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Other stabilisation objectives within an inflation targeting regime: Some stochastic simulation experiments

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We use the Reserve Bank of New Zealand's macroeconomic model (FPS) to look at the feasibility of using monetary policy to reduce variability in output, the exchange rate and interest rates while maintaining an inflation target. Our experiment suggests that policy could be altered to increase the stability of interest rates, the exchange rate, inflation, or output, relative to the base case reaction function in FPS, but such a policy would incur some cost in terms of the variability of the other variables. In particular, we find that greater exchange rate stability would have relatively large costs in terms of the stability of all three other variables, primarily because monetary policy that leans too dramatically against exchange rate disturbances can create significant real economy variability. Relative to West (2003), we find larger costs of operating monetary policy to achieve exchange rate stabilisation. We attribute this finding to the relatively inertial inflation expectation process in FPS.

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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2006/04.

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Length: 27 p.
Date of creation: May 2006
Date of revision:
Handle: RePEc:nzb:nzbdps:2006/04

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  1. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules Under Model Uncertainty," American Economic Review, American Economic Association, vol. 93(3), pages 622-645, June.
  2. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
  3. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  4. Olivier Basdevant & David Hargreaves, 2003. "Modelling structural change: the case of New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2003/03, Reserve Bank of New Zealand.
  5. Kenneth D. West, 2004. "Monetary Policy and the Volatility of Real Exchange Rates in New Zealand," NBER Working Papers 10280, National Bureau of Economic Research, Inc.
  6. Aaron Drew & Ben Hunt, 1998. "The Forecasting and Policy System: stochastic simulations of the core model," Reserve Bank of New Zealand Discussion Paper Series G98/6, Reserve Bank of New Zealand.
  7. Kai Leitemo & Ulf Soderstrom, 2001. "Simple monetary policy rules and exchange rate uncertainty," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  8. Paul Conway & Aaron Drew & Ben Hunt & Alasdair Scott, 1998. "Exchange rate effects and inflation targeting in a small open economy: a stochastic analysis using FPS," Reserve Bank of New Zealand Discussion Paper Series G99/4, Reserve Bank of New Zealand.
  9. David Hargreaves, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 66, pages 2, September.
  10. Jonathan David Ostry & Anne Marie Gulde & Atish R. Ghosh & Holger C. Wolf, 1995. "Does the Nominal Exchange Rate Regime Matter?," IMF Working Papers 95/121, International Monetary Fund.
  11. P.A. Tinsley, 1993. "Fitting both data and theories: polynomial adjustment costs and error- correction decision rules," Finance and Economics Discussion Series 93-21, Board of Governors of the Federal Reserve System (U.S.).
  12. Dominick Stephens, 2006. "Should monetary policy attempt to reduce exchange rate volatility in New Zealand?," Reserve Bank of New Zealand Discussion Paper Series DP2006/05, Reserve Bank of New Zealand.
  13. Tim Hampton, 2002. "The role of the Reserve Bank's macro model in the formation of interest rate projections," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 65, June.
  14. Aaron Drew & Ben Hunt, 1998. "The Forecasting and Policy System: preparing economic projections," Reserve Bank of New Zealand Discussion Paper Series G98/7, Reserve Bank of New Zealand.
  15. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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Cited by:
  1. Willy Chetwin & Tim Ng & Daan Steenkamp, 2013. "New Zealand’s short- and medium-term real exchange rate volatility: drivers and policy implications," Reserve Bank of New Zealand Analytical Notes series AN2013/03, Reserve Bank of New Zealand.
  2. Dominick Stephens, 2006. "Should monetary policy attempt to reduce exchange rate volatility in New Zealand?," Reserve Bank of New Zealand Discussion Paper Series DP2006/05, Reserve Bank of New Zealand.

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