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How Costly is Exchange Rate Stabilisation for an Inflation Targeter? The Case of Australia

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  • MARK CROSBY
  • TIMOTHY KAM
  • KIRDAN LEES

Abstract

This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linear-quadratic formulation of inflation targeting, we append a term that penalises deviations in the exchange rate to the central bank's loss function. For a simple forward-looking new-Keynesian model, we show that the central bank can reduce volatility in the exchange rate relatively costlessly by aggressively responding to the real exchange rate. However, when we append correlated shocks to better match summary statistics of the Australian data, we find that the costs associated with reducing exchange rate volatility are larger: output volatility increases substantially. Finally, we apply our method to a variant of a small backward-looking new-Keynesian model of the Australian economy. Under this model, large increases in inflation and output volatility accrue if the central bank attempts to mitigate exchange rate volatility. Copyright © 2008 The Economic Society of Australia.

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Article provided by The Economic Society of Australia in its journal Economic Record.

Volume (Year): 84 (2008)
Issue (Month): 266 (09)
Pages: 354-365

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Handle: RePEc:bla:ecorec:v:84:y:2008:i:266:p:354-365

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  1. Fuhrer, Jeffrey C. & Rudebusch, Glenn D., 2004. "Estimating the Euler equation for output," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1133-1153, September.
  2. Mark Crosby, 2004. "Exchange Rate Volatility and Macroeconomic Performance in Hong Kong," Review of Development Economics, Wiley Blackwell, vol. 8(4), pages 606-623, November.
  3. Arize, Augustine C & Osang, Thomas & Slottje, Daniel J, 2000. "Exchange-Rate Volatility and Foreign Trade: Evidence from Thirteen LDC's," Journal of Business & Economic Statistics, American Statistical Association, vol. 18(1), pages 10-17, January.
  4. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  5. Ivan Tchakarov & Paul Bergin, 2003. "Does Exchange Rate Risk Matter for Welfare?," Computing in Economics and Finance 2003 61, Society for Computational Economics.
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  7. Richard Dennis, 2002. "Exploring the role of the real exchange rate in Australian monetary policy," Working Paper Series 2002-19, Federal Reserve Bank of San Francisco.
  8. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  9. Bennett T. McCallum & Edward Nelson, 1997. "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," NBER Working Papers 5875, National Bureau of Economic Research, Inc.
  10. Arturo Estrella & Jeffrey C. Fuhrer, 2002. "Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models," American Economic Review, American Economic Association, vol. 92(4), pages 1013-1028, September.
  11. Ulf Söderström & Paul Söderlind & Anders Vredin, 2005. "New-Keynesian Models and Monetary Policy: A Re-examination of the Stylized Facts," Scandinavian Journal of Economics, Wiley Blackwell, vol. 107(3), pages 521-546, 09.
  12. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
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