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Optimal exchange-rate policy in a low interest rate environment

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  • Pavasuthipaisit, Robert
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    Abstract

    This paper examines optimal monetary policy with an explicit zero lower bound in a small open-economy model. The paper finds that the gains from commitment are increasing in the openness of the economy while the optimal rate of inflation is decreasing in the openness of the economy. These results imply that the main findings of Adam and Billi (2007) for a closed-economy model are also true for an open-economy model. Finally, the paper finds that the effectiveness of the exchange-rate channel as a stabilization tool in the low interest rate environment depends on whether the central bank can make a credible commitment. If the central bank cannot commit and makes monetary-policy decisions on a discretionary basis, the optimal path of the nominal exchange rate will exhibit an appreciation, rather than depreciation as suggested in the literature.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of the Japanese and International Economies.

    Volume (Year): 23 (2009)
    Issue (Month): 3 (September)
    Pages: 264-282

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    Handle: RePEc:eee:jjieco:v:23:y:2009:i:3:p:264-282

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    Web page: http://www.elsevier.com/locate/inca/622903

    Related research

    Keywords: Zero lower bound Liquidity trap Exchange-rate policy Open-economy macroeconomics;

    References

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    1. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
    2. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," Working Papers Central Bank of Chile 409, Central Bank of Chile.
    3. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    4. Sebastian Edwards & Eduardo Levy Yeyati, 2003. "Flexible Exchange Rates as Shock Absorbers," NBER Working Papers 9867, National Bureau of Economic Research, Inc.
    5. Volker Wieland & Gunter Coenen, 2003. "The Zero-Interest-Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," Computing in Economics and Finance 2003 138, Society for Computational Economics.
    6. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
    7. Athanasios Orphanides & Volker Wieland, 1999. "Efficient monetary policy design near price stability," Finance and Economics Discussion Series 1999-67, Board of Governors of the Federal Reserve System (U.S.).
    8. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, January.
    9. Lars E.O. Svensson, 2004. "The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large OPen Economies," Working Papers 072004, Hong Kong Institute for Monetary Research.
    10. Wieland, Volker & Coenen, Günter, 2004. "Exchange-rate policy and the zero bound on nominal interest," CFS Working Paper Series 2004/14, Center for Financial Studies (CFS).
    11. Volker Wieland (Goethe University Frankfurt) & Günter Coenen (European Central Bank), 2004. "Exchange Rate Policy and the Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 65, Society for Computational Economics.
    12. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
    13. Allan H. Meltzer, 1999. "Commentary : monetary policy at zero inflation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-276.
    14. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
    15. McCallum, Bennett T, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 870-904, November.
    16. Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper RWP 05-08, Federal Reserve Bank of Kansas City.
    17. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
    18. Roberto M. Billi, 2007. "Optimal inflation for the U.S," Research Working Paper RWP 07-03, Federal Reserve Bank of Kansas City.
    19. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
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