Exploring the role of the real exchange rate in Australian monetary policy

An important issue in small open-economies is whether policymakers should respond to exchange rate movements when they formulate monetary policy. Micro-founded models tend to suggest that there is little to be gained from responding to exchange rate movements, and the literature has largely concluded that such a response is unnecessary, or even undesirable (Taylor, 2001). This paper examines this issue using an estimated model of the Australian economy. In contrast to micro-founded models, according to this model policymakers should allow for movements in the real exchange rage and the terms-of-trade when they set interest rates. Further, taking real exchange rate movements into account appears even more important with price level targeting than with inflation targeting.