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Fixed Exchange Rate Versus Inflation Targeting: Evidence from DSGE Modelling

Viktors Ajevskis () and Kristine Vitola
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Kristine Vitola: Bank of Latvia

No 2011/02, Working Papers from Latvijas Banka

Abstract: We evaluate implications of inflation targeting versus fixed exchange rate regime for the UK, Sweden, Poland, the Czech Republic, Estonia, Latvia and Lithuania, i.e. seven EU non-euro area countries. To this end, we estimate a small open economy DSGE model and simulate a model under estimated structural parameters and different sets of policy parameters. The results obtained are compared in terms of inflation, output gap and interest rate volatility. For inflation targeting countries, a policy switch to fixed exchange rate would entail 3–6 times higher inflation volatility. In the Baltic economies, a policy change to inflation targeting with fully flexible exchange rate would amplify inflation volatility 2–4 times, whereas the existing price stabilisation and exchange rate fluctuations within the ERM II bands would entail 3–6 times more volatile inflation. Policy simulations thus show evidence that in all the countries the existing monetary rule guarantees more stable inflation and output than under alternative regimes.

Keywords: DSGE; small open economy; fixed exchange rate; inflation targeting; Bayesian estimation (search for similar items in EconPapers)
JEL-codes: C11 C3 C51 D58 E58 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-eec, nep-mac, nep-mon and nep-opm
Date: 2011-07-25
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