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External Shocks and Monetary Policy. Does it Pay to Respond to Exchange Rate Desviations?

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  • Rodrigo Caputo

    ()
    (Central Bank of Chile, Agustinas 1180, Santiago, Chile.)

Abstract

There is substantial evidence suggesting that central banks in open economies react to exchange rate fluctuations, in addition to expected inflation and output. In some developing countries this reaction is comparatively larger and it is nonlinear. In an estimated structural macro model for Chile, this paper assesses the advantages and potential costs of adopting such a reaction function. We conclude that, in the face of most of the external shocks, a policy rule that responds to exchange rate misalignments smooths inflation and output variability, while marginally increasing interest rate fluctuations. On the other hand, for some domestic innovations such a rule performs poorly. When all the shocks are considered at the same time, this rule generates important welfare gains. Finally, when the volatility of external shocks rises, increasing the response to exchange rate misalignments brings welfare improvements. In fact, a more aggressive response to the exchange rate offsets the impact that greater external volatility has on output and inflation, at the cost of inducing higher interest rate fluctuations. In this way, one can interpret the nonlinear reaction to the exchange rate as an optimal response to a more volatile external environment. JEL Classification: D43, L13

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Bibliographic Info

Article provided by Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines in its journal Revista de Analisis Economico.

Volume (Year): 24 (2009)
Issue (Month): 1 (Junio)
Pages: 55-99

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Handle: RePEc:ila:anaeco:v:24:y:2009:i:1:p:55-99

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Keywords: Small Open Economy; Optimal Monetary Policy; Taylor Rules; Exchange Rate.;

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Cited by:
  1. Argov, Eyal & Elkayam, David, 2007. "An Estimated New Keynesian Model for Israel," MPRA Paper 9412, University Library of Munich, Germany.
  2. Argov, Eyal & Binyamini, Alon & Elkayam, David & Rozenshtrom, Irit, 2007. "A Small Macroeconomic Model to Support Inflation Targeting in Israel," MPRA Paper 4784, University Library of Munich, Germany.
  3. Ronald H. Lange, 2013. "Monetary policy reactions and the exchange rate: a regime-switching structural VAR for Canada," International Review of Applied Economics, Taylor & Francis Journals, vol. 27(5), pages 612-632, September.

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