Does the RBNZ respond to exchange rate fluctuations?

Abstract

This note re-visits the evidence on whether the Reserve Bank of New Zealand targets exchange rates in its Taylor rule. Estimating a standard small-open-economy DSGE model of the New Zealand economy using Bayesian methods, we find that the DSGE model with exchange rate in the Taylor rule generates a statistically significant better fit compared to the model without the exchange rate. This supports the view that while inflation has the highest weight in the Taylor rule, the RBNZ targets the exchange rate when making interest rate decisions. We also find a large weight on the smoothing parameter. The weight on the exchange rate is statistically significant but is smaller compared to the parameter attached to output. We use a large time span (1975–2018) for New Zealand standards for the full sample, and we also perform various subsample analyses and find time-variation in the Taylor rule parameters.