Exchange Rate Effects and Inflation Targeting in a Small Open Economy: A Stochastic Analysis Using Fps

Reserve Bank of New Zealand Discussion Paper No. G99/4

20 Pages Posted: 22 Oct 2002

See all articles by Ben Hunt

Ben Hunt

International Monetary Fund (IMF) - Research Department

Paul Conway

WESTPAC Institutional Bank - Economic Team

Aaron Drew

Government of New Zealand - Department of Economics; Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO)

Alasdair M. Scott

International Monetary Fund (IMF)

Date Written: May 1998

Abstract

In this paper, stochastic simulations of the Reserve Bank of New Zealand's new macroeconomic model, FPS, are used to examine the issue of which price index monetary policy should stabilise in a small open economy. Under the class of policy rules considered, targeting a measure of domestic inflation, which does not include the direct effects of exchange rate movements on the price of imported goods, results in lower variability in real output, nominal interest rates, the exchange rate and domestic price inflation. The result is robust if direct exchange rate effects influence agents' expectations of generalised inflation and if the policy maker is uncertain about how direct exchange rate effects influence expectations. Tracing out efficient policy frontiers under the two alternative targets illustrates that for a given level of CPI variability, output variability can be significantly reduced by targeting domestic price inflation.

JEL Classification: E52, E32, E37

Suggested Citation

Hunt, Benjamin and Conway, Paul and Drew, Aaron and Scott, Alasdair M., Exchange Rate Effects and Inflation Targeting in a Small Open Economy: A Stochastic Analysis Using Fps (May 1998). Reserve Bank of New Zealand Discussion Paper No. G99/4. Available at SSRN: https://ssrn.com/abstract=321387 or http://dx.doi.org/10.2139/ssrn.321387

Benjamin Hunt (Contact Author)

International Monetary Fund (IMF) - Research Department ( email )

700 19th Street NW
Washington, DC 20431
United States

Paul Conway

WESTPAC Institutional Bank - Economic Team ( email )

PO Box 691
Wellington
New Zealand
(644) 381-1414 (Phone)

Aaron Drew

Government of New Zealand - Department of Economics ( email )

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

Organization for Economic Co-Operation and Development (OECD) - Economics Department (ECO) ( email )

2 rue Andre Pascal
Paris Cedex 16, MO 63108
France

Alasdair M. Scott

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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