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Fixed Exchange Rate Versus Inflation Targeting: Evidence from DSGE Modelling

  • Viktors Ajevskis

    (Bank of Latvia)

  • Kristine Vitola

    (Bank of Latvia)

We evaluate implications of inflation targeting versus fixed exchange rate regime for the UK, Sweden, Poland, the Czech Republic, Estonia, Latvia and Lithuania, i.e. seven EU non-euro area countries. To this end, we estimate a small open economy DSGE model and simulate a model under estimated structural parameters and different sets of policy parameters. The results obtained are compared in terms of inflation, output gap and interest rate volatility. For inflation targeting countries, a policy switch to fixed exchange rate would entail 3–6 times higher inflation volatility. In the Baltic economies, a policy change to inflation targeting with fully flexible exchange rate would amplify inflation volatility 2–4 times, whereas the existing price stabilisation and exchange rate fluctuations within the ERM II bands would entail 3–6 times more volatile inflation. Policy simulations thus show evidence that in all the countries the existing monetary rule guarantees more stable inflation and output than under alternative regimes.

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Paper provided by Latvijas Banka in its series Working Papers with number 2011/02.

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Date of creation: 25 Jul 2011
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Handle: RePEc:ltv:wpaper:201102
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  1. Smets, Frank & Wouters, Raf, 2004. "Forecasting with a Bayesian DSGE model: an application to the euro area," Working Paper Series 0389, European Central Bank.
  2. Sbordone, Argia, 1998. "Prices and Unit Labor Costs: A New Test of Price Stickiness," Seminar Papers 653, Stockholm University, Institute for International Economic Studies.
  3. Paolo Gelain & Dmitry Kulikov, 2009. "An estimated dynamic stochastic general equilibrium model for Estonia," Bank of Estonia Working Papers 2009-5, Bank of Estonia, revised 30 Dec 2009.
  4. G. M. Martin & C. S. Forbes, 1999. "Using simulation methods for bayesian econometric models: inference, development and communication: some comments," Econometric Reviews, Taylor & Francis Journals, vol. 18(1), pages 113-118.
  5. Viktors Ajevskis & Kristine Vitola, 2009. "Advantages of Fixed Exchange Rate Regime from a General Equilibrium Perspective," Working Papers 2009/04, Latvijas Banka.
  6. Gali, Jordi & Gertler, Mark, 1999. "Inflation dynamics: A structural econometric analysis," Journal of Monetary Economics, Elsevier, vol. 44(2), pages 195-222, October.
  7. John Geweke, 1998. "Using simulation methods for Bayesian econometric models: inference, development, and communication," Staff Report 249, Federal Reserve Bank of Minneapolis.
  8. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
  9. Thomas Lubik & Frank Schorfheide, 2003. "Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation," Economics Working Paper Archive 505, The Johns Hopkins University,Department of Economics.
  10. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  11. W. E. Griffiths, 1999. "Estimating consumer surplus comments on "using simulation methods for bayesian econometric models: inference development and communication"," Econometric Reviews, Taylor & Francis Journals, vol. 18(1), pages 75-87.
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