Background:

One of the most important contributions of Structuralism is the contractionary devaluation hypothesis. It was developed for a world of fixed or semi-fixed exchange rates and low capital mobility. Although the literature has addressed new problems, such as the “balance sheet” effects, the literature has not considered the implications for the administration of an Inflation Targeting regime.

Methods:

We analyze the stability conditions of a stylized model that describes mainly the Latin-American economies, combining contractionary effects from devaluations with monetary policy rules.

Results:

When devaluations are contractionary exchange rate movements can be destabilizing. Stability is more likely if the Central Bank does not targets the output-gap. Foreign exchange reserve accumulation policies increase the likelihood of having a stable system.

Conclusions:

Contractionary effects from devaluations complicates the administration of monetary policy if Inflation Targeting is operative. Policies that aim to regulate capital flows, combined with foreign exchange reserve accumulation, can improve the Inflation Targeting regime.