Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-offs

Giancarlo Corsetti, Luca Dedola and Sylvain Leduc

No 12850, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: What determines the optimal monetary trade-off between internal objectives (inflation, and output gap) and external objectives (competitiveness and trade imbalances) when inefficient capital flows cause exchange rate misalignment and distort current account positions? We characterize this trade-off analytically, using the workhorse model of modern monetary theory in open economies under incomplete markets–where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive a quadratic approximation of the utility-based global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under co- operation. We show that, in economies with a low degree of exchange rate pass-through, the optimal response to inefficient capital inflows associated with real appreciation is contractionary, above and beyond the natural rate: the optimal policy curbs excessive demand at the cost of exacerbating currency overvaluation. In contrast, a high degree of pass-through, and/or low trade elasticities, warrants expansionary policies that lean against exchange rate appreciation and competitive losses, at the cost of inefficient inflation.

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)
Date: 2018-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon, nep-opm and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (21)

Downloads: (external link)
https://cepr.org/publications/DP12850 (application/pdf)
CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

Related works:
Working Paper: Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-offs (2018)
Working Paper: Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-off (2018)
Working Paper: Exchange rate misalignment, capital flows, and optimal monetary policy trade-offs (2018)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:cpr:ceprdp:12850

Ordering information: This working paper can be ordered from
https://cepr.org/publications/DP12850

Access Statistics for this paper

More papers in CEPR Discussion Papers from C.E.P.R. Discussion Papers Centre for Economic Policy Research, 33 Great Sutton Street, London EC1V 0DX.
Bibliographic data for series maintained by ().