Optimal Monetary Policy and Portfolio Choice

Sebastian Fanelli

No 1586, 2017 Meeting Papers from Society for Economic Dynamics

Abstract: A recent and rapidly increasing literature has documented the presence of sizeable cross-currency mismatches in countries' balance sheets. Yet, existing studies of optimal monetary policy focus on economies with either a single bond or complete markets. We bridge this gap by studying a small open economy with nominal rigidities where home agents are able to borrow abroad in both home- and foreign-currency bonds. In this environment, monetary policy faces a trade-off between providing insurance and doing inflation-targeting. To solve the optimal policy problem, we develop a technique to approximate the solution around the deterministic steady state with locally incomplete markets. When home-currency-bond markets are perfect, the central bank commits to a smooth exchange rate to induce agents to be significantly exposed to currency risk, giving monetary policy firepower to create wealth transfers at low cost. In contrast, if markets are imperfect and agents cannot choose such large positions, a volatile exchange rate is the only way to provide insurance. Finally, we show that despite the presence of aggregate demand externalities, private portfolio choice decisions are efficient in the approximated model.

Date: 2017
New Economics Papers: this item is included in nep-dge, nep-mon and nep-opm
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:red:sed017:1586

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