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An Optimal Currency Basket to Minimize Output and Inflation Volatility: Theory and an Application to H ong K ong
Author(s) -
Ma Zihui,
Cheng Leonard K.
Publication year - 2014
Publication title -
pacific economic review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.34
H-Index - 33
eISSN - 1468-0106
pISSN - 1361-374X
DOI - 10.1111/1468-0106.12053
Subject(s) - currency , economics , volatility (finance) , monetary economics , inflation (cosmology) , devaluation , econometrics , economy , physics , theoretical physics
In this paper we develop a theoretical model of an optimal currency basket for a small open economy. A currency basket for the home economy is defined as a chosen weighted average of a subset of foreign currencies, and an optimal currency basket is taken to be one that minimizes a given weighted average of the expected output volatility and expected inflation volatility. This theoretical model is then applied to H ong K ong, which has adopted a currency board system for close to 30 years. We estimate an optimal currency basket for H ong K ong and compare its performance with the existing currency board system as well as with currency baskets whose weights are given by export and import trade shares.