How Costly is Exchange Rate Stabilisation for an Inflation Targeter? The Case of Australia

12 Pages Posted: 8 Sep 2008

See all articles by Mark Crosby

Mark Crosby

University of Melbourne - Melbourne Business School

Timothy Kam

Australian National University - School of Economics

Kirdan R. Lees

Government of New Zealand - Department of Economics

Abstract

This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linear-quadratic 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.

Suggested Citation

Crosby, Mark and Kam, Timothy and Lees, Kirdan R., How Costly is Exchange Rate Stabilisation for an Inflation Targeter? The Case of Australia. Economic Record, Vol. 84, Issue 266, pp. 354-365, September 2008, Available at SSRN: https://ssrn.com/abstract=1264075 or http://dx.doi.org/10.1111/j.1475-4932.2008.00496.x

Mark Crosby (Contact Author)

University of Melbourne - Melbourne Business School ( email )

200 Leicester Street
Carlton, Victoria 3053 3186
Australia

Timothy Kam

Australian National University - School of Economics

Canberra, Australian Capital Territory 2601
Australia

Kirdan R. Lees

Government of New Zealand - Department of Economics ( email )

2 The Terrace
P.O. Box 2498
Wellington
New Zealand

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
1
Abstract Views
474
PlumX Metrics