Emerging market economies often face sudden stops in capital inflows or reduced access to the international capital market. This paper analyzes what monetary policy should accomplish in such an event. Optimal monetary policy induces higher interest rates and exchange rate depreciation. The interest rate hike discourages borrowing and consumption, mitigating the impact of the increased cost of borrowing. The exchange rate depreciation provides a boost to export revenues, reducing the need for, but not averting, a domestic recession. The paper shows that the arrival of the sudden stop further aggravates the time inconsistency problem. Optimal policy is fairly well approximated by a flexible targeting rule, which stabilizes a basket composed of domestic price inflation, exchange rate and output. We show that from a welfare perspective, the success of a fixed exchange rate regime depends on the economic environment. For the benchmark parameterization, the peg performs the worst of the simple rules considered. For alternative parameterizations that feature low nominal rigidities or high elasticity of foreign demand, the fixed exchange rate regime performs relatively better.
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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number
323.
References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
David Backus & Bryan Routledge & Stanley Zin, 2004.
"Exotic Preferences for Macroeconomists,"
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04-20, New York University, Leonard N. Stern School of Business, Department of Economics.
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David K. Backus & Bryan R. Routledge & Stanley E. Zin, 2005.
"Exotic Preferences for Macroeconomists,"
NBER Chapters,
in: NBER Macroeconomics Annual 2004, Volume 19, pages 319-414
National Bureau of Economic Research, Inc.
[Downloadable!]
Ricardo J. Caballero & Arvind Krishnamurthy, 2004.
"Inflation Targeting and Sudden Stops,"
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in: The Inflation-Targeting Debate, pages 423-446
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[Downloadable!]
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Cited by: (explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)
Andrea Ferrero & Mark Gertler & Lars E. O. Svensson, 2007.
"Current Account Dynamics and Monetary Policy,"
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in: International Dimensions of Monetary Policy
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[Downloadable!]
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