Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets

Alan Sutherland () and Ozge Senay

No 11198, CEPR Discussion Papers from Centre for Economic Policy Research

Abstract: Recent literature shows that, when international financial trade is restricted to autarky or a single bond, there are internal and external welfare trade-offs that imply optimal monetary policy, in principle, deviates from inflation targeting in order to offset real exchange rate misalignments. This paper develops a more realistic model of incomplete markets, where there is international trade in multiple assets. The analysis shows that the presence of multiple assets creates a potentially powerful interaction between monetary policy and household portfolio allocation. This interaction is, by definition, not present when there is financial autarky or a single tradeable bond and this paper shows that the interaction with portfolio allocation can imply that optimal monetary policy generates a quantitatively much more significant stabilisation of the real exchange rate gap than implied by simpler models of financial market incompleteness.

Keywords: Optimal monetary policy; Financial market structure; Country portfolios (search for similar items in EconPapers)
JEL-codes: E52 E58 F41 (search for similar items in EconPapers)
Date: 2016-03
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon, nep-opm and nep-pke
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (13)

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Journal Article: Optimal monetary policy, exchange rate misalignments and incomplete financial markets (2019)
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