Economics – Effectiveness of policy options to meet all macroeconomic objectives | e-Consult

Exchange Rate Targeting: Exchange rate targeting is a monetary policy regime where a country's central bank commits to maintaining its currency's value at a specific level against another currency (or a basket of currencies). The central bank achieves this by intervening in the foreign exchange market, buying or selling its own currency to keep the exchange rate within a narrow band around the target.

Conditions for Adoption: A country might choose exchange rate targeting under the following conditions:

• High Inflation History: If a country has experienced high inflation in the past, targeting can help to anchor inflation expectations and stabilize the currency.
• Limited Policy Credibility: If a country lacks credibility in its ability to control inflation, targeting can signal a commitment to price stability.
• Fixed Capital Flows: If a country receives a large and stable inflow of capital, targeting can help to maintain the currency's value.

Challenges in Maintaining the Target:

• Speculative Attacks: If markets believe the central bank will be unable to maintain the target, they may launch speculative attacks on the currency, forcing the central bank to spend large amounts of foreign reserves.
• External Shocks: Unexpected external shocks (e.g., changes in commodity prices, global recessions) can put pressure on the exchange rate and make it difficult for the central bank to maintain the target.
• Loss of Monetary Policy Independence: Exchange rate targeting limits the central bank's ability to use monetary policy to address domestic economic problems. The primary focus becomes maintaining the exchange rate target.