Optimal Monetary Policy under Uncertainty

2016

Open Econ Rev

Abstract:Inflation targeting countries generally define the inflation objective in terms of the consumer price index. Studies in the academic literature, however, reach conflicting conclusions concerning which measure of inflation a central bank should target in a small open economy. This paper examines the properties of domestic, CPI, and real-exchange-rate-adjusted (REX) inflation targeting. In one class of open economy New Keynesian models there is an isomorphism between optimal monetary policy in an open versus closed economy. In the type of model we consider, where the real exchange rate appears in the Phillips curve, this isomorphism breaks down; openness matters. REX inflation targeting restores the isomorphism but this may not be desirable. Instead, under domestic and CPI inflation targeting the exchange rate channel can be exploited to enhance the effects of monetary policy. Our results indicate that CPI inflation targeting can deliver price stability across the three inflation objectives and will be desirable to a central bank with a high aversion to inflation instability. REX inflation targeting does well in delivering output stability and has a relative advantage in economies where demand shocks are predominant. In general, the choice of the inflation objective affects the trade-offs between policy goals and thus policy choices and outcomes.

Section: Resultsmentioning

confidence: 99%

What to Aim for? The Choice of an Inflation Objective when Openness Matters

Froyen

2016

Open Econ Rev

“…The trade‐offs between the target variables, on which the parameter of the target rule depends, involves parameters of the demand side of the model in several cases. In the open economy, the presence of a direct exchange rate channel in the Phillips curve results in the optimal θ depending on all the parameters in the model (see Froyen and Guender , pp. 245–53) .…”

Section: Key Issuesmentioning

confidence: 99%

“…Doing so ensures that the output gap follows a stable autoregressive process. For more details the reader is referred to Froyen and Guender (, p. 199).…”

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confidence: 99%

Instrument versus Target Rules As Specifications of Optimal Monetary Policy

Froyen

2012

International Finance

Central banks frequently apply target rules or instrument rules in the conduct of monetary policy. For a central bank with multiple target variables such as the Federal Reserve's ‘dual mandate’, a target rule expresses the desired values for each target and the relative weight given to each. The so‐called Taylor rule, in which the central bank chooses how to respond to the output gap and inflation, is an example of an instrument rule. This paper sets out the parameters of ‘optimal’ target and instrument rules and analyses their relative merits. In contrast to Svensson and Woodford, we find that target rules offer no clear advantages over optimal instrument rules. From a policy perspective, this suggests that the case for target rules has been overstated. The use of optimal instrument rules accords with current Federal Reserve practice whereby the federal funds rate responds to optimal forecasts – those using all available information.

“…However, as emphasised above, estimating such a narrow specification of the test equation ignores the effect of other 2 See also Anker (1999). 3 Froyen and Guender (2007) provide a textbook analysis of instrument versus target rules. variables on observed exchange rate changes.…”

Section: Introductionmentioning

confidence: 99%

“…Woodford (2003) andFroyen and Guender (2007) describe policy from a timeless perspective.6 Part A of the appendix shows how the target rule is determined from an intertemporal perspective.7 In McCallum's specification of the simple instrument rule, the policy instrument responds to the change in the nominal exchange rate.© 2014 Economic Society of Australia…”

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confidence: 99%

Monetary Policy and the Uncovered Interest Rate Parity Puzzle: Theory and Empirical Results for Oceania

2014

Economic Record

This article offers a theory-based explanation for why highinterest-rate countries see their currencies appreciate, the so-called UIP puzzle. The central bank bases its target rule on the lag of the policy instrument and the CPI inflation rate. When combined with a stylised model of an open economy, the endogenous target rule can account for the systematic negative relation between the change in the exchange rate and the lagged interest rate differential. Foreign inflation and the foreign interest rate also affect nominal exchange rate changes. The model-based behaviour of the exchange rate is tested on New Zealand and Australian data with mixed results. I IntroductionAbsent any risk premium, the uncovered interest rate parity (UIP) hypothesis suggests that a positive interest rate differential (domestic interest rate minus foreign interest rate) should be compensated in full by a depreciation of the domestic currency over the term to maturity of the underlying short-term financial asset. In practice, the presumed one-for-one relationship between the interest rate differential and the expected change in the nominal exchange rate is not apparent in the data. In fact, many studies report a negative association between movements in the interest rate differential and observed changes in the nominal exchange rate. The observed violation of the UIP condition has been labelled the 'UIP Puzzle'. focus exclusively on whether uncovered interest rate parity holds between New Zealand and Australia over the 198-2008 (July) sample period. Their empirical study excludes the immediate period after the float of the Kiwi dollar as well as the peak and aftermath of the Global Financial Crisis. Following the standard atheoretical testing procedure, which relies on regressing the realised change in the nominal exchange rate on the lagged interest rate differential, they investigate whether UIP holds over the short term (90-day horizon) and over the long term (five-year and 10-year horizon, respectively). They find no evidence in favour of the UIP hypothesis over a short horizon. Over longer horizons the evidence is mixed with a 10-year horizon providing the strongest support for the theory. Burnside (2013) explores the role of New Zealand's risk premium as a factor in the country's imbalances. In this context, he also examines whether UIP holds between New Zealand and various other countries, Australia being one of them. He detects a positive yet statistically insignificant link between NZ and AUS dollar exchange rate movements and interest rate differentials over the 1990-2010 period and interprets this as evidence in favour of the UIP hypothesis. 207