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Decreasing Returns, Risk Premium Shocks, and Optimal Monetary Policy

Author

Listed:
  • Carlos J. García

    (ILADES – Universidad Alberto Hurtado)

  • Wildo D. González

    (Central Bank of Chile)

  • Angélica Sepúlveda

    (ILADES – Universidad Alberto Hurtado)

Abstract

We show that the simultaneous existence of two key elements in an open economy—decreasing returns and risk premium shocks to the exchange rate that violate the UIP—produce significant changes in the implementation of optimal monetary policy. First, we demonstrate that it is optimal to accommodate inflation when a positive shock occurs, but it is preferable to intervene in the exchange rate when the shock is negative. Second, the empirical evidence of this study, based on five economies with different degrees of development, shows the relevance of these two elements and confirms that central banks should pursue an asymmetric and more complex policy to deal with these type of shocks, rather than a linear Taylor rule that includes the exchange rate

Suggested Citation

  • Carlos J. García & Wildo D. González & Angélica Sepúlveda, 2015. "Decreasing Returns, Risk Premium Shocks, and Optimal Monetary Policy," ILADES-UAH Working Papers inv307, Universidad Alberto Hurtado/School of Economics and Business.
    • Handle: RePEc:ila:ilades:inv307
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    More about this item

    Keywords

    Decreasing Returns To Scale; Risk Premium Shock; Exchange Rate; And Optimal Monetary Policy;
    All these keywords.

    JEL classification:

    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • E53 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Deposit Insurance
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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