exchange rate was used as a way of (implicitly) taxing the export sector. Whereas Goldberg and Klein (1997) found that foreign direct investment into some less developed countries is significantly affected by bilateral real exchange rates. There is a general agreement among economists that a severe macroeconomic disequilibrium will evolve as a result of sustained real exchange rate misalignment. However, Caballero and Corbo (1988) study the conditions under which increases in the degree of uncertainty about the real exchange rate depress exports and find a clear and strong negative effect of real exchange rate uncertainty on export performance in several least developed countries. Besides exchange rate movements have an important impact on inflation divergence within the EMU and in particular that Ireland's outlying inflationary experience in 2000-2003 was strongly affected by the dollar's weakness through. ( Philip R. Lane2004)
Inflation and exchange rates are two important drivers of any economy. Inflation means continuously increase in price of goods and services which lead to depreciate the respective currency. So many theories have already been addressed on the core concept of inflation, its causes and its impact on overall economy. A major root cause of inflation is excessive supply of money in an economy. This causes price hike in an economy which reduces the purchasing power of a currency. Before globalization, the impact of inflation is confined to the national boundaries, but now it crosses the border and percolates on both developing and developed nations(Ramiz Rehman, Muhammad Rehman and Awais Raoof, 2010 ) .
Among key economic issues, the inflation problem has received a great deal of attention both in public and policy circles alike due to its significant economic and social cost. Thus, several theories have been advanced in the literature attempting to explain the causes of inflation and proposing ways to contain it. In the last three decades, the inflation has been a serious problem world-wide.Harberger (1963), Vogel (1974), Barth and Bennett (1975), Karnosky (1976), Batten (1981), Gordon (1988), Haslag (1990), Salih (1993), and Darrat (1994). while Specifying the objective of monetary policy as a well-defined target or target range for the rate of inflation is becoming increasingly common among central banks (for example, New Zealand, Canada, United Kingdom, Sweden, Finland, Australia and Spain). Theory suggests that if the primary cost of inflation arises from consumers' uncertainty regarding the future purchasing power of their incomes, then monetary policy should strive to stabilise a utility-constant consumer price index. In the absence of such ideal indices, central banks have opted to target some available index of consumer prices. For small open economies, movements in the nominal exchange rate often account for a significant part of the variation in these indices via their direct effect on the price of imported goods. This paper examines whether preferable macroeconomic outcomes can be achieved if monetary policy focuses on an index that excludes such direct exchange rate effects on consumer prices that there is one argument for targeting indices free of direct exchange rate effects is that the monetary authority should focus primarily on persistent sources of inflation.
As outlined in Mayes, Chapple and Yates (1995)
