equations that represent aggregate demand,
aggregate supply, equation for imported inflation, the uncovered interest rate
parity condition, term structure, and the policy-reaction function5 . In addition,
several identities are present. As our intention is not to calibrate or estimate the
model based on data available for any particular country, the parametrisation
of the model, i.e. the model coefficients, simply follows reasonable values that
may be found in the relevant literature.

Aggregate demand, aggregate supply and equation for imported inflation take
the following form

ŷt = 0.7ŷt−1 − 0.10r̂t − 0.20ẑt + 0.3ŷt∗ + ǫyt (1)

e
πt = 0.65πt−1 + (1 − 0.65 − 0.25)πt+1 + (2)
M
+ 0.25(πt−1 + ∆z̄) + 0.10ŷt + ǫπt
πtM M
= 0.8πt−1 + (1 − 0.8)(πt∗ − ∆st ) + ǫM
t (3)

where ŷt , r̂t , ẑt and ŷt∗ represent deviation of actual output, real interest rate,
real exchange rate and foreign output from their respective non-inflationary
(natural) levels, πt , πt+1 e
, πt∗ and πtM stay for domestic, expected (model con-
sistent), foreign and imported inflation and ∆z̄ and ∆st represent changes in
trend real and nominal exchange rates. The variables are in logs, except for
interest rates.

Policy rule and term structure are represented as

e e
it = 0.8it−1 + (1 − 0.8)(r̄ + πt+1 + 2.5(πt+1 − π T ) + 0.5ŷt ) + ǫit (4)
It = (i + it+1 + it+2 + it+3 )/4; (5)

where it represents the policy (short-term) rate, r̄ is trend short-term real in-
terest rate, π T is inflation target and It is the long-term (one-year) nominal
interest rate.

Finally, the UIP equation looks as

st = st+1 + (it − i∗t )/4 − premt (6)

where st is the nominal exchange rate at time t, st+1 is its rationally expected
future value next quarter (given the whole structure of the model economy, past
data and anticipated shocks) and i∗t is the foreign nominal (short-term) interest
5 Berg, Laxton and Karam (2006a) and (2006b) propose even simpler version of the model

that consists of four equations only. In comparison to our model the equations for imported
inflation and the term structure are not used.

5
rate. The interest rate differential between domestic and foreign short (3M)
interest rates it − i∗t is quoted in annual terms. prem is the premium required
by investors for holding domestic securities.

Equation (6) itself states that the expected change in the nominal exchange
rate must be equal to the existing interest rate differential adjusted for the risk
premium. However, when explored in a general equilibrium model the exchange
rate becomes a variable that immediately adjusts to the existing as well as ex-
pected interest rate differentials. To overcome such a pattern it is possible to
substitute for the model consistent expectation of the exchange rate st+1 a com-
bination of both recently observed exchange rate st−1 and the model consistent
expectation st+1 . It is clear that inclusion of past exchange rate st−1 makes the
exchange rate expectations partly backward-looking and the exchange rate per-
sistent. It is worth to mention, however, that this adjustment is a non-trivial, if
the nominal exchange rate is expected to follow a deterministic trend given per-
manent inflation differential and/or eventual economy’s real convergence. When
this is the case then also the backward-looking economic agents must expect the
level of the nominal exchange rate to move from time t−1 to time t+1 following
the observed inflation differential and trend change in the real exchange rate (if
applicable).

In practice, the modification may take the form of one proposed by Benes,
Vavra and Vlcek (2002), where the backward-looking economic agents use the
differential between the domestic and foreign inflation and the trend change in
the real exchange rate to move the exchange rate level from time t − 1 to time
t + 16 .

∆s = β(2/4(∆z̄ − π + π ∗ )) + (7)
+ (1 − β)(∆s + ∆st+1 ) + (it − i∗t )/4 + prem + ǫst

Here, the β parameter serves as a share of forward- or backward looking eco-

nomic agents. Note, that when β = 0, equation (7) becomes a standard UIP
equation, while when β = 1 the nominal exchange rate follows the predeter-
mined path given by ∆z̄ − π + π ∗ .

One could argue that (7) might be viewed as equation allowing for combina-
tion of IT and exchange rate management as long as the central banks sets its
exchange rate target equal to ∆z̄ −π +π ∗ and β differs from zero. As will be dis-
cussed in next section, however, this would be true only if the term ∆z̄ − π + π ∗
was modified for ∆z̄ − π T + π̄ ∗ , where π T and π̄ ∗ are domestic and foreign
inflation targets. Nevertheless, as will be shown in the next section, even then
the (7) does not serve as a general solution to the problem of coexistence of IT
exchange rate management. Indeed, it collapses when β approaches 1.
6 Theexact notation of (7) differs from the one used in Beneš, Vávra and Vlȩk (2002) as
they work with the level of the exchange rate. For consistency of our work we keep on (7)
here.

6
The model further consists of several identities and transformations
e
rt = it − πt+1 (8)
r̂t = rt − r̄ (9)
r̄ = r̄∗ − ∆z̄ + prem (10)
∆zt = ∆st + πt − πt∗ (11)
ẑt = ẑt−1 + (∆zt − ∆z̄)/4 (12)
i∗t = r̄∗ + πt+1
e
(13)

where rt is the short-term real interest rate, r̄∗ is the foreign trend real interest
rate and ∆zt is the change in the real exchange rate. Note, that for sake of
simplicity π ∗ , ŷ ∗ , r̄∗ as well as ∆z̄, prem and π T are assumed to equal zero.

4 Inflation Targeting and Exchange Rate Pegs

Modelling of the transmission mechanism when an exchange rate peg coexist

with elements of inflation targeting has to satisfactorily address the following
issues: i) ability of a central bank to set interest rates independently of interest
rate parity, and ii) independence of the monetary policy to choose its inflation
target

The first issue is that of a monetary policy instrument independence in the case
when the exchange rate is fixed, which under usual circumstances delegates
monetary policy conduct to outside world (a reference country). Under these
normal circumstances, the sheer force of international arbitrage (with no capital
controls) would lead to convergence of nominal interest rates to those of the main
trading partners (subject to a risk premium). The management of interest rates
would thus lie outside the influence of the central bank. Yet, the monetary
policy may achieve independence, if it is willing to work against the forces
of international arbitrage and provide such amounts of liquidity so as to keep
interest rates at any level it considers fit (to reach the inflation target, for
instance).

The issue essentially boils down how to model the exchange-interest rate link
in such cases. Although the central bank may in theory attempt to control
the entire yield curve by controlling the supply of instruments with relevant
maturities, in practice it controls (as an instrument) only short run interest
rates, while the long rates are determined by the market. We choose this as the
appropriate institutional assumption to be modelled. The choice is supported by
international practice of conducting monetary policy as well as the experience of
the countries for which the modelling strategy is most relevant, e.g. Botswana,
Egypt, Hungary or Slovakia, whose long interest rates reflect the expectations
of the current (or expected) exchange rate peg.

In this institutional setting, the key modelling challenge is how to make the long
interest rates follow foreign rates, when short run rates are set independently
and the UIP arbitrage does not hold on short maturities.

7
The virtue of the UIP condition is that, when the country credibly fixes its
exchange rate, it is alone sufficient to guarantee that domestic yields follow
foreign yields on long maturities. To see this, let us return to the uncovered
interest rate parity equation such as (6). Because we are interested in the case
of a credible peg, we assume the premium away from now on without any loss
in generality7 . Relationship such as (6) holds for long maturities as well and for
iterating the equation forward we obtain :
T
X
st = sT + [(is − i∗s )/4 − premt ] , T ≥ t
t
= sT + (ItT − ItT ∗ )(T − t + 1)/4.
sT is the expected exchange rate at some distant date T and I is the appropriate
long run interest rate between time t and T (valid for T − t + 1 quarterly periods
and quoted in annual terms). If such relationships held with credibly fixed
exchange rate (st = sT , ∀T , premium is zero), both short and long run rates in
the domestic economy would be determined by foreign rates:
it = i∗t , ItT = ItT ∗ .
Hence, the UIP condition alone guarantees the equalization of yields on long
securities, when the monetary policy passively keeps the exchange rate peg.

When the monetary authority, on the other hand, controls its short run nominal
rates in a violation of the UIP, equalization of long yields has to be achieved by
other means than a simple UIP condition. It is done by a particular combination
of three elements: an interest rate rule, setting of the inflation target, and real
interest rate arbitrage on long horizons.

Interest rate rule determines interest rate on long horizons. To see this, consider
a stylized interest rate rule for an IT country:
it = ı̄ + α(πt − π T AR ), (14)
ı̄t = r̄ + πt .
The interest rates react to deviation of inflation πt from the target π T . Bars
denote stationary (trend) values of nominal and real (r̄) interest rates with the
property that limt→∞ x̄t = xt . Such a rule implies that domestic long interest
rates are as:
T
X
ItT = 1/4 ∗ (T − t + 1) is
t
" T
#
X
= 1/4 ∗ (T − t + 1) α(PtT − PtT,T AR ) + ı̄s ,
t
T
X T
X
PtT = πs , PtT,T AR = πsT AR
t t
7A convenient assumption only. As long as the forward exchange rates are unbiased pre-
dictors of future exchange rates, risk premium is zero. In later sections we in fact derive
a formula for modelling a risk premium stemming from managing the exchange rate by the
monetary authority.

8
PtT and PtT,T AR are time t expectations of the differences in the price levels
between T and t, based on the expectations of actual and target inflation rates
respectively.

To inspect how domestic long rates relate to foreign long interest rates, the
setting of the target (influencing the expected price level P ) and determination
of the long run level of nominal (and hence real) interest rates have to be made
more explicit.

The choice of the target is not independent, if the monetary authority wishes to
control inflation and keep exchange rate fixed; long run properties of the econ-
omy constrain it. The monetary authority cannot aspire to change real variables
in the long run, hence the real exchange rate is exogenous to it. Assuming a
particular long run trajectory of real exchange rates z̄t , such that

lim z̄t = st − p∗t + pt (15)

t→∞
lim △z̄t = △st + πt − πt∗
t→∞

in the long run, the domestic inflation is exogenous to the monetary authority
as long as it fixes st (△st = 0), and its stationary value is determined by the
long run depreciation of the real exchange rate and foreign inflation,

π T AR = π̄t = △z̄t + πt∗ (16)

The inflation target then has to be set in accordance with the stationary level
of inflation, implying for the expected change in the price between the periods
T and t based on inflation target: PtT,T AR = Z̄tT + PtT ∗ (Z̄tT ≡ z̄T − z̄t ).

Using (15), PtT,T AR approaches the expected change in the actual price level:
limT →∞ PtT,T AR = PtT . The long enough interest rates are then given as:
T
X
lim ItT = 1/4 ∗ (T − t + 1) ı̄s . (17)
T →∞
t

It follows that stationary values of nominal (and real) interest rates are also
exogenous to the monetary policy8 . They are linked to foreign rates by assuming
equalization of real returns in the long run.

The real interest rate parity for long run trends has:

−△z̄t = r̄t − r̄t∗ (18)

Observing (16), stationary values of nominal rates are then equal:

ı̄t = ı̄∗t − π ∗ − △z̄t + π̄

= ı̄∗t
8 The monetary policy cannot affect real interest rates in the long run by the choice of the

IT paradigm. Because inflation target is outside its control as long as it fixes the exchange
rate, long run nominal rates of interest are exogenous to it as well.

9
Going back to (17), the returns on long instruments are equalized on long enough
horizons, as implied by international arbitrage:

lim ItT = lim ItT ∗

T →∞ T →∞

Hence, with fixed ex rate, the system of equations (16), (14), (18), and the
identities

z̄t ≡ △z̄t + z̄t−1 ,

zt ≡ △zt + zt−1 ,
△zt ≡ △st + πt − πt∗ ,

and a provision guaranteeing the satisfaction of (15) provides both management

of short run interest rates, as well as alignment of the implied long rates along
their foreign benchmark. The provision guaranteeing the satisfaction of (15)
has to come from the rest of the model, which is routinely accomplished (see
the appendix for the complete model used later for simulations).

4.1 Model Properties

The practice of controlling inflation via interest rates while maintaining the
exchange rate peg brings along a particular behaviour of the model economy,
which is in general different from that of a full fledged IT with an exchange rate
float. This subsection analyzes this difference against the backdrop of three
canonical shocks: output gap (demand), Phillips curve (supply), and exchange
rate. All shocks are unexpected, lasting one period. Apart from the exchange
rate - interest rate specification, both models are otherwise same and their full
details are in the Appendix 1.

The responses of both models are given in the series of charts in Figures 2
through 4. Inspecting the demand and supply side shocks, we observe that the
response of the main variables of the policy concern, i.e. output and inflation, are
qualitatively very similar in both models. Quantitatively, however, the exchange
rate peg makes the responses more pronounced. As a result, the profile of policy
rates consistent with bringing the inflation back to the target is more volatile
as well.

The higher volatility of the variables when exchange rate is fixed does not come
from the absence of the direct exchange rate inflation channel of the transmis-
sion. This is apparent from the fact that the profile of imported inflation in
inflationary and demand shocks with flexible exchange rate is actually helping
to propagate the shock, rather than to tame it. In other words, it is the demand
side (output gap) that stabilizes the economy. In driving the demand, however,
the real exchange rate does not help to stabilize the shock when the nominal
exchange rate is fixed as much as when the exchange rate is flexible. Hence, the
nominal (and real) interest rates has to move more to compensate for this.

The situation is different with the exchange rate shock. Although the responses
of the main variables in the model with fixed ex rate are again more pronounced,

10
they are also qualitatively different. That is because this time, the reaction
of interest rates with flexible exchange rate helps to tame the shock via the
direct exchange rate inflation (rather than the output) channel. This offsetting
reaction of nominal exchange rate comes immediately, but is entirely absent
when the exchange rate is fixed, which helps to propagate the shock over time.

In summary, the conduct of monetary policy targeting inflation while maintain-

ing a fixed ex rate regime has to count on a larger volatility of its main macro
variables, including its policy rate, keeping other relationships in the model as
well as its calibration unchanged. This experiment is, however, subject to the
Lucas critique, at least in the sense, that it is precisely the reduced form model
coefficient that should be different in the two regimes. Nevertheless, for calibra-
tion of models in such situations as well as other analytical purposes it is still a
useful result.

5 Inflation Targeting and Managed Floats

Fixed exchange rate modelled together with inflation targeting is a rare situ-
ation. More often are IT countries engaged in some form of managing their
exchange rate floats. Indeed, no country mentioned above fully fixes its ex-
change rate. Then, the UIP in (6) has an influence on the movement of the
exchange rate, but not an exclusive one. The question of this section is how to
technical model the coexistence of both regimes in this case.

An intuition would call for an ex rate equation weighing the UIP condition with
some form of fixing, such as st = st−1 .

st = βst−1 + (1 − β) (st+1 + (it − i∗t )/4) , or

△st = (1 − β) (st+1 − st−1 + (it − i∗t )/4)

This, however, is not stationary (st+1 − st−1 = △st+1 + △st ) and in order to
honour the stationary properties of the model, the expression of the fix has to
be replaced by a more general expression, such as:

st = β(st−1 + 2(−π̄t + △z̄t + π̄t∗ )) + (1 − β) (st+1 + (it − i∗t )/4) , or

△st = 2β(−π̄t + △z̄t + π̄t∗ ) + (1 − β) (st+1 − st−1 + (it − i∗t )/4) . (19)

Then, at one extreme (β = 0), the exchange rate is modeled by the UIP condi-
tion, at the other (β = 1) it is fixed at the current level (see (16)).

The term in the first brackets of (19) is the change in the exhange rate consistent
with reaching of inflation target, e.g. ∆s̄t = −π̄t + △z̄t + π̄t∗ . There are various
interpretations of this term. The most popular is that it reflects exchange rate
expectations of financial market analysts who have a view of the long-term
economic potential (△z̄t ) and adjust it for inflation differentials. Yet it is not
clear, why the expectations should enter in the UIP in this particular form.
Instead, the Appendix shows that (19) can arise from systematic central bank
interventions.

11
The other modification to the pure exchange rate peg is that with a flexible
exchange rate the monetary authority gains flexibility in choosing its target.
However, in order to retain the generality of the model, instead of removing we
replace (16) by
π T AR = β(△z̄t + π̄t∗ ) + (1 − β)π̃, (20)
which has (16) as a special case. π̃ is a free parameter to be set so that a par-
ticular inflation target is met, given the value of β. The equation (20) replaces
(16) in the system of equations modelling the exchange rate from the earlier
section, and (19) is a new addition to the system.

This proposed modelling of exchange rate behaviour lowers the sensitivity of

exchange rate movement to the interest rate differential and permits to control
the volatility of the exchange rate in response to shocks to model residuals.
Rewriting (19) shows that the expected deprecation of the exchange rate is
lower than implied by the conventional interest rate parity differential:

st = β(st−1 + 2(−π̄t + △z̄t + π̄t∗ )) + (1 − β) (st+1 + (it − i∗t )/4) , or

= st+1 + (it − i∗t )/4 − premt
premt = β [st+1 − st−1 − 2∆s̄t + (it − i∗t )/4]
β
premt = [st − st−1 − 2∆s̄t ] (21)
1−β

The elements in premt play the role of the traditional risk premium in the UIP
(6). Higher interest rate differential (ceteris paribus) increases the so defined
risk premium and works against its own arbitraging effect. The formulation in
(21) substitutes out the interest rate differential, showing that the risk premium
introduces an element of backward-lookingness into the UIP equation.

This mechanism clearly limits the volatility of the exchange rate in the model
simulations. The exchange rate is more stable the more weight is put on the
first (backward) element in (19). Figure 5 demonstrates this using stochastic
simulations of a full model (see the Appendix): the unconditional volatility of
the exchange rate falls with higher β 9 . The parameter thus plays a role of a
weight measuring the exchange rate flexibility in the particular IT regime.

Our formulation of the UIP equation is convenient, intuitively appealing, and

can be understood as a reduced form of a micro-founded financial sector model.
The Appendix provides one such foundation based on systematic FX interven-
tions of a central bank, but there may be others.10 Our formulation is also
consistent with the theoretical finding (e.g. Krugman, 1991) that exchange rate
bands alter the sensitivity of the exchange rate to the interest rate differential
at all points, not only in the immediate neighborhood of the bands. As shown
in the next section, our formulation indeed provides for modeling of informal
9 In this experiment the model economy is subjected to shocks drawn randomly from their

covariance matrix implied by the data and the current model. This is done for several values
of β ∈ h0; 1i . The variance of the exchange rate error term has been set to zero, but the
covariance matrix of the error terms does not change with different β. In practice, however,
for each parameter β a new covariance matrix of shocks should be estimated.
10 Ho (2004) is an example of a general equilibrium analysis of intervention, however in a

flexible price equilibrium.

12
(i.e. not announced) exchange rate bands, whose center is the the backward
looking element of (19): a projection of past exchange rate, taking into account
the likely real exchange rate and inflation movement11 .

The proposed exchange rate formulation appears to be a superior alternative

to the manner the exchange rate behaviour is often modelled in reduced form
New-Keynesian forecasting models. There the desire to achieve realistic model
properties in terms of responses to shocks lead to an adjusted UIP condition
similar to (19) in level, see e.g. Beneš,Vávra and Vlček (2002). There the
authors have:

st = β(st−1 + 2∆s̄t ) + (1 − β) st+1 + (it − i∗t )/4, or (22)

= st+1 + (it − i∗t )/4 − premt
premt = β [st+1 − st−1 − 2∆s̄t ]
β
= [st − st−1 − 2∆s̄t − (it − i∗t )/4] (23)
1−β

The motivation often given for this particular formulation rests on the existence
of backward-looking agents evaluating the future exchange rate using some form
of monetarist approach. But this is truly nothing more than a convenient con-
struct to limit the exchange rate fluctuations.

Our approach has a number of advantages over this standard one. First, it also
provides for the limiting case of an exchange rate peg. Where the two approaches
differ most is at and in the neighborhood of β = 1. While our formulation clearly
converges to a fixed exchange rate, on which the interest rate differential has a
decreasing influence, the traditional approach has little interpretability in that
region. The interest rate differential retains all its influence on the exchange
rate movement, but with opposite implications from the conventional UIP: pos-
itive differentials are associated with appreciating (rather than depreciating)
exchange rates.

Second, our formulation can be mapped to explicit micro-foundations. Those

microfoundations have nothing to do with backward-looking expectations of
agents, but rather with their perception of the degree to which the exchange rate
is managed by the monetary authority. The parameter β can then be mapped
to the degree of exchange rate flexibility (measured, say by its unconditional
standard error).

Finally, the ability of (22) to contain exchange rate fluctuations is limited. As

explained earlier, the interest rate differential does not lose its significance for
exchange rate movements as β rises in (22), only its quality is different. And as
Figure 6 demonstrates the relationship between the volatility of exchange rate
and β need not even be monotonic. The figure also documents that the standard
deviation for β = 1 is still about 60% of the original one with unadjusted UIP
(β = 0), while that of (19) is 0.
11 As shown in the previous section, any central bank has to set their exchange rate and

inflation targets consistently with each other, which is exactly what the backward-looking
element of (19) does.

13
The main importance of our innovation therefore is in providing for modeling of
informal exchange rate bands in this class of reduced form small open economy
models.12 As shown above, given the structure of shocks the parameter β can
be chosen so as the expected unconditional volatility of the exchange rate is
within pre-defined bands. And, as shown in the Appendix, the parameter β
could be directly linked to the degree with which the central bank smoothes Fx
deviations from a pre-aggreed parity.

In addition to hybrid IT regimes that engage in informal exchange rate smooth-

ing, our strategy may also be useful for modeling regimes with formal exchange
rate bands or those that transit from a free float inflation targeting to an ex-
change rate based system, e.g. ERM II. Although these countries typically have
a firm control over market interest rates as their operational variables, they may
still find it necessary to manipulate the exchange rate directly through inter-
ventions, rather than relying on the interest rates channel only. Our strategy is
relevant for such cases to the extent that these countries engage in systematic
exchange rate targeting (either through interventions or interest rates) so as the
bands are never reached in practice (and when reached, they are not defended).
Otherwise, our linearized strategy has no capacity to model the disciplining ef-
fect of formal bands (Krugman, 1991). A companion paper (see Benes et. al.,
forthcoming) deals with these issues more formally.

6 Hybrid Inflation Targeting: Exchange and In-

terest Rate Corridors13

The approach in the previous section can be generalized to provide for cases
where the central bank has an imperfect control over both exchange and in-
terest rates. In other words, both exchange and interest rates move in proba-
bilistic corridors determined by the central banks’ systematic behavior. Such
generalization is most relevant for intermediate regimes that experiment with
introducing inflation as an intermediate variable, while still engaged in exchange
rate management (usually through some sort of exchange rate corridors) and
replacing exchange rates with interest rates as instruments. Our strategy allows
for an imperfect control over market interest rates, which is a common situation
in the regimes whose monetary programs involve targeting monetary aggregates
through either banking reserves or monetary base as operational targets, and
whose markets may not be developed enough to enable effective interest rate
targeting.
12 Interms of practical modelling implications, our approach of modelling the exchange rate
may not yield significantly different results from the more conventional approach in many
instances. Experiments have shown that the model responses are very similar in both cases
for β as high as 0.5. A significant difference arises only for β close to 1 (the limiting case is
depicted in the previous series of charts).
13 This section is based on Benes, J., Vavra, D. 2005, ”Modeling of exchange rate and interest

rate corridors in simple gap New Keynesian models”, mimeo, National Bank of Ukraine and
IMF.

14
The corner-stone of our generalized modeling strategy is a symmetric treatment
of both the exchange rate interest rates. Each is assumed to evolve around a
policy defined level that is made consistent with achieving the inflation target
and economy’s long-term trends using Taylor-type rules (a Taylor type rule
for manipulating the exchange rate had been estimated by Parrado, 2004b, for
Singapore). The following are the modified equations (exchange rate expressed
in levels for the sake of exposition):
st = sP t + ŝt
sP
t = st−1 + ∆s̄t + γ(πt − π T AR ) (24)
∗
st = βsP t + (1 − β) (st+1 + (it − it )/4) (25)
it = iPt + ı̂t
iP
t = ı̄ + α(πt − π T AR ) (26)
∗
it = χiP t + (1 − χ) (4 (st − st+1 ) + it ) (27)
Υt = st − (st+1 + (it − i∗t )/4) (28)
The equations introduce four new variables: sP and iP that denote policy levels
of interest and exchange rates (consistent with the inflation targets), and ŝ and
ı̂ as the measures of actual deviation from these levels. The policy levels move
according to Taylor rules targeting inlation (for practical reasons, smoothing
terms were omitted). Their natural interpretation is the crawling peg exchange
rate parity or taylor rule interest rate levels respectively. Equations (24) and
(25) represent the modified UIP equation introduced in the previous section
- collapsing to (19) for γ = 0, while equations (26) and (27) modify model-
ing of the market interest rate behavior (replacing (14) above) using the same
principle.

The degree with which the market exchange and interest rates follow their re-
spective policy level trajectories is parameterized between 0 and 1 using para-
meters β and χ. When the respective parameter reaches 1, the central bank
controls the rate perfectly at the desired policy level; in the other extreme, the
rate is determined freely by model mechanisms – by uncovered interest rate
parity condition.

Finally, the variable Υ measures the extent to which the UIP condition is vi-
olated – expressed as an interest rate equivalent – and is an indicator of the
intervention volumes necessary to maintain the interest and exchange rate si-
multaneously at their desired levels. Violating the arbitrage condition is only
possible, if there is an infinite supply of instruments – in this case the central
bank engages in permanent interventions – buying or selling short-term instru-
ments to roll the situation over (e.g. sterilized interventions in case of interest
rate sensitive capital inflow in fixed exchange rate economies).

6.1 Interpreting β and χ

The parameters can be understood as putting some loose corridor in place for
both the exchange and interest rate, whose width (in terms of volatility) is
determined on the basis of the model parameterization and the shock structure.

15
The parameters represent various (unspecified) institutional factors that may
prevent the central bank from enforcing the desired policy levels. For instance,
the central bank may introduce an informal exchange rate corridor around the
policy trajectory in order to promote market development and facilitate greater
exchange rate flexibility later on. On the other hand, the central banks (espe-
cially with nascent money markets) may not be able to limit the volatility of
money market interest rates beyond a certain threshold, given by institutional
characteristics of the market.

The requirement of model stability puts some constraints on the possible com-
binations of both parameter values. For instance, while it is possible that either
or both exchange and interest rates are forced to be on their policy level tra-
jectories (β = χ = 1), it is not possible that they are both jointly set loose
from these levels (β = χ = 0), as there would be no mechanism stabilizing the
model (and inflation) in the face of a shock. Note also that when the monetary
authority has no control over the exchange (interest) rate, i.e. β = 0 (χ = 0),
then its control over the interest rate (exchange rate) is necessarily perfect; in
other words the value of χ (β) becomes irrelevant.

Most empirically relevant cases are the following:

• β = χ = 1; The central bank practices a hard peg exchange rate regime

(level made consistent with inflation target and economy fundamentals),
but simultaneously manipulates market interest rates (either directly or
through a reserve based system) in order to achieve the targeted rate of
inflation, as in Section 3. As a result of violating market determination of
both rates, the bank almost permanently intervenes. In a special case of
this regime (when γ 6= 0), the exchange rate does not follow a predeter-
mined trajectory, but its rate of crawl changes frequently in order to help
achieve the desired level of inflation.
• β = 0, χ = 1 The most standard inflation targeting case. The central
bank exercises a perfect control over money market interest rates as its
only instrument to target inflation, and the exchange rate is freely floated.

• β ∈ (0, 1), χ = 1; the central bank exercises a perfect control over money
market interest rates as its main instrument to target inflation, but also
imposes an informal corridor on its exchange rate whose central parity is
consistent with the target and the economy fundamentals, as in Section
4. A situation prevailing in several IT regimes (e.g. Hungary), but also
typical for early stages of IT introduction.

• β ∈ (0, 1), χ ∈ (0, 1). The central bank does not have a perfect control over
money market interest rates, but at the same time allows some exchange
rate flexibility. Situation in some intermediate regimes that transit to
a greater exchange rate flexibility, but lack proper infrastructure to use
other instruments - the exchange rate thus continues to play a role of
instrument too.

• β = 1, χ ∈ (0, 1). The central bank uses exchange rate as its main instru-
ment to target inflation, while market interest rates are allowed to move

16
 in more or less loose corridor. Situation that may arise in very small open
economies with a dominant exchange rate channel (e.g. Singapore or New
Zealand in early 1990s).

6.2 Implications for the model behavior

We will now examine the effects of introducing β and χ parameters on the model
properties. For brevity we illustrate them using the output gap shock, but the
findings are representative for other shocks above too.

First, we run experiments changing the width of the exchange rate corridor by
varying β, while keeping a perfect interest rate control (χ = 1). Responses
of real variables (such as output or real interest rates) are not much affected,
unlike those for inflation and policy variables, including interest and exchange
rates (Figure 10). Inflation is much faster contained with wider exchange rate
bands (very low values of β), as nominal and real exchange rates are allowed
to appreciate more in response to an interest rate hike. As a consequence, the
interest rate reaction is smaller than with narrower bands. For the narrower
bands, on the other hand, inflation continues to build up for some time after
the shock, before the stabilization forces of higher real interest (and exchange)
rates are finally able to contain it.

Exchange rate volatility is clearly contained within the corridor and the path
is qualitatively similar and returns to the baseline for any positive value of β.
This is in contrast to a free float, when the exchange rate falls below (rises
above) the control trajectory for a given real exchange rate path, when the
shock raises (lowers) the price level. Finally, the central bank has to intervene
when a corridor is in place– at the beginning by buying the foreign exchange, as
the interest rate reaction is larger than required by a free float – later by selling
FX, when the interest rate response falls below a free float one.

Second we experiment with changing the width of the interest rate corridor
by varying χ, while keeping the exchange rate within a band implied by β =
0.5.14 Figure 11 illustrates how varying χ limits the unconditional volatility
of the interest rate deviation from the policy desired level. Figure 12 then
shows the impulse responses after a demand shock for different values of χ.
In contrast to exchange rate corridor experiments, the profiles for the most
important variables, such as inflation, exchange rate and output are not much
affected by the interest rate corridor width. However, the profile of market
interest rates is very different in each case. They even fall below the baseline,
when the central bank has little control over them. This is because in such
situations market interest rates are deterimined purely by the UIP arbitrage.
Hence, no FX interventions are needed to support the corridor. And as the
markets expect the exchange rate parity to tighten gradually (following the
14 Note that this experiment actually contains two effects. In addition to changing the

interest rate corridor (χ), the exchange rate corridor width also moves despite β being constant,
because different χ imply different unconditional volatilities of the exchange rate. We would
have to recalibrate β for each value of χ to obtain the same exchange rate corridor width in
these simulations.

17
Taylor type rule), an inflow of capital puts market rates down. As a result,
inflation is higher with wider interest rate corridors, which points at potential
pitfalls of targeting inflation using the exchange rate as the only instrument.

In summary, the width of interest and exchange rate corridors matters for infla-
tion, but not much for output. Inflation is faster contained with narrower ex-
change and interest rate corridors, as in this case the interest rate transmission is
most effective by also working through the exchange rate channel. Targeting in-
flation using only exchange rate as the instrument risks counter-productive side
effects, as the interest rate channel may work against the stabilization effects of
the exchang rate.

7 Conclusions

We analyze modelling implications of a simultaneous IT and exchange rate man-

agement in a framework of a reduced form new keynesian model of monetary
transmission. We explain the importance of modeling interest and exchange
rates as independent instruments (operational variables) in targeting inflation,
as opposed to using interest rates to target both inflation and exchange rate as
intermediate objectives.

Modelling of such a hybrid IT policy requires an adjustment to the UIP condition

that reduces sensitivity of the expected exchange rate change to interest rate
differentials. We first show this modification for the extreme case of an exchange
rate peg, which also restricts the monetary policy choice of the inflation target.
We then develop a more general modification of the UIP and show that it can
arise from an optimizing behavior in a financial market model. We show how
our strategy can be used to model (informal) exchange rate bands, and how we
can model most of the hybrid IT regimes, including exchange and interest rate
bands.

The main advantage of our approach is that it provides for the analysis of
regimes with a high weight on a fixed exchange rate trajectory, including infor-
mal exchange rate bands. It is thus suitable for countries that are in transition
from a fixed (or strongly managed) exchange rate regime to a more flexible one
with elements of IT. In addition to such hybrid IT regimes that engage in in-
formal exchange rate smoothing, our strategy may also be useful for modeling
regimes with formal exchange rate bands or those that transit from a free float
inflation targeting to an exchange rate based system, e.g. ERM II.

References
[1] Beneš, J., Vávra, D. and Vlček, J. (2002): ’Medium-Term Macroeconomic
Modeling and Its Role in the Czech National Bank Policy (in Czech)’, Czech
Journal of Economics and Finance, 52, No. 4, p.p. 197-231.

18
 [2] Bulı́ř, A., Hurnı́k, J. (2006): ’The Maastricht Inflation Criterion: How
Unpleasant is Purgatory?’, Economic Systems, 30, No.4 (December), p.p.
385-404.
[3] Geršl, A., Holub, T. (2006): ’Foreign Exchange Interventions Under Infla-
tion Targeting: The Czech Experience’, Contemporary Economic Policy,
24, No. 4 (October), p.p. 475-491.

[4] Edwards, S., Végh, C. (1997): ’Banks and Macroeconomic Disturbances

under Predetermined Exchange Rates’, Journal of Monetary Economics,
40, No. 2 (October), p.p. 239-278.
[5] Ho, Wai-Ming. (2004): ’The Liquidity Effects of Foreign Exchange Inter-
vention’, Journal of International Economics 63, p.p. 179-208.

[6] Krugman, P. (1991): ’Target Zones and Exchange Rate Dynamics’, Quar-
terly Journal of Economics, 106 (3), August 1991, p.p. 669-682.

[7] Parrado, E. (2004a): ’Inflation Targeting and Exchange Rate Rules in an

Open Economy’, IMF Working Paper 04/21, Washington: International
Monetary Fund.

[8] Parrado, E. (2004b): ’Singapore’s Unique Monetary Policy: How Does it

Work?’, IMF Working Paper 04/10. Washington: International Monetary
Fund.
[9] Natalucci, F., Ravenna, F. (2002): ’The Road to Adopting the Euro: Mon-
etary Policy and Exchange Rate Regimes in EU Candidate Countries’,
International Finance Discussion Papers 741. Washington: Board of Gov-
ernors of the Federal Reserve System.
[10] Mishkin, Frederic S., Savastano, Miguel A. (2001): ’Monetary Policy
Strategies for Latin America’, World Bank Policy Research Working Paper
No. 2685, Washington: World Bank.

[11] Sarno, L., Taylor, M. (2001): ’Official Intervention in the Foreign Exchange
Market: Is It Effective and, If So, How Does It Work? Journal of Economic
Literature, 39, No. 3 (September), p.p. 839-868.

A Appendix: Microfoundations for the modified

UIP

This appendix provides structured foundations to the modified UIP equation

(21) in the main text using a partial equilibrium model of a financial sector in
a small open economy.15 In addition, it also provides for a channel closing the
net foreign asset position of a small open economy. Though partial equilibrium,
15 The appendix is based on the forthcoming paper: Benes, J., Otker-Robe, I., Vavra, D.,

2008, “Active Monetary Policy with Direct Policy Measures,” mimeo, IMF.

19
the financial sector model can easily be incorporated in a general equilibrium
model of a small open economy.

The financial sector is composed of perfectly competitive commercial banks and

a central bank (see Figure 1 for their balance sheets in domestic currency). The
banks borrow from abroad (domestic currency equivalent of B ∗ ) and provide
loans to residents (B) and invest excess liquidity at open market operations of
the central bank (O). The central bank withdraws liquidity by open market
operations at a given reference rate i (that moves, say, using a Taylor rule
- assumed exogenous here) and holds foreign exchange reserves against these
operations (F x). Without a loss of generality, the economy is cash-less.

Figure 1: Schematic balance sheet

In intermediating the foreign borrowing, the banks face marginal costs that are
an increasing function of their clients’ loan-to-value ratio (with the value, say,
of the clients’ stock of capital assumed exogenous). This technology constraint
is a short-cut providing for a variable lending risk premium, but is consistent
with standard modeling approaches of the banking sector (see e.g. Edwards and
Vegh, 1997). Moreover, when borrowing abroad, the banks face a risk premium
that is an increasing function of the ratio between the economy’s current account
(assumed exogenous) and its foreign exchange reserves.

A.1 Banks’ Problem

The banks maximize their cash-flow stream subject to the balance sheet and
technology constraints. Periodic cash flow is given as

CFt =
Bt−1 exp(idt−1 ) + Ot−1 exp(it−1 ) + Bt∗
∗
St−1 Bt−1
µ µ ¶¶
CAt−1
− exp i∗t−1 + φ − Ψ(Bt−1 , Vt−1 ) − Bt − Ot ,
St F xt−1

where i∗ , i, id are foreign interest, central bank reference and domestic lending
rates respectively, S is the exchange rate, and Φ(.) and Ψ(.) denote the risk
premium and cost functions respectively.

20
The banks (owned by households) maximize the net present value of their cash-
flow stream (discounted at the household’s discount factor β):

∞
X
max β t CFt , s.t.
{B,O,B }t=0
∗ ∞
t=0
Ot + Bt = Bt∗
B
ΨB (B, V ) = ψ( ), ψ ′ (.) ≥ 0
V
{i, i∗ , V, CA, F x}∞t=0
FOCs : µ µ ¶¶
St ∗ CAt
exp(it ) = exp it + φ (29)
St+1 F xt
Bt
exp(idt ) = exp(it ) + ψ( ) (30)
Vt

Equation (29) is a standard UIP condition with a risk premium dependent on

the reserve coverage of the current account deficit. Equation (30) shows that
bank loan rates depend on the reference rate and a variable premium dependent
on the loan to value ratio. The variable premium provides for unpward sloping
credit supply curve and a channel for closing consumption (net foreign asset
position) of the economy in the steady state.

Taking logs of (29)

³ and´ assuming a particular functional form of the risk pre-
mium function φ CA t
F xt = − log(F xt /F x) = f xt − f xt , we get the following
UIP condition with the risk premium dependent on the stock of Fx reserves:

st = st+1 + it − i∗t − f xt − f xt .
¡ ¢
(31)

A.2 Central Bank’s Problem

Primarily, the central bank is concerned about exchange rate fluctuations devi-
ating from the slope consistent with the inflation target (∆s = ∆z + π ∗ − π).
It intervenes by accumulating or decumulating its stock of FX reserves in order
to smooth these deviations, according to a rule:

F xt = F xt / exp (λ(∆st − ∆st )) (32)

f xt − f xt = λ(∆st − ∆st ) (33)

Substituting in (31) we have the formulation (31) from the main text (up to a
constant):

st = st+1 + it − i∗t − λ(∆st − ∆st ).

21
As an alternative, the central bank may also be concerned about the profits
it distributes to the government, adjusting the level of reserves according the
expected profits from its operations (while not being a full profit optimizer):

f xt − f xt = λ(∆st − ∆st ) − κ (st − st+1 + i∗t − it )

In a special case of λ = κ this rule also gives rise to the same UIP condition
of the main text, although with a different coefficient interpretation than in a
pure exchange rate smoothing case:

st = st+1 + it − i∗t − λ(∆st − ∆st − st + st+1 − i∗t + it )

λ
= st+1 + it − i∗t − (∆st − ∆st ).
1−λ

B Figures

Figure 2: Demand shock

Inflation (q−o−q) Output Gap

0.2 1.2
Float
Managed 1
0.15
0.8
0.1 0.6

0.05 0.4

0.2
0
0

−0.05 −0.2
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

0.5 0.05

0.4 0

0.3 −0.05

0.2 −0.1

0.1 −0.15

0 −0.2

−0.1 −0.25

−0.2 −0.3
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

22
 Figure 3: Inflation shock

Inflation (q−o−q) Output Gap

1.2 0
Float
1 Managed −0.1

0.8 −0.2

0.6 −0.3

0.4 −0.4

0.2 −0.5

0 −0.6

−0.2 −0.7
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

1 0.2

0.1

0
0.5
−0.1

−0.2
0
−0.3

−0.4

−0.5 −0.5
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Figure 4: Exchange rate shock

Inflation (q−o−q) Output Gap

0.1 0.3
Float
0 Managed 0.2

−0.1 0.1

−0.2 0

−0.3 −0.1

−0.4 −0.2

−0.5 −0.3

−0.6 −0.4
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

0.5 0.6

0.4
0
0.2

0
−0.5
−0.2

−0.4
−1
−0.6

−1.5 −0.8
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

23
 Figure 5: Exchange rate volatility and β (new model)
1
New Model

0.9

0.8

0.7
Standard Deviation

0.6

0.5

0.4

0.3

0.2

0.1

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Beta

Figure 6: Exchange rate volatility and β (models comparison)

1.4
New Model
Standard Model

1.2

1
Standard Deviation

0.8

0.6

0.4

0.2

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Beta

24
 Figure 7: Demand shock (β = 0.5)

Inflation (q−o−q) Output Gap

0.15 1.2
Float
Managed 1
0.1
0.8
0.05 0.6

0 0.4

0.2
−0.05
0

−0.1 −0.2
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

0.25 0.1

0.2
0
0.15

0.1
−0.1
0.05

0
−0.2
−0.05

−0.1 −0.3
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Figure 8: Inflation shock (β = 0.5)

Inflation (q−o−q) Output Gap

1.2 −0.1
Float
1 Managed
−0.2
0.8

0.6 −0.3

0.4 −0.4
0.2
−0.5
0

−0.2 −0.6
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

0.8 0.4

0.6 0.2

0.4 0

0.2 −0.2

0 −0.4

−0.2 −0.6
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

25
 Figure 9: Exchange rate shock (β = 0.5)

Inflation (q−o−q) Output Gap

0.2 0.3
Float
0.1 Managed 0.2

0 0.1

−0.1 0

−0.2 −0.1

−0.3 −0.2

−0.4 −0.3

−0.5 −0.4
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Import Prices (q−o−q)

0.2 0.5

0
0

−0.2
−0.5
−0.4

−1
−0.6

−0.8 −1.5
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Figure 10: Demand shock: corridors and varying β

Inflation (q−o−q) Output Gap

0.15 1
Beta = 0
0.1 Beta = 0.5
Beta = 1 0.5
0.05
0
0

−0.05 −0.5
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Nominal Exchange Rate (level)

0.6 0.6

0.4 0.4

0.2 0.2

0 0

−0.2 −0.2
1Q1 2Q1 3Q1 4Q1 1Q1 3Q1 5Q1 7Q1 9Q1

Interventions (in terms of interest rate) Real Exchange Rate (level)

0.1 0.4

0.05 0.3

0 0.2

−0.05 0.1

−0.1 0
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

26
 Figure 11: Interest rate volatility and χ (β = 0.5)
6

4
Standard Deviation

0
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
Keta

Figure 12: Demand shock: corridors and varying χ (β = 0.5)

Inflation (q−o−q) Output Gap

0.3 1.5
Chi = 0
0.2 Chi = 0.5 1
Chi = 1
0.1 0.5

0 0

−0.1 −0.5
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

Interest Rate Nominal Exchange Rate (level)

0.6 0.15

0.4 0.1

0.2 0.05

0 0

−0.2 −0.05
1Q1 2Q1 3Q1 4Q1 1Q1 3Q1 5Q1 7Q1 9Q1

Interventions (in terms of interest rate) Real Exchange Rate (level)

0.1 0.4

0.05 0.3

0 0.2

−0.05 0.1

−0.1 0
1Q1 2Q1 3Q1 4Q1 1Q1 2Q1 3Q1 4Q1

27