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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.

Suggested Citation

  • Mark Crosby & Timothy Kam & Kirdan Lees, 2008. "How Costly is Exchange Rate Stabilisation for an Inflation Targeter? The Case of Australia," The Economic Record, The Economic Society of Australia, vol. 84(266), pages 354-365, September.
  • Handle: RePEc:bla:ecorec:v:84:y:2008:i:266:p:354-365
    DOI: 10.1111/j.1475-4932.2008.00496.x
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    Cited by:

    1. Heinz‐Peter Spahn, 2007. "Exchange Rate Stabilisation, Learning And The Taylor Principle," Australian Economic Papers, Wiley Blackwell, vol. 46(2), pages 136-151, June.

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    More about this item

    JEL classification:

    • C51 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Model Construction and Estimation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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