CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules

Alfred Guender

Working Papers in Economics from University of Canterbury, Department of Economics and Finance

Abstract: Employing an optimizing framework, this paper shows that a target rule dominates a simple instrument rule when the focus of monetary policy is on CPI inflation. The target rule approach produces a systematic relationship between the current CPI inflation rate and the lagged policy instrument that renders the former immune to the stochastic risk premium. No matter how policy parameters are set, the optimal simple instrument rule cannot replicate the superior stabilization results achieved by the target rule approach. The optimal simple instrument rule also fails to account for the UIP puzzle. In contrast, the target rule approach can motivate the widely reported phenomenon whereby high interest rate currencies tend to appreciate. In fact the degree of openness and the central bank’s relative aversion to CPI inflation variability determine the sensitivity of observed changes in the nominal exchange rate to the lagged interest rate differential.

Keywords: CPI Inflation Targeting; UIP Puzzle; Instrument Rule; Target Rule; Optimal Monetary Policy (search for similar items in EconPapers)
JEL-codes: E4 E5 F3 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2011-05-01
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Persistent link: https://EconPapers.repec.org/RePEc:cbt:econwp:11/18

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