Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response?

Giancarlo Corsetti, Luca Dedola () and Sylvain Leduc

No 2020-04, Working Paper Series from Federal Reserve Bank of San Francisco

Abstract: How should monetary policy respond to capital inflows that appreciate the currency, widen the current account deficit and cause domestic overheating? Using the workhorse open-macro monetary model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, solve for the optimal targeting rules under cooperation and characterize the constrained-optimal allocation. The answer is sharp: the optimal monetary stance is contractionary if the exchange rate pass-through (ERPT) on import prices is incomplete, expansionary if ERPT is complete–implying that misalignment and exchange rate volatility are higher in economies where incomplete pass through contains the effects of exchange rates on price competitiveness.

Keywords: Currency misalignments; trade imbalances; asset markets and risk sharing; optimal targeting rules; international policy cooperation; exchange-rate pass-through (search for similar items in EconPapers)
JEL-codes: E44 E52 E61 F41 F42 (search for similar items in EconPapers)
Pages: 45
Date: 2020-02-26
New Economics Papers: this item is included in nep-cba, nep-mac and nep-opm
Note: This version: January 2020
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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Related works:
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2022)
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2020)
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedfwp:87525

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DOI: 10.24148/wp2020-04

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