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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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Bibliographic Info

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. Jordi Galí & Tommaso Monacelli, 2004. "Monetary policy and exchange rate volatility in a small open economy," Economics Working Papers 835, Department of Economics and Business, Universitat Pompeu Fabra.
  2. 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.
  3. 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.
  4. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," NBER Working Papers 12163, National Bureau of Economic Research, Inc.
  5. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
  6. 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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  11. Hamid Faruqee & Douglas Laxton & Bart Turtelboom & Peter Isard & Eswar Prasad, 1998. "Multimod Mark III: The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund.
  12. Volker Wieland & Gunter Coenen, 2003. "The Zero-Interest-Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," Computing in Economics and Finance 2003 138, Society for Computational Economics.
  13. Bennett McCallum, 2002. "Inflation Targeting and the Liquidity Trap," 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 9, pages 395-438 Central Bank of Chile.
  14. Günter Coenen & Volker Wieland, 2004. "Exchange-Rate Policy and the Zero Bound on Nominal Interest," CFS Working Paper Series 2004/14, Center for Financial Studies.
  15. M S Mohanty & Philip Turner, 2006. "Foreign exchange reserve accumulation in emerging markets: what are the domestic implications?," BIS Quarterly Review, Bank for International Settlements, September.
  16. 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.
  17. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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