Central Bank Learning, Terms of Trade Shocks & Currency Risk: Should Exchange Rate Volatility Matter for Monetary Policy?

Guay C. Lim () and Paul McNelis ()

No 509, Boston College Working Papers in Economics from Boston College Department of Economics

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 risk responding to domestic exchange rate volatility. 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 preferred stance is one which targets inflation and growth, not inflation only nor inflation, growth and depreciation. Including exchange rate changes as targets significantly increases output variability, but marginally reduces inflation variability.

Keywords: Currency risk; learning; parameterized expectations; policy targets (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-mon
Date: 2001-10-01
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Persistent link: http://EconPapers.repec.org/RePEc:boc:bocoec:509

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