Should inflation-targeting central banks respond to exchange rate movements?

This paper examines whether it is optimal for inflation-targeting central banks to respond to exchange-rate movements. The paper finds that exchange-rate movements can provide a signal on the developments in the economy that the central bank cannot perfectly observe. The results suggest that when the degrees of exchange-rate pass-through and international financial integration are high, it is optimal for the central bank to pay more attentions to exchange-rate movements. These results however depend on two conditions: 1) the ability of the central bank to observe the true exchange-rate process and 2) the number of real frictions in the model economy.