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What do robust policies look like for open economy inflation targeters?

Typical New Keynesian open economy models suggest a limited response to the exchange rate. This paper examines the role of the open economy in determining robust rules when the central bank fears various model misspecification errors. The paper calibrates a hybrid New Keynesian model to broadly fit the economies of three archetypal open economy inflation targeters - Australia, Canada, and New Zealand - and seeks robust time-consistent policy. We find that policies robust to model misspecification react more aggressively to not only the exchange rate, but also inflation, the output gap and their associated shocks. This result generalizes to the context of a flexible inflation targeting central bank that cares about the volatility of the real exchange rate. However, when the central bank places only a small weight on interest rate smoothing and fears misspecification in only exchange rate determination, a more cautious policy is recommended for all but an exchange rate shock. It is also shown that the benefits of an exchange rate channel far outweigh the concomitant costs of uncertain exchange rate determination.

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File URL: http://www.rbnz.govt.nz/research_and_publications/discussion_papers/2006/dp06_08.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 DP2006/08.

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Length: 26 p.
Date of creation: Sep 2006
Date of revision:
Handle: RePEc:nzb:nzbdps:2006/08
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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.
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  4. Kai Leitemo & Ulf Söderström, 2005. "Robust monetary policy in the New-Keynesian framework," Macroeconomics 0508032, EconWPA.
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  8. Dennis, Richard & Soderstrom, Ulf, 2006. "How Important Is Precommitment for Monetary Policy?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(4), pages 847-872, June.
  9. Kenneth West, 2003. "Monetary policy and the volatility of real exchange rates in New Zealand," New Zealand Economic Papers, Taylor & Francis Journals, vol. 37(2), pages 175-196.
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  18. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  19. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
  20. Giordani, Paolo & Soderlind, Paul, 2004. "Solution of macromodels with Hansen-Sargent robust policies: some extensions," Journal of Economic Dynamics and Control, Elsevier, vol. 28(12), pages 2367-2397, December.
  21. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
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