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Current account dynamics and monetary policy

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  • Andrea Ferrero
  • Mark Gertler
  • Lars E.O. Svensson

Abstract

We explore the implications of current account adjustment for monetary policy within a simple two country SGE model. Our framework nests Obstfeld and Rogoff's (2005) static model of exchange rate responsiveness to current account reversals. It extends this approach by endogenizing the dynamic adjustment path and by incorporating production and nominal price rigidities in order to study the role of monetary policy. We consider two different adjustment scenarios. The first is a "slow burn" where the adjustment of the current account deficit of the home country is smooth and slow. The second is a "fast burn" where, owing to a sudden shift in expectations of relative growth rates, there is a rapid reversal of the home country's current account. We examine several different monetary policy regimes under each of these scenarios. Our principal finding is that the behavior of the domestic variables (for instance, output, inflation) is quite sensitive to the monetary regime, while the behavior of the international variables (for instance, the current account and the real exchange rate) is less so. Among different policy rules, domestic inflation targeting achieves the best stabilization outcome of aggregate variables. This result is robust to the presence of imperfect pass-through on import prices, although in this case stabilization of consumer price inflation performs similarly well.

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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-26.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-26

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  1. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
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  10. Vasco Cúrdia, 2005. "Monetary Policy under Sudden Stops," International Finance 0510025, EconWPA, revised 02 Nov 2005.
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