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The Optimal Monetary Policy Response to Exchange Rate Misalignments

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  • Cambell Leith

    ()

  • Simon Wren-Lewis

    ()

Abstract

A common feature of exchange rate misalignments is that they produce a divergence between traded and non-traded goods sectors, which appears to pose a dilemma for policy makers. In this paper we develop a small open economy model which features traded and non-traded goods sectors with which to assess the extent to which monetary policy should respond to exchange rate misalignments. To do so we initially contrast the efficient outcome of the model with that under flexible prices and find that the flex price equilibrium exhibits an excessive exchange rate appreciation in the face of a positive UIP shock. By introducing sticky prices in both sectors we provide a role for policy in the face of UIP shocks. We then derive a quadratic approximation to welfare which comprises quadratic terms in the output gaps in both sectors as well as sectoral rates of inflation. These can be rewritten in terms of the usual aggregate variables, but only after including terms in relative sectoral prices and/or the terms of trade to capture the sectoral composition of aggregates. We derive optimal policy analytically before giving numerical examples of the optimal response to UIP shocks. Finally, we contrast the optimal policy with a number of alternative policy stances and assess the robustness of results to changes in model parameters.

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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Conference Paper Series with number 0605.

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Date of creation: Sep 2006
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Handle: RePEc:san:cdmacp:0605

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  1. Gianluca Benigno & Christoph Thoenissen, 2004. " Consumption and Real Exchange Rates with Incomplete Markets and Non-traded Goods," CDMA Conference Paper Series, Centre for Dynamic Macroeconomic Analysis 0405, Centre for Dynamic Macroeconomic Analysis, revised Dec 2006.
  2. McCallum, Bennett T & Nelson, Edward, 2000. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," Oxford Review of Economic Policy, Oxford University Press, Oxford University Press, vol. 16(4), pages 74-91, Winter.
  3. Robert Kollmann, 2005. "Macroeconomic effects of nominal exchange rate regimes: new insights into the role of price dynamics," ULB Institutional Repository 2013/7624, ULB -- Universite Libre de Bruxelles.
  4. Galí, Jordi & Monacelli, Tommaso, 2002. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3346, C.E.P.R. Discussion Papers.
  5. Lane, Philip R., 1999. "The New Open Economy Macroeconomics: a Survey," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2115, C.E.P.R. Discussion Papers.
  6. Nooman Rebei & Eva Ortega, 2005. "A Two Sector Small Open Economy Model. Which Inflation to Target?," Computing in Economics and Finance 2005, Society for Computational Economics 298, Society for Computational Economics.
  7. Giancarlo Corsetti & Paolo Pesenti, 2001. "International dimensions of optimal monetary policy," Staff Reports, Federal Reserve Bank of New York 124, Federal Reserve Bank of New York.
  8. Dupor, Bill, 2005. "Stabilizing non-fundamental asset price movements under discretion and limited information," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(4), pages 727-747, May.
  9. Corsetti, Giancarlo & Dedola, Luca & Leduc, Sylvain, 2004. "International risk-sharing and the transmission of productivity shocks," Working Paper Series, European Central Bank 0308, European Central Bank.
  10. Jian Wang, 2007. "Home bias, exchange rate disconnect, and optimal exchange rate policy," Working Papers, Federal Reserve Bank of Dallas 0701, Federal Reserve Bank of Dallas.
  11. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 116(512), pages F208-F231, 06.
  12. Kollmann, Robert, 2002. "Monetary Policy Rules in the Open Economy: Effects on Welfare and Business Cycles," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3279, C.E.P.R. Discussion Papers.
  13. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  14. Campbell Leith & Simon Wren-Lewis, 2006. "The Costs of Fiscal Inflexibility - Extended," Working Papers, Business School - Economics, University of Glasgow 2005_23, Business School - Economics, University of Glasgow.
  15. Jordi Gali & Tommaso Monacelli, 2005. "Optimal fiscal policy in a monetary union," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco.
  16. Julio J. Rotemberg & Michael Woodford, 1999. "Interest Rate Rules in an Estimated Sticky Price Model," NBER Chapters, in: Monetary Policy Rules, pages 57-126 National Bureau of Economic Research, Inc.
  17. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2006. "Nominal Rigidities in an Estimated Two Country," Computing in Economics and Finance 2006, Society for Computational Economics 162, Society for Computational Economics.
  18. Paul R. Bergin, 2004. "How Well Can the New Open Economy Macroeconomics Explain the Exchange Rate and Current Account?," NBER Working Papers 10356, National Bureau of Economic Research, Inc.
  19. Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
  20. Campbell Leith & Jim Malley, 2007. "A Sectoral Analysis of Price-Setting Behavior in U.S. Manufacturing Industries," The Review of Economics and Statistics, MIT Press, vol. 89(2), pages 335-342, May.
  21. Campbell Leith & Simon Wren-lewis, 2006. "The Costs of Fiscal Inflexibility," WEF Working Papers, ESRC World Economy and Finance Research Programme, Birkbeck, University of London 0005, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
  22. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 762, Board of Governors of the Federal Reserve System (U.S.).
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Citations

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Cited by:
  1. Charles Engel, 2011. "Currency Misalignments and Optimal Monetary Policy: A Reexamination," American Economic Review, American Economic Association, American Economic Association, vol. 101(6), pages 2796-2822, October.
  2. Povoledo, Laura, 2009. "The Volatility of the Tradeable and Nontradeable Sectors: Theory and Evidence," MPRA Paper 14852, University Library of Munich, Germany, revised Feb 2009.
  3. Fernando Alexandre & Pedro Bação & John Driffill, 2007. "Optimal monetary policy with a regime-switching exchange rate in a forward-looking model," NIPE Working Papers, NIPE - Universidade do Minho 26/2007, NIPE - Universidade do Minho.
  4. Campbell Leith & Simon Wren-Lewis, 2002. "Taylor Rules in the Open Economy," Working Papers, Business School - Economics, University of Glasgow 2002_14, Business School - Economics, University of Glasgow.
  5. Wang, Jian, 2010. "Home bias, exchange rate disconnect, and optimal exchange rate policy," Journal of International Money and Finance, Elsevier, Elsevier, vol. 29(1), pages 55-78, February.
  6. Adriana Soares Sales & João Barata Ribeiro Blanco Barroso, 2012. "Coping with a Complex Global Environment: a Brazilian perspective on emerging market issues," Working Papers Series, Central Bank of Brazil, Research Department 292, Central Bank of Brazil, Research Department.

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