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Exchange rate targeting in the presence of foreign debt obligations

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  • Staveley-O’Carroll, James
  • Staveley-O’Carroll, Olena M.

Abstract

We study the impact of foreign debt on the optimal degree of trade-off between the three open economy objectives of the central bank—the desire to smooth exchange rate fluctuations to promote consumption risk sharing, the need for exchange rate flexibility to facilitate expenditure-switching in the face of sticky prices, and the incentive to tilt international prices so as to lower the labor effort of domestic households (terms-of-trade externality)—in a two-country productivity-shock-driven DSGE model with incomplete asset markets and deviations from purchasing power parity. We find that high levels of net foreign debt call for a policy with a significant degree of exchange rate management, which can constrain the extent of otherwise inefficient cross-border wealth transfers that arise due to debt valuation and risk premium effects. In particular, the central bank can improve consumer welfare by up to 0.1% of steady state consumption by responding to exchange rate fluctuations when domestic debt-to-GDP ratio reaches 100%. We also find that the ranking of optimal policy rules depends on the elasticity of import-export substitution. When home and foreign goods are complements, the responsiveness of the real exchange to shocks is muted, in turn mitigating the excessive cross-country wealth transfer associated with the debt valuation effect. In this case, CPI targeting outperforms the nominal peg at high levels of debt by improving international risk sharing.

Suggested Citation

  • Staveley-O’Carroll, James & Staveley-O’Carroll, Olena M., 2018. "Exchange rate targeting in the presence of foreign debt obligations," Journal of Macroeconomics, Elsevier, vol. 56(C), pages 113-134.
  • Handle: RePEc:eee:jmacro:v:56:y:2018:i:c:p:113-134
    DOI: 10.1016/j.jmacro.2017.12.005
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    Keywords

    International risk sharing; Foreign debt; Optimal monetary policy; Exchange rate targeting;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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