Exchange rate misalignment and external imbalances: What is the optimal monetary policy response?

How should monetary policy respond to excessive capital inflows that appreciate the currency and widen the external deficit? Using the workhorse open-macro model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, and solve for the optimal t...

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Published in:Journal of international economics 2023-09, Vol.144, p.103771, Article 103771
Main Authors: Corsetti, Giancarlo, Dedola, Luca, Leduc, Sylvain
Format: Article
Language:English
Subjects:
Asset markets and risk sharing
Currency misalignment
Exchange rate pass-through
International policy cooperation
Optimal targeting rules
Trade imbalances
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description How should monetary policy respond to excessive capital inflows that appreciate the currency and widen the external deficit? Using the workhorse open-macro model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, and solve for the optimal targeting rules under cooperation. The optimal monetary stance is expansionary if the exchange rate pass-through (ERPT) on import prices is complete, contractionary if nominal rigidities attenuate ERPT. Excessive capital inflows, however, may lead to currency undervaluation instead of overvaluation for some parameter values. The optimal stance is then invariably expansionary to support domestic demand.
doi_str_mv 10.1016/j.jinteco.2023.103771
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source ScienceDirect Freedom Collection 2022-2024
subjects Asset markets and risk sharing
Currency misalignment
Exchange rate pass-through
International policy cooperation
Optimal targeting rules
Trade imbalances
title Exchange rate misalignment and external imbalances: What is the optimal monetary policy response?
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