Inflation targeting and sudden stops

Emerging economies experience sudden stops in capital inflows. As we have argued in Caballero and Krishnamurthy (2002), having access to monetary policy during these sudden stops is useful, but mostly for "insurance" rather than for aggregate demand reasons. In this environment, a central bank that cannot commit to monetary policy choices will ignore the insurance aspect and follow a procyclical rather than the optimal countercyclical monetary policy. The central bank will also intervene excessively to support the exchange rate. These inefficiencies are exacerbated by the presence of an expansionary bias. In order to solve these problems, we propose modifying the central bank's objective to (i) include state-contingent inflation targets, (ii) target a measure of inflation that overweights non-tradable inflation, and (iii) weigh reserves holdings. Keywords: External Shocks, Domestic and International Liquidity, Inflation Targeting, Fear of Floating, Commitment, Underinsurance. JEL Classification: E0, E4, E5, F0, F3, F4, G1.