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Optimal Exchange Intervention in an Inflation Targeting Regime: Some Cautionary Tales

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  • Matthew Canzoneri

    ()

  • Robert Cumby

    ()

Abstract

Devaluations and fiscal retrenchments coming from developed countries are buffeting less developed countries. Many emerging market countries have adopted inflation targeting as “best practice,” but now they are being advised to enhance their inflation targeting regimes with foreign exchange intervention. Here we use a DSGE model to tell some cautionary tales about this advice. A Taylor rule guides interest rate setting, while foreign exchange interventions are used as a second tool of monetary policy. These interventions are effective in our model since domestic and key currency bonds are imperfect substitutes. We derive optimal (Ramsey) intervention policies in response to foreign devaluations and fiscal retrenchments, and find that they are rather complex. So, we compare the optimal responses to policies that simply smooth real or nominal exchange rate movements. Our results suggest that discretion may be the better part of valor: pure inflation targeting may come closer to the optimal policy than exchange rate smoothing. A secondary result may also be of some interest: foreign exchange interventions have a stronger impact on inflation and output in an inflation targeting regime than do sterilized interventions; the Taylor rule augments the effects of a given intervention. Copyright Springer Science+Business Media New York 2014

Suggested Citation

  • Matthew Canzoneri & Robert Cumby, 2014. "Optimal Exchange Intervention in an Inflation Targeting Regime: Some Cautionary Tales," Open Economies Review, Springer, vol. 25(3), pages 429-450, July.
  • Handle: RePEc:kap:openec:v:25:y:2014:i:3:p:429-450
    DOI: 10.1007/s11079-013-9287-3
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    References listed on IDEAS

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    1. Jaromir Benes & Andrew Berg & Rafael Portillo & David Vavra, 2015. "Modeling Sterilized Interventions and Balance Sheet Effects of Monetary Policy in a New-Keynesian Framework," Open Economies Review, Springer, vol. 26(1), pages 81-108, February.
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    Keywords

    Foreign exchange intervention; E5; F3; F4;

    JEL classification:

    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • F3 - International Economics - - International Finance
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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