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Central Bank Learning, Terms Of Trade Shocks & Currency Risks: Should Only Inflation Matter For Monetary Policy?

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  • G. C. LIM
  • PAUL D. McNELIS

Abstract

This paper examines the role of interest rate policy in a small open economy subject to terms of trade shocks, and time-varying currency risks. The private sector makes optimal decisions in an intertemporal non-linear setting with rational, forward-looking expectations. In contrast, the monetary authority practices "least-squares learning" about the evolution of inflation, output growth, and exchange rate depreciation in alternative policy scenarios. Interest rates are set by linear quadratic optimization, with the objectives for inflation, output growth, or depreciation depending on current conditions. The simulation results show that the prefered stance is one which targets inflation only. Including other targets such as growth and exchange rate changes significantly increases output variability, and unambiguously decreases welfare.

Suggested Citation

  • G. C. LIM & PAUL D. McNELIS, 2002. "Central Bank Learning, Terms Of Trade Shocks & Currency Risks: Should Only Inflation Matter For Monetary Policy?," Department of Economics - Working Papers Series 831, The University of Melbourne.
  • Handle: RePEc:mlb:wpaper:831
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    References listed on IDEAS

    as
    1. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
    2. Duffy, John & McNelis, Paul D., 2001. "Approximating and simulating the stochastic growth model: Parameterized expectations, neural networks, and the genetic algorithm," Journal of Economic Dynamics and Control, Elsevier, vol. 25(9), pages 1273-1303, September.
    3. Schmitt-Grohe, Stephanie & Uribe, Martin, 2003. "Closing small open economy models," Journal of International Economics, Elsevier, pages 163-185.
    4. Chris Ryan & Christopher Thompson, 2000. "Inflation Targeting and Exchange Rate Fluctuations in Australia," RBA Research Discussion Papers rdp2000-06, Reserve Bank of Australia.
    5. L.J. Christiano & C.J. Gust, 1999. "Taylor Rules in a Limited Participation Model," DNB Staff Reports (discontinued) 33, Netherlands Central Bank.
    6. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 31-34, January.
    7. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, January.
    8. Thomas Sargent & Noah Williams & Tao Zha, 2009. "The Conquest of South American Inflation," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 211-256, April.
    Full references (including those not matched with items on IDEAS)

    More about this item

    Keywords

    Currency risks; learning; parameterized expectations; policy targets;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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