How much should inflation targeters care about the exchange rate?

A DSGE model is used to examine whether including the exchange rate in the central bank's policy rule can improve economic performance. Smoothing the exchange rate helps both financially-robust economies and financially-vulnerable emerging economies in handling risk premium shocks and, given a small weight placed on the exchange rate, the effects on inflation and output volatility are minimal with demand and cost-push shocks. Financially-vulnerable economies are especially likely to benefit from exchange rate smoothing due to perverse movements of the exchange rate they experience when hit by demand shocks and being more prone to risk premium shocks. (C) 2011 Elsevier Ltd. All rights reserved.