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Central Bank Learning, Terms of Trade Shocks & Currency Risks: Should Only Inflation Matter for Monetary Policy?

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  • G.C. Lim
  • P.D. McNelis

Abstract

This paper examines the role of interest rate policy in a small open economy subject to terms of trade shocks, and time-varying currency risks. The private sector makes optimal decisions in an intertemporal non-linear setting with rational, forward-looking expectations. In contrast, the monetary authority practices "least-squares learning" about the evolution of inflation, output growth, and exchange rate depreciation in alternative policy scenarios. Interest rates are set by linear quadratic optimization, with the objectives for inflation, output growth, or depreciation depending on current conditions. The simulation results show that the prefered stance is one which targets inflation only. Including other targets such as growth and exchange rate changes significantly increases output variability, and unambiguously decreases welfare.
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Suggested Citation

  • G.C. Lim & P.D. McNelis, 2002. "Central Bank Learning, Terms of Trade Shocks & Currency Risks: Should Only Inflation Matter for Monetary Policy?," Computing in Economics and Finance 2002 68, Society for Computational Economics.
    • Handle: RePEc:sce:scecf2:68
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    References listed on IDEAS

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    1. Duffy, John & McNelis, Paul D., 2001. "Approximating and simulating the stochastic growth model: Parameterized expectations, neural networks, and the genetic algorithm," Journal of Economic Dynamics and Control, Elsevier, vol. 25(9), pages 1273-1303, September.
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    3. Thomas Sargent & Noah Williams & Tao Zha, 2009. "The Conquest of South American Inflation," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 211-256, April.
    4. Lawrence J. Christiano & Christopher J. Gust, 1999. "Taylor rules in a limited participation model," Working Paper Series WP-99-3, Federal Reserve Bank of Chicago.
    5. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
    6. Chris Ryan & Christopher Thompson, 2000. "Inflation Targeting and Exchange Rate Fluctuations in Australia," RBA Research Discussion Papers rdp2000-06, Reserve Bank of Australia.
    7. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156, National Bureau of Economic Research, Inc.
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    More about this item

    Keywords

    monetary policy; currency risks; learning; parametrized expectations;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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