ABSTRACT
This paper investigates the relationship between inflation targeting policy and U.S. trade imbalance. This study uses a simple DSGE approximation under three inflation targeting scenarios based on a modified Taylor rule which includes foreign interest rate but excludes output gap. The driving forces are rational expectations components of consumption Euler equation, and inflation rate. Other variables used include domestic and foreign interest rates, exchange rate, exports, imports, and capital inflows. Optimal parameter estimates based on 1980 to 2014 quarterly data indicate that inflation targeting has a destabilizing force on the change in trade imbalance. The magnitude of targeted rate whether1percent or 2 percent is not a significant factor in altering changes in trade imbalance. Accuracy of this approximation is verified by the Judd-Gaspar test on inflation rate. Chow test result confirms the significance of the 2008 Great Recession on a structural change in the U.S. economy.
Keywords
Inflation targeting, U.S. trade imbalance, DSGE approximation