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How costly is exchange rate stabilisation for an inflation targeter? The case of Australia

This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linearquadratic formulation of inflation targeting, we append a term that penalises deviations in the exchange rate to the central bank’s loss function. For a simple forward-looking New Keynesian model, we show that the central bank can reduce volatility in the exchange rate relatively costlessly by aggressively responding to the real exchange rate. However, when we append correlated shocks – to better match summary statistics of the Australian data – we find that the costs associated with reducing exchange rate volatility are larger: output volatility increases substantially. Finally, we apply our method to a variant of a small backward-looking New Keynesian model of the Australian economy. Under this model, large increases in inflation and output volatility accrue if the central bank attempts to mitigate exchange rate volatility.

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File URL: http://www.rbnz.govt.nz/research_and_publications/discussion_papers/2006/dp06_07.pdf
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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2006/07.

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Length: 25 p.
Date of creation: Jun 2006
Date of revision:
Handle: RePEc:nzb:nzbdps:2006/07
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  1. Lindé, Jesper, 2001. "Estimating New-Keynesian Phillips Curves: A Full Information Maximum Likelihood Approach," Working Paper Series 129, Sveriges Riksbank (Central Bank of Sweden), revised 30 Apr 2001.
  2. Söderström, Ulf & Söderlind, Paul & Vredin, Anders, 2002. "New-Keynesian Models and Monetary Policy: A Reexamination of the Stylized Facts," SSE/EFI Working Paper Series in Economics and Finance 511, Stockholm School of Economics, revised 15 Aug 2003.
  3. Richard Dennis, 2002. "Exploring the role of the real exchange rate in Australian monetary policy," Working Paper Series 2002-19, Federal Reserve Bank of San Francisco.
  4. Fuhrer, Jeffrey C. & Rudebusch, Glenn D., 2004. "Estimating the Euler equation for output," Journal of Monetary Economics, Elsevier, vol. 51(6), pages 1133-1153, September.
  5. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
  6. Ivan Tchakarov & Paul Bergin, 2003. "Does Exchange Rate Risk Matter for Welfare?," Computing in Economics and Finance 2003 61, Society for Computational Economics.
  7. Bennett T. McCallum & Edward Nelson, 1997. "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," NBER Working Papers 5875, National Bureau of Economic Research, Inc.
  8. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc.
  9. Arize, Augustine C & Osang, Thomas & Slottje, Daniel J, 2000. "Exchange-Rate Volatility and Foreign Trade: Evidence from Thirteen LDC's," Journal of Business & Economic Statistics, American Statistical Association, vol. 18(1), pages 10-17, January.
  10. Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  11. Mark Crosby, 2004. "Exchange Rate Volatility and Macroeconomic Performance in Hong Kong," Review of Development Economics, Wiley Blackwell, vol. 8(4), pages 606-623, November.
  12. Frank Schorfheide, 2000. "Loss function-based evaluation of DSGE models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 15(6), pages 645-670.
  13. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
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