Exchange rate effects and inflation targeting in a small open

In this paper, stochastic simulations of the Reserve Bank of New Zealand’s new macroeconomic model, FPS, are used to examine the issue of which price index should monetary policy stabilise in a small open economy. Under the class of policy rules considered, targeting a measure of domestic inflation, which does not include the direct effects of exchange rate movements on the price of imported goods, results in lower variability in real output, nominal interest rates, the exchange rate and domestic price inflation. The result is robust if direct exchange rate effects influence agents’ expectations of generalised inflation and if the policy maker is uncertain about how direct exchange rate effects influence expectations. Tracing out efficient policy frontiers under the two alternative targets illustrates that for a given level of CPI variability, output variability can be significantly reduced by targeting domestic price inflation. 1 The authors would like to thank the participants at the 1998 BIS Model Builder’s Meeting for their helpful comments, particularly Francesco Lippi.