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Optimal exchange-rate policy in a low interest rate environment

  • Pavasuthipaisit, Robert
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    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.

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    Article provided by Elsevier in its journal Journal of the Japanese and International Economies.

    Volume (Year): 23 (2009)
    Issue (Month): 3 (September)
    Pages: 264-282

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    Handle: RePEc:eee:jjieco:v:23:y:2009:i:3:p:264-282
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    1. Klaus Adam & Roberto M. Billi, 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Research Working Paper RWP 05-08, Federal Reserve Bank of Kansas City.
    2. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    3. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy Rules for Inflation Targeting," NBER Working Papers 6512, National Bureau of Economic Research, Inc.
    4. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
    5. Bennett T. McCallum, 2000. "Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rates," NBER Working Papers 7677, National Bureau of Economic Research, Inc.
    6. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
    7. 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.
    8. 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.
    9. Bennett T. McCallum, 2001. "Inflation Targeting and the Liquidity Trap," Working Papers Central Bank of Chile 112, Central Bank of Chile.
    10. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, June.
    11. Sebastian Edwards & Eduardo Levy Yeyati, 2004. "Flexible Exchange Rates as Shock Absorbers," Business School Working Papers exchangerates, Universidad Torcuato Di Tella.
    12. Volker Wieland (Goethe University Frankfurt) & Günter Coenen (European Central Bank), 2004. "Exchange Rate Policy and the Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 65, Society for Computational Economics.
    13. Coenen, Günter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Working Paper Series 0218, European Central Bank.
    14. Roberto M. Billi, 2007. "Optimal inflation for the U.S," Research Working Paper RWP 07-03, Federal Reserve Bank of Kansas City.
    15. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
    16. Sebastian Edwards, 2006. "The Relationship Between Exchange Rates and Inflation Targeting Revisited," NBER Working Papers 12163, National Bureau of Economic Research, Inc.
    17. Wieland, Volker & Coenen, Günter, 2004. "Exchange-rate policy and the zero bound on nominal interest," CFS Working Paper Series 2004/14, Center for Financial Studies (CFS).
    18. 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.
    19. 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.
    20. 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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