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Optimal exchange rate policy in a low interest rate environment

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Author Info
Pavasuthipaisit, Robert

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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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File URL: http://mpra.ub.uni-muenchen.de/3596/
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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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Related research
Keywords: Zero lower bound liquidity trap exchange rate policy open-economy macroeconomics.

Find related papers by JEL classification:
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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

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References listed on IDEAS
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  1. Günter Coenen & Volker W. Wieland, 2004. "Exchange-Rate Policy and the Zero Bound on Nominal Interest Rates," American Economic Review, American Economic Association, vol. 94(2), pages 80-84, May. [Downloadable!]
    Other versions:
  2. 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. [Downloadable!]
    Other versions:
  3. 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. [Downloadable!] (restricted)
    Other versions:
  4. 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. [Downloadable!]
  5. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    Other versions:
  6. Svensson, Lars-E-O, 2001. "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 19(S1), pages 277-312, February. [Downloadable!]
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  7. Hamid Faruqee & Peter Isard & Douglas Laxton & Eswar Prasad & Bart Turtelboom, 1998. "Multimod Mark III: The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund. [Downloadable!]
  8. Coenen, Günter & Wieland, Volker, 2003. "The Zero-Interest Rate Bound and the Role of the Exchange Rate for Monetary Policy in Japan," CEPR Discussion Papers 3895, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  9. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," NBER Working Papers 12163, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  10. 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. [Downloadable!]
  11. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 870-935.
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  12. 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. [Downloadable!] (restricted)
  13. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
  14. 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. [Downloadable!]
  15. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April. [Downloadable!] (restricted)
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  16. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September. [Downloadable!] (restricted)
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