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The exchange rate and inflation targeting

Adrian Orr, Alasdair Scott, Bruce D. White

During the last few years the New Zealand dollar has appreciated substantially and depreciated steeply. In these circumstances it is not surprising that the exchange rate has been the focus of much attention in debates about monetary policy. Questions which have arisen include: • why do exchange rates move? • how and why do exchange rate movements affect inflation? • when should monetary policy react to exchange rate movements and when should it not? This article sets out a framework for approaching these questions. The authors also describe how the Reserve Bank’s approach to the exchange rate has evolved as it has gained experience with inflation targeting in a small open economy.