Inflation Targeting and Exchange Rate Regimes; Evidence from the Financial Markets

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 mid to late 90s 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 about the conflict 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 should be conducted in a free floating exchange rate regime.