The Choice Of Loss Function-based Exchange Rate Changes

This paper establishes a model of discussing exchange rate choice in the framework of loss function and macroeconomic goals, and applies this model to discuss the RMB exchange rate. Loss function combines the growth goals and inflation goals, and exchange rate enters into the loss function through its impact to growth and inflation. The model concludes that in long term, stable exchange rate is good for macroeconomic stability, and in short term, optimal exchange rate change should reduce the distances between real economic outputs and the targeted outputs. When there is trade-off between growth and inflation, sub-optimal exchange rate change choice depends on the relative dislike coefficient to inflation. If the public dislike the inflation with a relative high ratio, then appreciation would be the choice to deflate the inflation. In the empirical study on the RMB exchange rate, given the current economic situation in China and its economic goals, appreciation would be preferred to minimize the loss if the dislike coefficient is larger than a standard value, otherwise, the benefit of deflating inflation by appreciation will be offset by the loss that appreciation brings in the product and the labor markets.