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Other stabilisation objectives within an inflation targeting regime: Some stochastic simulation experiments

James Twaddle, David Hargreaves, Tim Hampton

We use the Reserve Bank of New Zealand’s macroeconomic model (FPS) to look at the feasibility of using monetary policy to reduce variability in output, the exchange rate and interest rates while maintaining an inflation target. Our experiment suggests that policy could be altered to increase the stability of interest rates, the exchange rate, inflation, or output, relative to the base case reaction function in FPS, but such a policy would incur some cost in terms of the variability of the other variables. In particular, we find that greater exchange rate stability would have relatively large costs in terms of the stability of all three other variables, primarily because monetary policy that leans too dramatically against exchange rate disturbances can create significant real economy variability. Relative to West (2003), we find larger costs of operating monetary policy to achieve exchange rate stabilisation. We attribute this finding to the relatively inertial inflation expectation process in FPS.