Optimal monetary policy, exchange rate misalignments and incomplete financial markets

Ozge Senay and Alan Sutherland ()

Journal of International Economics, 2019, vol. 117, issue C, 196-208

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: 2019
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Citations: View citations in EconPapers (9)

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Related works:
Working Paper: Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:inecon:v:117:y:2019:i:c:p:196-208

DOI: 10.1016/j.jinteco.2018.12.001

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