Central Bank Learning, Terms of Trade Shocks & Currency Risk: Should Exchange Rate Volatility Matter for Monetary Policy?
AbstractThis paper examines the role of interest rate policy in a small open economy subject to terms of trade shocks and time-varying currency risk responding to domestic exchange rate volatility. The private sector makes optimal decisions in an intertemporal non-linear setting with rational,forward-looking expectations. In contrast,the monetary authority practices least-squares learning about the evolution of inflation, output growth, and exchange rate depreciation in alternative policy scenarios. Interest rates are set by linear quadratic optimization, with the objectives for inflation, output growth, or depreciation depending on current conditions. The simulation results show that the preferred stance is one which targets inflation and growth, not inflation only nor inflation, growth and depreciation. Including exchange rate changes as targets significantly increases output variability, but marginally reduces inflation variability.
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Bibliographic InfoPaper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 509.
Length: 26 pages
Date of creation: 01 Oct 2001
Date of revision:
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Postal: Boston College, 140 Commonwealth Avenue, Chestnut Hill MA 02467 USA
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Currency risk; learning; parameterized expectations; policy targets;
This paper has been announced in the following NEP Reports:
- NEP-ALL-2001-10-09 (All new papers)
- NEP-CBA-2001-10-09 (Central Banking)
- NEP-IFN-2001-10-09 (International Finance)
- NEP-MON-2001-10-09 (Monetary Economics)
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