Exchange rates as an instrument of monetary policy

Ana Maria Santacreu and Ilian Mihov

No 773, 2013 Meeting Papers from Society for Economic Dynamics

Abstract: We analyze, in the context of a small open economy, the welfare effects of a monetary rule in which the central bank targets the nominal exchange rate. We show that, if the uncovered interest parity (UIP) holds, this rule is equivalent to the standard Taylor rule in terms of impulse responses to exogenous shocks, the time series properties of aggregate variables, and optimal monetary rules. We then introduce endogenous deviations from the UIP condition, by modelling a time-varying risk premium that generates a wedge between the interest rate differential and the rate of exchange rate depreciation. Our aim is to show that in this case, using the change in the exchange rate might be a welfare improving policy for the central bank, because in this situation of more stable exchange rates, the risk premium is reduced. We then analyze how the volatility of the main endogenous variables behaves when this policy is followed.

Date: 2013
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Working Paper: The Exchange Rate as an Instrument of Monetary Policy (2017)
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