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Alternative Targeting Regimes, Transmission Lags, and the Exchange Rate Channel

  • Jean-Paul Lam

Using a closed-economy model, Jensen (2002) and Walsh (2003) have, respectively, shown that a policy regime that optimally targets nominal income growth (NIT) or the change in the output gap (SLT) outperforms a regime that targets inflation, because NIT and SLT induce more inertia in the actions of the central bank, effectively replicating the outcome obtained under precommitment. The author obtains a very different result when the analysis is extended to open-economy models. Flexible CPI-inflation targeting outperforms both SLT and NIT and is the most robust targeting regime. The gains from targeting CPI inflation are particularly large when the model features transmission lags and/or departures from the uncovered interest parity condition. The author also finds that the stabilization bias inherent in discretionary policy is smaller in an open-economy setting.

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Paper provided by Bank of Canada in its series Working Papers with number 03-39.

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Length: 38 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:bca:bocawp:03-39
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  1. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles Evans, 2001. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," NBER Working Papers 8403, National Bureau of Economic Research, Inc.
  3. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  4. Leitemo, Kai & Soderstrom, Ulf, 2005. "Simple monetary policy rules and exchange rate uncertainty," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 481-507, April.
  5. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, June.
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  12. Richard Dennis & Ulf Soderstrom, 2002. "How important is precommitment for monetary policy?," Working Paper Series 2002-10, Federal Reserve Bank of San Francisco.
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  15. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  16. Leitemo, Kai & Roisland, Oistein & Torvik, Ragnar, 2002. " Time Inconsistency and the Exchange Rate Channel of Monetary Policy," Scandinavian Journal of Economics, Wiley Blackwell, vol. 104(3), pages 391-97, September.
  17. Jón Steinsson, 2000. "Optimal monetary policy in an economy with inflation persistence," Economics wp11, Department of Economics, Central bank of Iceland.
  18. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  19. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  20. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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  22. Vestin, David, 2000. "Price-level Targeting versus Inflation Targeting in a Forward-looking Model," Working Paper Series 106, Sveriges Riksbank (Central Bank of Sweden).
  23. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
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