Ever since New Zealand adopted inflation targeting (IT) in 1990, IT has attracted significant attention from both developed and developing countries. As of 2010, 26 developed, emerging and developing countries have adopted IT. In my dissertation, I empirically examine the effect of capital openness on pass-though from exchange rate changes to domestic inflation, the responsiveness of the nominal interest rate to real exchange rate changes and the interest rate channel of the monetary policy transmission mechanism in inflation targeting small open economies. The empirical findings suggest that the pass-through from the exchange rate to domestic inflation increases in the presence of capital controls, deteriorating the inflation output-gap trade-off and increasing social loss. Further, I find that nominal interest rates in the IT countries do respond to exchange rate changes, however, this responsiveness declines significantly with greater capital openness. Finally, I empirically examine the interest rate channel of the monetary transmission mechanism in IT emerging market economies and find that the interest elasticities of private consumption and private investment significantly increases with greater financial development and greater capital openness, making private demand more sensitive to interest rate changes.