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Monetary Policy in an Equilibrium Portfolio Balance Model

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  • Michael Kumhof
  • Stijn van Nieuwerburgh

Abstract

Standard theory shows that sterilized foreign exchange interventions do not affect equilibrium prices and quantities, and that domestic and foreign currency denominated bonds are perfect substitutes. This paper shows that when fiscal policy is not sufficiently flexible in response to spending shocks, perfect substitutability breaks down and uncovered interest rate parity no longer holds. Government balance sheet operations can be used as an independent policy instrument to target interest rates. Sterilized foreign exchange interventions should be most effective in developing countries, where fiscal volatility is large and where the fraction of domestic currency denominated government liabilities is small.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 07/72.

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Length: 31
Date of creation: 01 Mar 2007
Date of revision:
Handle: RePEc:imf:imfwpa:07/72

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Keywords: Economic models; foreign exchange; exchange rate; monetary policy; inflation; exchange rate volatility; money supply; exchange rates; currency risk; nominal exchange rate; foreign currency; monetary economics; exchange rate movements; inflation target; money growth; exchange rate risk; exchange rate depreciation; price level; real money; exchange risk; foreign exchange risk; nominal interest rate; nominal interest rates; exchange rate determination; floating exchange rates; exchange rate dynamics; volatile exchange rates; real value; real interest rate; inflation targeting; money stock; exchange reserves; exchange rate regime; exchange markets; foreign exchange reserves; fixed exchange rates; foreign exchange markets; inflation tax; aggregate exchange rate; foreign exchange market;

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Cited by:
  1. Roberto Chang, 2008. "Inflation Targeting, Reserves Accumulation, and Exchange Rate Management in Latin America," BORRADORES DE ECONOMIA 004518, BANCO DE LA REPÚBLICA.
  2. Sarno, Lucio & Valente, Giorgio, 2008. "Exchange Rates and Fundamentals: Footloose or Evolving Relationship?," CEPR Discussion Papers 6638, C.E.P.R. Discussion Papers.

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