Monetary policy and the volatility of real exchange rates in New Zealand

Abstract

The relationship between interest rates and exchange rates is puzzling and poorly understood. But under some standard assumptions, interest rates can be adjusted to smooth real exchange rate movements at the possible price of increased volatility in other variables. In New Zealand, estimates made under some generous suppositions about what monetary policy is able to accomplish suggest that decreasing real exchange rate volatility by about 25% would require increasing output volatility by about 10–15%, inflation volatility by about 0–15% and interest rate volatility by about 15–40%.