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Exchange rate misalignment and external imbalances: What is the optimal monetary policy response?

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  • Corsetti, Giancarlo
  • Dedola, Luca
  • Leduc, Sylvain

Abstract

How should monetary policy respond to excessive capital inflows that appreciate the currency and widen the external deficit? 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 attenuate 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.

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  • Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2023. "Exchange rate misalignment and external imbalances: What is the optimal monetary policy response?," Journal of International Economics, Elsevier, vol. 144(C).
    • Handle: RePEc:eee:inecon:v:144:y:2023:i:c:s0022199623000570
    DOI: 10.1016/j.jinteco.2023.103771
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    More about this item

    Keywords

    Currency misalignment; Trade imbalances; Asset markets and risk sharing; Optimal targeting rules; International policy cooperation; Exchange rate pass-through;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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