What do robust policies look like for open economy inflation targeters?

Release date
01/09/2006
Reference
DP2006/08
Author
Kirdan Lees
Typical New Keynesian open economy models suggest a limited response to the exchange rate. This paper examines the role of the open economy in determining robust rules when the central bank fears various model misspecification errors. The paper calibrates a hybrid New Keynesian model to broadly fit the economies of three archetypal open economy inflation targeters – Australia,Canada and New Zealand – and seeks robust time-consistent policy. We find that policies robust to model misspecification react more aggressively to not only the exchange rate, but also inflation, the output gap and their associated shocks. This result generalizes to the context of a flexible inflation targeting central bank that cares about the volatility of the real exchange rate. However, when the central bank places only a small weight on interest rate smoothing and fears misspecification in only exchange rate determination, a more cautious policy is recommended for all but an exchange rate shock. It is also shown that the benefits of an exchange rate channel far outweigh the concomitant costs of uncertain exchange rate determination.