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

Mark Crosby (), Tim Kam and Kirdan Lees

No DP2006/07, Reserve Bank of New Zealand Discussion Paper Series from Reserve Bank of New Zealand

Abstract: 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.

JEL-codes: C51 E52 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-ifn, nep-mac and nep-mon
Date: 2006-06
View list of references

Downloads: (external link)
http://www.rbnz.govt.nz/research/discusspapers/dp06_07.pdf

Related works:
Journal Article: How Costly is Exchange Rate Stabilisation for an Inflation Targeter? The Case of Australia (2008)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: http://EconPapers.repec.org/RePEc:nzb:nzbdps:2006/07

Access Statistics for this paper

More papers in Reserve Bank of New Zealand Discussion Paper Series from Reserve Bank of New Zealand
Contact information at EDIRC.
Series data maintained by Reserve Bank of New Zealand Knowledge Centre ().