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CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules

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Abstract

Employing an optimizing framework, this paper shows that a target rule dominates a simple instrument rule when the focus of monetary policy is on CPI inflation. The target rule approach produces a systematic relationship between the current CPI inflation rate and the lagged policy instrument that renders the former immune to the stochastic risk premium. No matter how policy parameters are set, the optimal simple instrument rule cannot replicate the superior stabilization results achieved by the target rule approach. The optimal simple instrument rule also fails to account for the UIP puzzle. In contrast, the target rule approach can motivate the widely reported phenomenon whereby high interest rate currencies tend to appreciate. In fact the degree of openness and the central bank’s relative aversion to CPI inflation variability determine the sensitivity of observed changes in the nominal exchange rate to the lagged interest rate differential.

Suggested Citation

  • Alfred Guender, 2011. "CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules," Working Papers in Economics 11/18, University of Canterbury, Department of Economics and Finance.
  • Handle: RePEc:cbt:econwp:11/18
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    File URL: http://www.econ.canterbury.ac.nz/RePEc/cbt/econwp/1118.pdf
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    References listed on IDEAS

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    1. Bennett T. McCallum, 2002. "Recent developments in monetary policy analysis: the roles of theory and evidence," Economic Quarterly, Federal Reserve Bank of Richmond, issue Win, pages 67-96.
    2. Richard T. Froyen & Alfred V. Guender, 2007. "Optimal Monetary Policy under Uncertainty," Books, Edward Elgar Publishing, number 12510, December.
    3. Richard T. Froyen & Alfred Guender, 2011. "Instrument Versus Target Rules As Specifications of Optimal Monetary Policy: What are the Issues, If Any?," Working Papers in Economics 11/20, University of Canterbury, Department of Economics and Finance.
    4. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
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    More about this item

    Keywords

    CPI Inflation Targeting; UIP Puzzle; Instrument Rule; Target Rule; Optimal Monetary Policy;

    JEL classification:

    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance

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