CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules (2011)
Type of ContentDiscussion / Working Papers
PublisherCollege of Business and Economics
University of Canterbury. Department of Economics and Finance
Employing an optimizing framework, this paper shows that a target rule dominates a simple instrument rule when the focus of monetary policy is on CPI inflation. The target rule approach produces a systematic relationship between the current CPI inflation rate and the lagged policy instrument that renders the former immune to the stochastic risk premium. No matter how policy parameters are set, the optimal simple instrument rule cannot replicate the superior stabilization results achieved by the target rule approach. The optimal simple instrument rule also fails to account for the UIP puzzle. In contrast, the target rule approach can motivate the widely reported phenomenon whereby high interest rate currencies tend to appreciate. In fact the degree of openness and the central bank’s relative aversion to CPI inflation variability determine the sensitivity of observed changes in the nominal exchange rate to the lagged interest rate differential.
CitationGuender, A.V. (2011) CPI Inflation Targeting and the UIP Puzzle: An Appraisal of Instrument and Target Rules. Department of Economics and Finance. 28pp..
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KeywordsCPI Inflation Targeting; UIP Puzzle; Instrument Rule; Target Rule; Optimal Monetary Policy
ANZSRC Fields of Research38 - Economics::3801 - Applied economics::380112 - Macroeconomics (incl. monetary and fiscal theory)
15 - Commerce, Management, Tourism and Services::1502 - Banking, Finance and Investment
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