Globalisation, pass-through and the optimal policy response to exchange rates

• Published in: Journal of international money and finance 2014-12, Vol.49, p.104-128
• Main Authors: Devereux, Michael B., Yetman, James
• Format: Article
• Language: English
• Subjects: Asia; Central banks; Economic models; Economic theory; Exchange rate pass-through; Exchange rates; Foreign exchange; Foreign exchange intervention; Foreign exchange rates; Globalization; Keynesian theory; Keynesianism; Monetary policy; Open economies; Studies
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2014.05.009

In this paper we examine how monetary policy should respond to nominal exchange rates in a New Keynesian open economy model that allows for a non-trivial role for sterilised intervention. The paper develops the argument against the backdrop of the evolving policy-making environment of Asian economies. Sterilised intervention can be a potent tool that offers policymakers an additional degree of freedom in maximising global welfare. We show that the gains to sterilised intervention are greater when goods market integration is low and exchange rate pass-through is high. However, increased financial internationalisation reduces the effectiveness of sterilised intervention, as the international policy trilemma becomes more relevant. Unsterilised intervention may also have a role to play, although the potential welfare gains from this are generally smaller. Most central banks in Asia have actively used sterilised foreign exchange intervention as a policy tool to smooth exchange rates. But, over time, declining exchange rate pass-through and the increasing international integration of financial and goods markets will tend to reduce the efficacy of sterilised intervention. Given the limited effectiveness of unsterilised intervention, our model implies that the role of exchange rate movements in the optimal setting of monetary policy in Asia is decreasing. •We model the optimal policy response to exchange rates.•Sterilised intervention can be a powerful policy tool.•But welfare gains depend on exchange rate pass-through and goods and financial market integration.•Changes in Asian economies imply a smaller role for intervention in future.