Risk-premium shocks and the prudent exchange rate policy

Syed Ali and Sajid Anwar

International Review of Economics & Finance, 2022, vol. 77, issue C, 97-122

Abstract: Using a medium-size New Keynesian open economy model, we examine the issue of a prudent exchange rate policy when the economy encounters an adverse risk-premium shock. We show that the shock leads to terms of trade (ToT) deterioration and an increase in both the aggregate output and inflation. While examining the choice of an appropriate exchange rate policy to deal with the effects of the shock, analytical results of our baseline model show that neither a fully flexible nor a fully pegged exchange rate policy can yield the desired outcome. In the absence of the supply-side effects of ToT and a cost channel of monetary policy, a managed exchange rate policy can stabilize both domestic inflation and aggregate output. However, in the presence of either a cost channel of monetary policy or supply-side effects of the ToT or both, the central bank faces a trade-off between aggregate output and domestic inflation stabilization. We find that the presence of a cost channel of monetary policy gives rise to a pro-cyclical exchange rate policy. Simulation of a more general model suggests that, instead of using the conventional Taylor rule, the central bank should follow a ToT-augmented Taylor rule, which involves further monetary tightening as the ToT deteriorates. We find that the need for monetary tightening is linked to both the nominal and real rigidities in economy, which gives rise to increased exchange rate volatility. We also briefly consider the case of a productivity shock.

Keywords: Risk-premium and productivity shocks; Exchange rate policy; Supply-side effects of the terms-of-trade; Cost channel of monetary policy; Emerging market economies (search for similar items in EconPapers)
JEL-codes: E32 E44 E5 F30 F4 (search for similar items in EconPapers)
Date: 2022
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:reveco:v:77:y:2022:i:c:p:97-122

DOI: 10.1016/j.iref.2021.08.004

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