This paper proposes that interest rate policy be used to attain a flexible inflation target.Flexibility in this context means that the authorities also care about short-run fluctuations in domestic output and employment. The less powerful policy tool, sterilized intervention in the foreign exchange market, would be used to limit day to day changes in exchange rates.
We argue that the government should continue to be an important participant in the foreign exchange market but not attempt to establish a level for the exchange rate. Our proposal will involve intervention that is triggered by exchange rate volatility but constrained by an announced target for the government's overall net foreign asset position. The objective of this regime is to allow the government to participate in the foreign exchange market in a way that contributes to economic stability and promotes the development of the private sector's participation in foreign exchange and financial markets.

Executive Summary

I. Introduction

II. Policy Challenges
1. The Current Account, Net Debt and Capital Flows
2. Volatility
3. Exports
4. The Optimal Stock of Gross Reserves
5. A Safety Valve, Concerted Intervention

III Inflation Targeting
1. Overview
2. Credibility and Inflation Targeting

IV Alternative Intermediate Regimes

V. The Currency Board Arrangement
1. Overview
2. Traditional Challenges
3. The Gains from Currency Unions and Boards
4. A Currency Board for Korea?

VI. Recent Experience in Korea and other Emerging Markets
1. Intervention and Policy Objectives

VII. Concluding Remarks

References

Appendix