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Central Bank Learning, Terms Of Trade Shocks & Currency Risks: Should Only Inflation Matter For Monetary Policy?

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  • G. C. LIM
  • PAUL D. McNELIS

Abstract

This paper examines the role of interest rate policy in a small open economy subject to terms of trade shocks, and time-varying currency risks. 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 prefered stance is one which targets inflation only. Including other targets such as growth and exchange rate changes significantly increases output variability, and unambiguously decreases welfare.

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Bibliographic Info

Paper provided by The University of Melbourne in its series Department of Economics - Working Papers Series with number 831.

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Length: 28 pages
Date of creation: 2002
Date of revision:
Handle: RePEc:mlb:wpaper:831

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Keywords: Currency risks; learning; parameterized expectations; policy targets;

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  1. Lawrence J. Christiano & Christopher J. Gust, 1999. "Taylor rules in a limited participation model," Working Paper Series WP-99-3, Federal Reserve Bank of Chicago.
  2. Thomas Sargent & Noah Williams & Tao Zha, 2009. "The Conquest of South American Inflation," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 211-256, 04.
  3. Duffy, John & McNelis, Paul D., 2001. "Approximating and simulating the stochastic growth model: Parameterized expectations, neural networks, and the genetic algorithm," Journal of Economic Dynamics and Control, Elsevier, vol. 25(9), pages 1273-1303, September.
  4. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  5. Chris Ryan & Christopher Thompson, 2000. "Inflation Targeting and Exchange Rate Fluctuations in Australia," RBA Research Discussion Papers rdp2000-06, Reserve Bank of Australia.
  6. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 31-34, January.
  7. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  8. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
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