RESEARCH PAPER NO. 831

CENTRAL BANK LEARNING, TERMS OF TRADE SHOCKS & CURRENCY RISKS: SHOULD ONLY INFLATION MATTER FOR MONETARY POLICY?

by

G. C. LIM & PAUL D. McNELIS

JANUARY 2002

Department of Economics. University of Melbourne. Melbourne Victoria 3010 Australia

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 how that the preferred 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.