Inflation persistence and exchange rate regime: Implications for dynamic adjustment to shocks in a small open economy

► Exchange rate targeting regime generates oscillations and slow convergence to equilibrium in response to shocks due to the 'Walters critique' effect when inflation is highly persistent. ► The Walters effect happens when an inflationary economy entering a fixed exchange rate regime is forced to reduce nominal exchange rate, which in turn will reduce real interest rate, stimulate economy and exacerbate inflation. ► The Walters effect is moderated with more forward-looking Phillips curve. ► Flexible Inflation targeting regime allows to avoid cyclical adjustment to shocks when inflation is highly persistent.