Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response?

Giancarlo Corsetti, Luca Dedola and Sylvain Leduc
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Luca Dedola: European Central Bank and CEPR

No 20-E-04, IMES Discussion Paper Series from Institute for Monetary and Economic Studies, Bank of Japan

Abstract: How should monetary policy respond to capital inflows that appreciate the currency, widen the current account deficit and cause domestic overheating? Using the workhorse open-macro monetary model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, solve for the optimal targeting rules under cooperation and characterize the constrained-optimal allocation. The answer is sharp: the optimal monetary stance is contractionary if the exchange rate pass-through (ERPT) on import prices is incomplete, expansionary if ERPT is complete-implying that misalignment and exchange rate volatility are higher in economies where incomplete pass through contains the effects of exchange rates on price competitiveness.

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: 2020-03
New Economics Papers: this item is included in 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 (3)

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Related works:
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2022)
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2020)
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2020)
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Persistent link: https://EconPapers.repec.org/RePEc:ime:imedps:20-e-04

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