The Exchange Rate as an Instrument of Monetary Policy
Ilian Mihov and
Ana Maria Santacreu
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Ilian Mihov: INSEAD
No 2017-28, Working Papers from Federal Reserve Bank of St. Louis
Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.
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Working Paper: The Exchange Rate as an Instrument of Monetary Policy (2017)
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