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Optimal exchange rate policy in a low interest rate environment

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  • Pavasuthipaisit, Robert

Abstract

This paper examines optimal exchange policy when nominal interest rates are unusually low, as experienced by several Asian economies and Japan since July 2006. The paper finds that in such environments, it is optimal to create a nominal depreciation to offset contractionary disturbances. However, the limited scope of monetary policy easing may compromise the ability of the central bank to create a nominal depreciation especially if the central bank makes decisions on monetary policy making on a discretionary basis. In order to successfully create a nominal depreciation, the central bank needs to rely on the expectations channel, by making a credible promise to keep its currency weak going forward. Finally, trade liberalization, by enhancing the role of the exchange rate channel on the transmission mechanism, may allow the central bank to achieve lower average inflation.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 3596.

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Date of creation: May 2007
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Handle: RePEc:pra:mprapa:3596

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Keywords: Zero lower bound; liquidity trap; exchange rate policy; open-economy macroeconomics;

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  1. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
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  3. Volker Wieland (Goethe University Frankfurt) & Günter Coenen (European Central Bank), 2004. "Exchange Rate Policy and the Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 65, Society for Computational Economics.
  4. Lars E.O. Svensson, 2004. "The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large OPen Economies," Working Papers 072004, Hong Kong Institute for Monetary Research.
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  12. Orphanides, Athanasios & Wieland, Volker, 2000. "Efficient Monetary Policy Design near Price Stability," Journal of the Japanese and International Economies, Elsevier, vol. 14(4), pages 327-365, December.
  13. Norman Loayza & Raimundo Soto, 2002. "Inflation Targeting: An Overview," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 1, pages 001-022 Central Bank of Chile.
  14. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," NBER Working Papers 12163, National Bureau of Economic Research, Inc.
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  16. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
  17. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
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