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

Giancarlo Corsetti, Luca Dedola and Sylvain Leduc

No 2022/71, RSCAS Working Papers from European University Institute

Abstract: How should monetary policy respond to excessive capital inflows that appreciate the currency, widen the external deficit and cause overheating? Using the workhorse open-macro model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, and solve for the optimal targeting rules under cooperation. The optimal monetary stance is expansionary if the exchange rate pass-through (ERPT) on import prices is complete, contractionary if nominal rigidities reduce the ERPT. Excessive capital inflows, however, may lead to currency undervaluation instead of overvaluation for some parameter values. The optimal stance is then invariably expansionary to support domestic demand.

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)
Date: 2022-11
New Economics Papers: this item is included in nep-cba, nep-dge, nep-inv, nep-mon, nep-opm and nep-upt
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Related works:
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)
Working Paper: Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response? (2020)
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