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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. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
    2. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Mar.
    3. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 263-267, May.
    4. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, Elsevier, vol. 12(3), pages 383-398, September.
    5. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(3), pages 728-752, April.
    6. Adam, Klaus & Billi, Roberto M., 2004. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Working Paper Series, European Central Bank 0377, European Central Bank.
    7. Bennett McCallum, 2002. "Inflation Targeting and the Liquidity Trap," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 9, pages 395-438 Central Bank of Chile.
    8. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, Federal Reserve Bank of Boston, pages 870-935.
    9. Athanasios Orphanides & Volker Wieland, 1999. "Efficient monetary policy design near price stability," Finance and Economics Discussion Series, Board of Governors of the Federal Reserve System (U.S.) 1999-67, Board of Governors of the Federal Reserve System (U.S.).
    10. 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, Society for Computational Economics 65, Society for Computational Economics.
    11. Sebastian Edwards & Eduardo Levy Yeyati, 2004. "Flexible Exchange Rates as Shock Absorbers," Business School Working Papers, Universidad Torcuato Di Tella exchangerates, Universidad Torcuato Di Tella.
    12. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," Working Papers Central Bank of Chile, Central Bank of Chile 409, Central Bank of Chile.
    13. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(5), pages 1071-1101, July.
    14. Jordi Gali & Tommaso Monacelli, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," NBER Working Papers 8905, National Bureau of Economic Research, Inc.
    15. Wieland, Volker & Coenen, Günter, 2004. "Exchange-rate policy and the zero bound on nominal interest," CFS Working Paper Series, Center for Financial Studies (CFS) 2004/14, Center for Financial Studies (CFS).
    16. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 625-631.
    17. 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, Hong Kong Institute for Monetary Research 072004, Hong Kong Institute for Monetary Research.
    18. Roberto M. Billi, 2007. "Optimal inflation for the U.S," Research Working Paper, Federal Reserve Bank of Kansas City RWP 07-03, Federal Reserve Bank of Kansas City.
    19. Allan H. Meltzer, 1999. "Commentary : monetary policy at zero inflation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, pages 261-276.
    20. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262100711, December.
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