Decreasing Returns, Risk Premium Shocks, and Optimal Monetary Policy

Carlos García, Wildo D. González and Angélica Sepúlveda
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Wildo D. González: Central Bank of Chile
Angélica Sepúlveda: ILADES – Universidad Alberto Hurtado

ILADES-UAH Working Papers from Universidad Alberto Hurtado/School of Economics and Business

Abstract: We show that the simultaneous existence of two key elements in an open economy—decreasing returns and risk premium shocks to the exchange rate that violate the UIP—produce significant changes in the implementation of optimal monetary policy. First, we demonstrate that it is optimal to accommodate inflation when a positive shock occurs, but it is preferable to intervene in the exchange rate when the shock is negative. Second, the empirical evidence of this study, based on five economies with different degrees of development, shows the relevance of these two elements and confirms that central banks should pursue an asymmetric and more complex policy to deal with these type of shocks, rather than a linear Taylor rule that includes the exchange rate

Keywords: Decreasing Returns To Scale; Risk Premium Shock; Exchange Rate; And Optimal Monetary Policy (search for similar items in EconPapers)
JEL-codes: E53 F33 F41 (search for similar items in EconPapers)
Pages: 54 pages
Date: 2015-01
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