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

Author

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

Abstract

How should monetary policy respond to excessive capital in•ows that appreciate the currency and widen the external de•cit? Using the workhorse two-country 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 in•ows, however, may lead to currency undervaluation instead of overvaluation for some parameter values. The optimal stance is then invariably expansionary to support domestic demand. JEL Classification: E44, E52, E61, F41, F42

Suggested Citation

  • Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2023. "Exchange rate misalignment and external imbalances: what is the optimal monetary policy response?," Working Paper Series 2843, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20232843
    Note: 80922
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    References listed on IDEAS

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    1. Emile A. Marin & Sanjay R. Singh, 2023. "Low Risk Sharing with Many Assets," Working Papers 361, University of California, Davis, Department of Economics.

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    More about this item

    Keywords

    asset markets and risk sharing; currency misalignment; exchange rate pass-through; international policy cooperation; optimal targeting rules; trade imbalances;
    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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