How costly is exchange rate stabilisation for an inflation targeter? The case of Australia

Release date
01/07/2006
Reference
DP2006/07
Authors
Mark Crosby; Timothy Kam; Kirdan Lees
Published as
Crosby, Mark, Timothy Kam and Kirdan Lees (2008). ‘How costly is exchange rate stabilisation for an inflation targeter? The case of Australia’, The Economic Record, Wiley, Volume 84(266), Pages 354-365, DOI: https://doi.org/10.1111/j.1475-4932.2008.00496.x.
This paper quantifies the costs of mitigating exchange rate volatility within the context of a flexible inflation targeting central bank. Within a standard linearquadratic 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.