The Latest Reserve Bank of New Zealand Discussion Papers
28 September, 2006
The following Discussion Paper has been released on the Reserve Bank's website. The discussion papers are available at
http://www.rbnz.govt.nz/research/discusspapers/
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DP2006/08
What do robust policies look like for open economy inflation targeters?
Kirdan Lees
http://www.rbnz.govt.nz/research/discusspapers/dp06_08.pdf
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DP2006/08
What do robust policies look like for open economy inflation targeters?
Kirdan Lees
http://www.rbnz.govt.nz/research/discusspapers/dp06_08.pdf
Abstract
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.
ENDS