Currency Misalignments and Optimal Monetary Policy: A Reexamination
AbstractThis paper examines optimal monetary policy in an open-economy two-country model with sticky prices. We show that currency misalignments are inefficient and lower world welfare. We find that optimal policy must target not only inflation and the output gap, but also the currency misalignment. However the interest rate reaction function that supports this targeting rule may involve only the CPI inflation rate. This result illustrates how examination of "instrument rules" may hide important trade-offs facing policymakers that are incorporated in "targeting rules". The model is a modified version of Clarida, Gali, and Gertler's (JME, 2002). The key change is that we allow pricing to market or local-currency pricing and consider the policy implications of currency misalignments. Besides highlighting the importance of the currency misalignment, our model also gives a rationale for targeting CPI, rather than PPI, inflation.
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Date of creation: Apr 2009
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Other versions of this item:
- Charles Engel, 2011. "Currency Misalignments and Optimal Monetary Policy: A Reexamination," American Economic Review, American Economic Association, vol. 101(6), pages 2796-2822, October.
- Charles Engel, 2009. "Currency Misalignments and Optimal Monetary Policy: A Re-examination," RBA Research Discussion Papers rdp2009-01, Reserve Bank of Australia.
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
This paper has been announced in the following NEP Reports:
- NEP-ALL-2009-04-05 (All new papers)
- NEP-CBA-2009-04-05 (Central Banking)
- NEP-MAC-2009-04-05 (Macroeconomics)
- NEP-MON-2009-04-05 (Monetary Economics)
- NEP-OPM-2009-04-05 (Open Economy Macroeconomic)
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