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Optimal Monetary Policy under Asset Market Segmentation

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  • Rajesh Singh
  • Amartya Lahiri
  • Carlos Vegh

Abstract

This paper studies optimal monetary policy in a small open economy under flexible prices. The paper’s key innovation is to analyze this question in the context of environments where only a fraction of agents participate in asset market transactions (i.e., asset markets are segmented). In this environment, we first show that there exist state contingent rules (based either on the rate of money growth or the devaluation rate) that can implement the first-best equilibrium. Such rules, however, would require the monetary authority to respond to contemporaneous shocks and would thus be difficult to implement. We then proceed to analyze optimal monetary policy rules within the class of non-state contingent rules. Our main result is that amongst non-state contingent rules, policies targeting monetary aggregates (which allow for nominal exchange rate flexibility) welfare-dominate rules that target the exchange rate. In particular, we find that a fixed exchange rate is never optimal. Our analysis would thus tend to support monetary policy arrangements that allow for nominal exchange rate flexibility

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Bibliographic Info

Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 643.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:nasm04:643

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Keywords: Optimal monetary policy; asset market segmentation;

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References

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  1. Lahiri, Amartya & Singh, Rajesh & Vegh, Carlos, 2007. "Segmented asset markets and optimal exchange rate regimes," Journal of International Economics, Elsevier, Elsevier, vol. 72(1), pages 1-21, May.
  2. Chatterjee, Satyajit & Corbae, Dean, 1992. "Endogenous Market Participation and the General Equilibrium Value of Money," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 100(3), pages 615-46, June.
  3. Alessandro Rebucci & Fabio Ghironi, 2002. "Monetary Rules for Emerging Market Economies," IMF Working Papers 02/34, International Monetary Fund.
  4. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  5. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2000. "Money, interest rates, and exchange rates with endogenously segmented markets," Staff Report, Federal Reserve Bank of Minneapolis 278, Federal Reserve Bank of Minneapolis.
  6. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, American Economic Association, vol. 94(4), pages 1183-1193, September.
  7. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  8. Alvarez, Fernando & Atkeson, Andrew, 1997. "Money and exchange rates in the Grossman-Weiss-Rotemberg model," Journal of Monetary Economics, Elsevier, Elsevier, vol. 40(3), pages 619-640, December.
  9. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
  10. Ernesto Talvi & Carlos A. Vegh, 2000. "Tax Base Variability and Procyclical Fiscal Policy," NBER Working Papers 7499, National Bureau of Economic Research, Inc.
  11. Grossman, Sanford & Weiss, Laurence, 1983. "A Transactions-Based Model of the Monetary Transmission Mechanism," American Economic Review, American Economic Association, American Economic Association, vol. 73(5), pages 871-80, December.
  12. Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Stabilization Policy and the Costs of Dollarization," Departmental Working Papers, Rutgers University, Department of Economics 200006, Rutgers University, Department of Economics.
  13. Fernando Alvarez & Robert E. Lucas & Warren E. Weber, 2001. "Interest Rates and Inflation," American Economic Review, American Economic Association, American Economic Association, vol. 91(2), pages 219-225, May.
  14. Rotemberg, Julio J, 1984. "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 92(1), pages 40-58, February.
  15. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  16. Casey B. Mulligan & Xavier Sala-i-Martin, 2000. "Extensive Margins and the Demand for Money at Low Interest Rates," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 108(5), pages 961-991, October.
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Cited by:
  1. Lahiri, Amartya & Singh, Rajesh & Vegh, Carlos, 2007. "Optimal Exchange Rate Regimes: Turning Mundell-Fleming's Dictum on Its Head," Staff General Research Papers 12816, Iowa State University, Department of Economics.

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