Expected Regime Change: Transition Toward Nominal Exchange Rate Stability

František Brázdik

This work presents an extension of a small open economy DSGE model allowing the transition toward a monetary policy regime aimed at exchange rate stability to be described. The model is estimated using the Bayesian technique to fit the properties of the Czech economy. In the scenarios assessed, the monetary authority announces and changes its policy so that it is focused solely on stabilizing the nominal exchange rate after a specific transition period is over. Four representative forms of monetary policy are followed to evaluate their properties over the announced transition period. Welfare loss functions assessing macroeconomic stability are defined, allowing the implications of the transition period regime choice for macroeconomic stability to be assessed. As these experiments show, exchange rate stabilization over the transition period does not deliver the lowest welfare loss. Under the assumptions taken, the strict inflation-targeting regime is identified as the best-performing regime for short transition periods. However, it can be concluded that for longer transition periods the monetary policy regime should respond to changes in the exchange rate.

JEL codes: E17, E31, E52, E58, E61, F02, F41

Keywords: monetary policy change, new Keynesian models, small open economy

Issued: March 2013

Download: CNB WP No. 2/2013 (pdf, 552 kB)