The effect of trade openness and exchange rate on inflation targeting in Thailand

Abstract

Over the past decade, many developing nations have adopted inflation targeting within their monetary policy strategy, with varied approaches to exchange rate flexibility. This paper investigates if monetary policies in economies with high trade openness should integrate exchange rate movements in setting interest rates. Conventional micro-founded models suggest limited benefits from including exchange rates in policy rules. However, using a dynamic stochastic general equilibrium framework focused on Thailand, a small open economy with high trade openness, we find that responding to exchange rate changes with policy rates enhances welfare, more so than disregarding these fluctuations. Additionally, we observe that increased trade openness leads to a flattening of the Phillips curve and hence requires a stronger policy response to deviations from the inflation target. Our findings highlight the critical role of considering exchange rate movements and the degree of trade openness in formulating monetary policies.