Optimal Monetary Policy and Incomplete Information: Does the Real Exchange Matter?

Rodrigo Caputo and Felipe Leal

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: In a small economy, with complete markets and domestic price stickiness, a monetary policy rule that reacts to domestic inflation implements the efficient allocation, as long as it also reacts to the natural rate of interest. In this case, a policy response to the exchange rate or any other foreign variable is inefficient. We show that, when the central bank is unable to observe the natural rate of interest, a domestic inflation targeting rule that reacts also to the real exchange rate is optimal. This rule is able to fully stabilize domestic inflation and, at the same time, induces efficient movements in relative prices (terms of trade) through nominal devaluations. Indeterminacy can arise, but a stronger policy response to domestic inflation can prevent this from happening.

Date: 2021-06
New Economics Papers: this item is included in nep-cba, nep-isf, nep-mac, nep-mon and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:chb:bcchwp:916

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