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A Floating versus Managed Exchange Rate Regime in a DSGE Model of India

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We first develop a two-bloc model of an emerging open economy interacting with the rest of the world calibrated using Indian and US data. The model features a financial accelerator and is suitable for examining the effects of financial stress on the real economy. Three variants of the model are highlighted with increasing degrees of financial frictions. The model is used to compare two monetary interest rate regimes: domestic Inflation targeting with a floating exchange rate (FLEX(D)) and a managed exchange rate (MEX). Both rules are characterized as a Taylor-type interest rate rules. MEX involves a nominal exchange rate target in the rule and a constraint on its volatility. We find that the imposition of a low exchange rate volatility is only achieved at a significant welfare loss if the policymaker is restricted to a simple domestic inflation plus exchange rate targeting rule. If on the other hand the policymaker can implement a complex optimal rule then an almost fixed exchange rate can be achieved at a relatively small welfare cost. This finding suggests that future research should examine alternative simple rules that mimic the fully optimal rule more closely.

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Paper provided by NIPE - Universidade do Minho in its series NIPE Working Papers with number 31/2010.

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Date of creation: 2010
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Handle: RePEc:nip:nipewp:31/2010

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Keywords: DSGE model; Indian economy; monetary interest rate rules; floating versus managed exchange rate; financial frictions;

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Cited by:
  1. Haider, Adnan & Din, Musleh-ud & Ghani, Ejaz, 2012. "Monetary policy, informality and business cycle fluctuations in a developing economy vulnerable to external shocks," MPRA Paper 42484, University Library of Munich, Germany.
  2. Chetan Ghate & Radhika Pandey & Ila Patnaik, 2011. "Has India emerged? Business cycle stylized facts from a transitioning economy," Indian Statistical Institute, Planning Unit, New Delhi Discussion Papers 11-05, Indian Statistical Institute, New Delhi, India.
  3. Paul Levine, 2010. "Monetary Policy in an Uncertain World : Probability Models and the Design of Robust Monetary Rules," Macroeconomics Working Papers 21853, East Asian Bureau of Economic Research.
  4. Paul Levine, 2012. "Policy focus: Monetary policy in an uncertain world: probability models and the design of robust monetary rules," Indian Growth and Development Review, Emerald Group Publishing, vol. 5(1), pages 70-88, April.
  5. Levine, Paul & Pearlman, Joseph, 2011. "Monetary and Fiscal Policy in a DSGE Model of India," Working Papers 11/96, National Institute of Public Finance and Policy.
  6. Vasco Gabriel & Paul Levine & Joseph Pearlman & Bo Yang, 2010. "An Estimated DSGE Model of the Indian Economy," School of Economics Discussion Papers 1210, School of Economics, University of Surrey.
  7. Ghate, Chetan & Pandey, Radhika & Patnaik, Ila, 2011. "Has India emerged? Business cycle facts from a transitioning economy," Working Papers 11/88, National Institute of Public Finance and Policy.

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