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The Exchange Rate Targeting of Central Banks Revised: The Role of Long-term Interest Rates

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  • Lahtinen, Markus
  • Mäki-Fränt, Petri
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    Abstract

    Using a New Keynesian macro model, the paper reconsiders the question, whether the central banks should directly respond to exchange rate movements. It is assumed that the transmission of monetary policy to output is carried out by the long-term interest rate, which is determined as a sum of expectations of short-term interest rates and a non-negligible term premium. According to the results, the central banks could gain from stabilizing the exchange rate movements more than suggested in the previous literature. The welfare gains are more clearly seen in the reduced volatility of inflation than stabilization of output, however. --

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    Bibliographic Info

    Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2007-28.

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    Date of creation: 2007
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    Handle: RePEc:zbw:ifwedp:5733

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    Keywords: Open economy; Exchange rate determination; Monetary policy;

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    1. Lutz Kilian & Mark P. Taylor, 2001. "Why Is It So Difficult to Beat the Random Walk Forecast of Exchange Rates?," Working Papers 464, Research Seminar in International Economics, University of Michigan.
    2. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
    3. Kai Leitemo & Ulf Soderstrom, 2001. "Simple monetary policy rules and exchange rate uncertainty," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    4. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers 1989, C.E.P.R. Discussion Papers.
    5. Nicoletta Batini & Andrew G Haldane, 1999. "Forward-looking rules for monetary policy," Bank of England working papers 91, Bank of England.
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