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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 monetary policy with an explicit zero lower bound in a small open-economy model. The paper finds that the gains from commitment are increasing in the openness of the economy while the optimal rate of inflation is decreasing in the openness of the economy. These results imply that the main findings of Adam and Billi (2007) for a closed-economy model are also true for an open-economy model. Finally, the paper finds that the effectiveness of the exchange-rate channel as a stabilization tool in the low interest rate environment depends on whether the central bank can make a credible commitment. If the central bank cannot commit and makes monetary-policy decisions on a discretionary basis, the optimal path of the nominal exchange rate will exhibit an appreciation, rather than depreciation as suggested in the literature.

Suggested Citation

  • Pavasuthipaisit, Robert, 2009. "Optimal exchange-rate policy in a low interest rate environment," Journal of the Japanese and International Economies, Elsevier, vol. 23(3), pages 264-282, September.
  • Handle: RePEc:eee:jjieco:v:23:y:2009:i:3:p:264-282
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    References listed on IDEAS

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    1. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
    2. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
    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.
    4. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters,in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
    5. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," Working Papers Central Bank of Chile 409, Central Bank of Chile.
    6. Edwards, Sebastian & Levy Yeyati, Eduardo, 2005. "Flexible exchange rates as shock absorbers," European Economic Review, Elsevier, vol. 49(8), pages 2079-2105, November.
    7. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, January.
    8. Glenn Rudebusch & Lars E.O. Svensson, 1999. "Policy Rules for Inflation Targeting," NBER Chapters,in: Monetary Policy Rules, pages 203-262 National Bureau of Economic Research, Inc.
    9. Lawrence H. Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
    10. 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.
    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.
    12. 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.
    13. 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.
    14. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 1071-1101, July.
    15. 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.
    16. Allan H. Meltzer, 1999. "Commentary : monetary policy at zero inflation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-276.
    17. Coenen, Gunter & Wieland, Volker, 2004. "Exchange-rate policy and the zero bound on nominal interest rates," MPRA Paper 76687, University Library of Munich, Germany.
    18. 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.
    19. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    20. Roberto M. Billi, 2007. "Optimal inflation for the U.S," Research Working Paper RWP 07-03, Federal Reserve Bank of Kansas City.
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    Cited by:

    1. Ida, Daisuke, 2013. "Optimal monetary policy rules in a two-country economy with a zero bound on nominal interest rates," The North American Journal of Economics and Finance, Elsevier, vol. 24(C), pages 223-242.

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