External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?

Rodrigo Caputo

No 300, Econometric Society 2004 Australasian Meetings from Econometric Society

Abstract: There is substantial evidence suggesting that central banks in open economies react to exchange rate fluctuations in addition to expected inflation and output. In some developing countries this reaction is comparatively larger and it is nonlinear. Using an estimated structural macromodel, this paper assesses the advantages and potential costs of adopting such a reaction function. We conclude that, in the face of most of the external shocks, a policy rule that responds to exchange rate misalignments smooths inflation and output variability, while marginally increasing interest rate fluctuations. On the other hand, for some domestic innovations such a rule performs poorly. When all the shocks are considered at the same time, this rule generates important welfare gains. Finally, when the volatility of external shocks rises, increasing the response to exchange rate misalignments brings welfare improvements. In fact, a more aggressive response to the exchange rate offsets the impact that greater external volatility has on output and inflation, at the cost of inducing higher interest rate fluctuations. In this way, one can interpret the nonlinear reaction to the exchange rate as an optimal response to a more volatile external environment

Keywords: Structural Macromodel; Monetary Policy Rules; GMM. (search for similar items in EconPapers)
JEL-codes: E52 E53 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Journal Article: External Shocks and Monetary Policy. Does it Pay to Respond to Exchange Rate Desviations? (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:ecm:ausm04:300

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