Transitional Exchange Rate Policy In A Low Per Capita Income Country

The equilibrium real exchange rate is determined by a sustainable balancing of the current and capital accounts of the balance of payments, in an intertemporal optimizing model. A real wage target gives a real exchange rate target, which will be more appreciated than the real equilibrium exchange rate, when labour productivity is low. In this case, under high global capital mobility and managed exchange rates, a rise in the expected depreciation of the exchange rate is associated with a fall in money balances. Real fundamentals decline and are made worse by monetary tightening, while cost-driven inflation continues since the inflationary gap rises. The actual exchange rate approaches the target exchange rate, and the widening gap between the actual and the equilibrium exchange rate raises domestic interest rates, lowering investment and productivity. In the context of free trade, a rule that changes the nominal exchange rate inversely to the temporary supply shocks driving inflation in international prices, can lower domestic inflation and allow the monetary policy to focus on the domestic cycles and narrow down the gap.