From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects

Melecky, Ales and Melecky, Martin (2008): From Inflation to Exchange Rate Targeting: Estimating the Stabilization Effects.

Abstract

This paper attempts to estimate possible losses in macroeconomic stabilization due to a move from inflation to exchange rate targeting on an example of the Czech Republic. The authors use an estimated New Keynesian policy model, general inflation and exchange rate targeting rules, and representative central bank loss functions to carry out such estimations. The authors find that for the Czech Republic moving from the historically applied inflation targeting to optimized exchange rate targeting should not involve any significant losses in macroeconomic stabilization. However, the Czech National Bank could improve its stabilization outcomes while remaining an inflation targeter. This requires the Czech National Bank to respond stronger to increasing expected future inflation and be less concerned about an opening output gap when adjusting its policy rate. Moving then from such optimized inflation targeting to optimized exchange rate targeting can result in significant losses in economic stabilization in the magnitude of 0.4 to 2 percentage points of GDP growth.

• Item Type: MPRA Paper
• Language: English
• Subjects: E - Macroeconomics and Monetary Economics > E3 - Prices, Business Fluctuations, and Cycles > E32 - Business Fluctuations ; Cycles; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy

References

Allard, C., Munoz, S. (2008). Challenges to Monetary Policy in the Czech Republic: An Integrated Monetary and Fiscal Analysis. IMF Working Paper 08/72, Washington D.C.

An, S., Schorfheide, F. (2005). Bayesian Analysis of DSGE Models. CEPR Discussion Paper 5207.

Benes, J., Hlédik, T., Kumhof, M., Vávra, D. (2005). An Economy in Transition and DSGE: What the Czech National Bank�s New Projection Model Needs. Czech National Bank Working Paper 12, Prague.

Benigno, G., Benigno, P., Ghironi, F. (2007). Interest Rate Rules for Fixed Exchange Rate Regimes. Journal of Economic Dynamics & Control 31, 2196-2211.

Bruha, J., Podpiera, J., Polák, S. (2007). The Convergence Dynamics of a Transition Economy: The Case of the Czech Republic. IMF Working Paper 07/116, Washington D.C.

Buncic, D., Melecky, M. (2008). An Estimated New Keynesian Policy Model for Australia. Economic Record 84(264), 1-16.

Cateau, G. (2005). Monetary Policy Under Model and Data-Parameter Uncertainty. Journal of Monetary Economics 54 (7), 2083-2101.

Chinn, M.D., Meredith, G. (2004). Monetary Policy and Long-Horizon Uncovered Interest Parity. IMF Sta¤ Papers 51, 409�430.

Cho, S., Moreno, A. (2006). A Small-Sample Study of the New-Keynesian Macro Model. Journal of Money, Credit and Banking 38, 1461�1481.

Christiano, L. J., Eichenbaum, M., Evans, C. (2001). Nominal Rigidities and the Dynamic E¤ects of a Shock to Monetary Policy. Working Paper 01-07, Federal Reserve Bank of Cleveland.

Clarida, R., Gali, J., Gertler, M. (2001). Optimal Monetary Policy in Open versus Closed Economies: An Integrated Approach. American Economic Review 91, 248�252.

Clarida, R., Gali, J., Gertler, M. (2002). A Simple Framework for International Monetary Policy Analysis. Journal of Monetary Economics 49, 879�904.

Fagan, G., Henry, J., Mestre, R. (2001). An Area-Wide Model (AWM) for the Euro Area. ECB Working Paper 42. Frankfurt am Main.

Ferreira, A.L., León-Ledesma, M.A. (2007). Does the Real Interest Parity Hypothesis Hold? Evidence for Developed and Emerging Markets. Journal of International Money and Finance 3, Vol. 26, 364-382.

Fuhrer, J., Moore, G. (1995). In�ation Persistence. Quarterly Journal of Economics 110 (1), 127-159.

Gali, J., Gertler, M. (1999). In�ation Dynamics: A Structural Econometric Analysis. Journal of Monetary Economics 44, 195�222.

Giordani, P. (2004). Evaluating New-Keynesan Models of a Small Open Economy. Oxford Bulletin of Economics and Statistics 66, 713�733.

Hnatkovska, V., Loayza, N. (2003). Volatility and Growth. World Bank Policy Research Working Paper Series 3184, Washington, D.C.

Judson, R., Orphanides, A. (1999). Inflation, Volatility and Growth. International Finance 2 (1), 117-138.

Justiniano, A., Preston, B. (2004). Small Open Economy DSGE Models: Speci�cation, Estimation and Model Fit. Manuscript, Columbia University.

Karam, P., Laxton, D., Rose, D., Tamirisa, N. (2008). The Macroeconomic Costs and Bene�ts of Adopting the Euro. IMF Staff Papers 55, 339�355.

Mark, N.C., Moh, Y.K. (2001). What do Interest-Rate Di¤erentials Tell us about the Exchange Rate? Manuscript, Ohio State University.

McCallum, B.T., Nelson, E. (2001). Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices. CEPR Discussion Paper 2756.

Melecky, M., Rodriguez-Palenzuela, R., Soderstrom, U. (2008). Forthcoming in Monetary Policy under Uncertainty and Learning, Proceedings from the 11th Annual Conference of the Central Bank of Chile, edited by Klaus Schmidt-Hebbel and Carl E. Walsh.

Monacelli, T. (2005). Monetary Policy in a Low Pass-Through Environment. Journal of Money, Credit and Banking 37, 1047�1066.

Rudebusch, G.D. (2001). Is the Fed Too Timid? Monetary Policy in an Uncertain World. Review of Economics and Statistics 83 (2), 203�217.

Sims, C.A. (2002). Solving Linear Rational Expectations Models. Computational Economics 20, 1-20.

Svensson, L.E.O. (1997). Exchange rate target or inflation target for Norway? in Anne Berit Christiansen and Jan Fredrik Qvigstad, eds., Choosing a Monetary Policy Target, Scandinavian University Press (Universitetsforlaget AS), Oslo, 120-138, 1997.

Svensson, L.E.O. (2000). Open-Economy In�ation Targeting. Journal of International Economics 50, 155�183.

Tinsley, P.A. (1999). Short Rate Expectations, Term Premiums, and Central Bank Use of Derivatives to Reduce Policy Uncertainty. Finance and Economics Discussion Paper No. 99-14, Board of Governors of the Federal Reserve System.

Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton University Press.