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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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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: 2006/06
Handle: RePEc:nzb:nzbdps:2006/07
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  1. Richard Dennis, 2003. "Exploring the Role of the Real Exchange Rate in Australian Monetary Policy," The Economic Record, The Economic Society of Australia, vol. 79(244), pages 20-38, 03.
  2. Glenn D. Rudebusch & Jeffrey C. Fuhrer, 2002. "Estimating the Euler equation for output," Working Paper Series 2002-12, Federal Reserve Bank of San Francisco.
  3. Paul R. Bergin & Ivan Tchakarov, 2003. "Does Exchange Rate Risk Matter for Welfare?," NBER Working Papers 9900, National Bureau of Economic Research, Inc.
  4. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  5. Arturo Estrella & Jeffrey C. Fuhrer, 2002. "Dynamic Inconsistencies: Counterfactual Implications of a Class of Rational-Expectations Models," American Economic Review, American Economic Association, vol. 92(4), pages 1013-1028, September.
  6. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  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. Mark Crosby, 2000. "Exchange Rate Volatility and Macroeconomic Performance in Hong Kong," Working Papers 032000, Hong Kong Institute for Monetary Research.
  9. 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.
  10. Ulf Söderström & Paul Söderlind & Anders Vredin, 2005. "New-Keynesian Models and Monetary Policy: A Re-examination of the Stylized Facts," Scandinavian Journal of Economics, Wiley Blackwell, vol. 107(3), pages 521-546, 09.
  11. 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.
  12. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
  13. Frank Schorfheide, 2000. "Loss function-based evaluation of DSGE models," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 15(6), pages 645-670.
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