IDEAS home Printed from
MyIDEAS: Login to save this article or follow this journal

External Shocks and Monetary Policy. Does it Pay to Respond to Exchange Rate Desviations?

  • Rodrigo Caputo


    (Central Bank of Chile, Agustinas 1180, Santiago, Chile.)

There is substantial evidence suggesting that central banks in open economies react to exchange rate fluctuations, in addition to expected inflation and output. In some developing countries this reaction is comparatively larger and it is nonlinear. In an estimated structural macro model for Chile, this paper assesses the advantages and potential costs of adopting such a reaction function. We conclude that, in the face of most of the external shocks, a policy rule that responds to exchange rate misalignments smooths inflation and output variability, while marginally increasing interest rate fluctuations. On the other hand, for some domestic innovations such a rule performs poorly. When all the shocks are considered at the same time, this rule generates important welfare gains. Finally, when the volatility of external shocks rises, increasing the response to exchange rate misalignments brings welfare improvements. In fact, a more aggressive response to the exchange rate offsets the impact that greater external volatility has on output and inflation, at the cost of inducing higher interest rate fluctuations. In this way, one can interpret the nonlinear reaction to the exchange rate as an optimal response to a more volatile external environment. JEL Classification: D43, L13

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL:
Download Restriction: no

Article provided by Ilades-Georgetown University, Universidad Alberto Hurtado/School of Economics and Bussines in its journal Revista de Analisis Economico.

Volume (Year): 24 (2009)
Issue (Month): 1 (Junio)
Pages: 55-99

in new window

Handle: RePEc:ila:anaeco:v:24:y:2009:i:1:p:55-99
Contact details of provider: Postal: Erasmo Escala 1835, 6500620 Santiago
Phone: (562) 692-0265
Fax: (562) 692-0303
Web page:

More information through EDIRC

Order Information: Email:

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Lars E. O. Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," NBER Working Papers 5797, National Bureau of Economic Research, Inc.
  2. Galí, Jordi & Gertler, Mark & López-Salido, J David, 2001. "European Inflation Dynamics," CEPR Discussion Papers 2684, C.E.P.R. Discussion Papers.
  3. Richard Dennis, 2000. "Optimal simple targeting rules for small open economies," Working Paper Series 2000-20, Federal Reserve Bank of San Francisco.
  4. repec:oup:restud:v:72:y:2005:i:3:p:707-734 is not listed on IDEAS
  5. Fuhrer, Jeffrey C, 1997. "The (Un)Importance of Forward-Looking Behavior in Price Specifications," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(3), pages 338-50, August.
  6. Pablo S. García & Luis Oscar Herrera & Rodrigo Valdés, 2001. "New Frontiers for Monetary Policy in Chile," Working Papers Central Bank of Chile 125, Central Bank of Chile.
  7. Jeffrey C. Fuhrer, 2000. "Habit Formation in Consumption and Its Implications for Monetary-Policy Models," American Economic Review, American Economic Association, vol. 90(3), pages 367-390, June.
  8. Mahadeva, Lavan & Sterne, Gabriel, 2002. "Inflation Targets as a Stabilization Device," Manchester School, University of Manchester, vol. 70(4), pages 619-50, Special I.
  9. Nicoletta Batini & Richard Harrison & Stephen P Millard, 2001. "Monetary policy rules for an open economy," Bank of England working papers 149, Bank of England.
  10. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
  11. Richard Dennis, 2003. "Exploring the Role of the Real Exchange Rate in Australian Monetary Policy," The Economic Record, The Economic Society of Australia, vol. 79(244), pages 20-38, 03.
  12. Amato, Jeffery D. & Laubach, Thomas, 2004. "Implications of habit formation for optimal monetary policy," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 305-325, March.
  13. Jeff Fuhrer & George Moore, 1995. "Inflation Persistence," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 127-159.
  14. Andrew G. Haldane & Nicoletta Batini, 1998. "Forward-Looking Rules for Monetary Policy," NBER Working Papers 6543, National Bureau of Economic Research, Inc.
  15. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  16. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
  17. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  18. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
  19. Clarida, Richard H, 2001. "The Empirics of Monetary Policy Rules in Open Economies," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 6(4), pages 315-23, October.
  20. Woodford, M., 1999. "Optimal Monetary Policy Inertia.," Papers 666, Stockholm - International Economic Studies.
  21. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
  22. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
  23. Renee Fry & Vance Martin & Brenda González-Hermosillo & Mardi Dungey, 2002. "International Contagion Effects from the Russian Crisis and the LTCM Near-Collapse," IMF Working Papers 02/74, International Monetary Fund.
  24. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
  25. Alexandre, Fernando & Driffill, John & Spagnolo, Fabio, 2002. "Inflation Targeting, Exchange Rate Volatility and International Policy Coordination," Manchester School, University of Manchester, vol. 70(4), pages 546-69, Special I.
  26. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 125-146, August.
  27. Sharon Kozicki & Peter A. Tinsley, 2001. "Dynamic specifications in optimizing trend-deviation macro models," Research Working Paper RWP 01-03, Federal Reserve Bank of Kansas City.
  28. Scott, Alasdair, 2003. "APPLIED MACROECONOMETRICS Carlo A. Favero Oxford University Press, 2001," Macroeconomic Dynamics, Cambridge University Press, vol. 7(02), pages 313-315, April.
  29. Frederic S. Mishkin & Adam S. Posen, 1997. "Inflation targeting: lessons from four countries," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 9-110.
  30. Jordi Gali & Mark Gertler, 2000. "Inflation Dynamics: A Structural Econometric Analysis," NBER Working Papers 7551, National Bureau of Economic Research, Inc.
  31. Norman Loayza & Raimundo Soto, 2002. "Inflation Targeting: An Overview," 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 1, pages 001-022 Central Bank of Chile.
  32. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  33. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
  34. Vitale, Paolo, 2003. "Foreign exchange intervention: how to signal policy objectives and stabilise the economy," Journal of Monetary Economics, Elsevier, vol. 50(4), pages 841-870, May.
  35. Fuhrer, Jeffrey C & Moore, George R, 1995. "Monetary Policy Trade-offs and the Correlation between Nominal Interest Rates and Real Output," American Economic Review, American Economic Association, vol. 85(1), pages 219-39, March.
  36. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  37. Bennett T. McCallum, 2001. "Should Monetary Policy Respond Strongly to Output Gaps?," NBER Working Papers 8226, National Bureau of Economic Research, Inc.
  38. Leitemo, Kai & Soderstrom, Ulf, 2005. "Simple monetary policy rules and exchange rate uncertainty," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 481-507, April.
  39. William B. English & William R. Nelson & Brian P. Sack, 2002. "Interpreting the significance of lagged interest rate in estimated monetary policy rules," Finance and Economics Discussion Series 2002-24, Board of Governors of the Federal Reserve System (U.S.).
  40. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear of Floating," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 379-408.
  41. Eiji Fujii & Menzie D. Chinn, 2000. "Fin de Siecle Real Interest Parity," NBER Working Papers 7880, National Bureau of Economic Research, Inc.
  42. Klaus Schmidt-Hebbel & Alejandro Werner, 2002. "Inflation Targeting in Brazil, Chile, and Mexico: Performance, Credibility, and the Exchange Rate," Working Papers Central Bank of Chile 171, Central Bank of Chile.
  43. Anderson, Gary & Moore, George, 1985. "A linear algebraic procedure for solving linear perfect foresight models," Economics Letters, Elsevier, vol. 17(3), pages 247-252.
  44. 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.
  45. Harvey, A C & Jaeger, A, 1993. "Detrending, Stylized Facts and the Business Cycle," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(3), pages 231-47, July-Sept.
  46. Julio J. Rotemberg & Michael Woodford, 1998. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy: Expanded Version," NBER Technical Working Papers 0233, National Bureau of Economic Research, Inc.
  47. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:ila:anaeco:v:24:y:2009:i:1:p:55-99. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Marcela Perticara)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.