CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules
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.
|Date of creation:||01 May 2011|
|Date of revision:|
|Contact details of provider:|| Postal: Private Bag 4800, Christchurch, New Zealand|
Phone: 64 3 369 3123 (Administrator)
Fax: 64 3 364 2635
Web page: http://www.econ.canterbury.ac.nz
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Bennett McCallum, 1999.
"Recent developments in monetary policy analysis: the roles of theory and evidence,"
Journal of Economic Methodology,
Taylor & Francis Journals, vol. 6(2), pages 171-198.
- 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.
- Bennett T. McCallum, . "Recent Developments in monetary policy analysis: The roles of theory and evidence," GSIA Working Papers 1999-12, Carnegie Mellon University, Tepper School of Business.
- Bennett T. McCallum, 1999. "Recent Developments in Monetary Policy Analysis: The Roles of Theory and Evidence," NBER Working Papers 7088, National Bureau of Economic Research, Inc.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:cbt:econwp:11/18. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Albert Yee)
If references are entirely missing, you can add them using this form.