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Currency Misalignments and Optimal Monetary Policy: A Reexamination

  • Charles Engel

This paper examines optimal monetary policy in an open-economy two-country world with sticky prices under pricing to market. We show that currency misalignments are inefficient and lower world welfare. We find that optimal policy must target consumer price inflation, the output gap, and the currency misalignment. The paper derives the loss function of a cooperative monetary policymaker and the optimal targeting rules. The model is a modified version of Clarida, Gali, and Gertler (JME, 2002). The key change is that we allow pricing to market or local-currency pricing and consider the policy implications of currency misalignments. (JEL E52, F31, F41)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.101.6.2796
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 101 (2011)
Issue (Month): 6 (October)
Pages: 2796-2822

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Handle: RePEc:aea:aecrev:v:101:y:2011:i:6:p:2796-2822
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  1. Lars E.O. Svensson, 1998. "Inflation Targeting as a Monetary Policy Rule," NBER Working Papers 6790, National Bureau of Economic Research, Inc.
  2. Ester Faia & Tommaso Monacelli, 2006. "Optimal Monetary Policy in a Small Open Economy with Home Bias," Computing in Economics and Finance 2006 521, Society for Computational Economics.
  3. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
  4. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
  5. Simon Wren-Lewis & Campbell Leith, 2007. "The Optimal Monetary Policy Response to Exchange Rate Misalignments," Economics Series Working Papers 305, University of Oxford, Department of Economics.
  6. Nooman Rebei & Steve Ambler & Ali Dib, 2004. "Optimal Taylor Rules in an Estimated Model of a Small Open Economy," Computing in Economics and Finance 2004 125, Society for Computational Economics.
  7. Wang, Jian, 2007. "Home bias, exchange rate disconnect, and optimal exchange rate policy," Working Papers 0701, Federal Reserve Bank of Dallas.
  8. Kai Leitemo & Ulf Soderstrom, 2001. "Simple monetary policy rules and exchange rate uncertainty," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
  9. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  10. Kollmann, Robert, 2002. "Monetary Policy Rules in the Open Economy: Effects on Welfare and Business Cycles," CEPR Discussion Papers 3279, C.E.P.R. Discussion Papers.
  11. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Working Papers 0016, University of Washington, Department of Economics.
  12. Adolfson, Malin & Laseén, Stefan & Lindé, Jesper & Svensson, Lars E.O., 2009. "Monetary Policy Trade-Offs in an Estimated Open-Economy DSGE Model," Working Paper Series 232, Sveriges Riksbank (Central Bank of Sweden).
  13. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
  14. Smets, Frank & Wouters, Raf, 2002. "Openness, imperfect exchange rate pass-through and monetary policy," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 947-981, July.
  15. Alan Sutherland, 2002. "Incomplete Pass-Through and the Welfare Effects of Exchange Rate Variability," Discussion Paper Series, Department of Economics 200212, Department of Economics, University of St. Andrews.
  16. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
  17. Coenen, Günter & Lombardo, Giovanni & Smets, Frank & Straub, Roland, 2008. "International transmission and monetary policy cooperation," Working Paper Series 0858, European Central Bank.
  18. Duarte, Margarida & Obstfeld, Maurice, 2008. "Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 949-957, October.
  19. De Paoli, Bianca, 2009. "Monetary policy and welfare in a small open economy," Journal of International Economics, Elsevier, vol. 77(1), pages 11-22, February.
  20. Evi Pappa, 2004. "Do the ECB and the Fed really need to cooperate? Optimal monetary policy in a two-country world," LSE Research Online Documents on Economics 512, London School of Economics and Political Science, LSE Library.
  21. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 743-764.
  22. Lars E.O. Svensson, 2002. "Inflation Targeting: Should It Be Modeled as an Instrument Rule or a Targeting Rule?," NBER Working Papers 8925, National Bureau of Economic Research, Inc.
  23. Benigno, Gianluca, 2004. "Real exchange rate persistence and monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 473-502, April.
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