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Current Account Dynamics and Monetary Policy

In: International Dimensions of Monetary Policy

  • Andrea Ferrero
  • Mark Gertler
  • Lars E. O. Svensson

We explore the implications of current account adjustment for monetary policy within a simple two-country DSGE model. Our framework nests Obstfeld and Rogoff's (2005) static model of exchange rate responsiveness to current account reversals. It extends this approach by endogenizing the dynamic adjustment path and by incorporating production and nominal price rigidities in order to study the role of monetary policy. We consider two different adjustment scenarios. The first is a "slow burn" where the adjustment of the current account deficit of the home country is smooth and slow. The second is a "fast burn" where, owing to a sudden shift in expectations of relative growth rates, there is a rapid reversal of the home country's current account. We examine several different monetary policy regimes under each of these scenarios. Our principal finding is that the behavior of the domestic variables (for instance, output, inflation) is quite sensitive to the monetary regime, while the behavior of the international variables (for instance, the current account and the real exchange rate) is less so. Among different policy rules, domestic inflation targeting achieves the best stabilization outcome of aggregate variables. This result is robust to the presence of imperfect pass-through on import prices, although in this case stabilization of consumer price inflation performs similarly well.

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This chapter was published in:
  • Jordi Galí & Mark J. Gertler, 2010. "International Dimensions of Monetary Policy," NBER Books, National Bureau of Economic Research, Inc, number gert07-1.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0521.
    Handle: RePEc:nbr:nberch:0521
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    1. Hamid Faruqee & Douglas Laxton & Dirk Muir & Paolo Pesenti, 2005. "Smooth Landing or Crash? Model-Based Scenarios of Global Current Account Rebalancing," NBER Working Papers 11583, National Bureau of Economic Research, Inc.
    2. Lars E.O. Svensson, 1998. "Inflation Targeting as a Monetary Policy Rule," NBER Working Papers 6790, National Bureau of Economic Research, Inc.
    3. Benigno, Gianluca & Benigno, Pierpaolo, 2003. "Designing targeting rules for international monetary policy cooperation," Working Paper Series 0279, European Central Bank.
    4. Giancarlo Corsetti & Paolo Pesenti, 2001. "International Dimensions of Optimal Monetary Policy," NBER Working Papers 8230, National Bureau of Economic Research, Inc.
    5. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2008. "An Equilibrium Model of "Global Imbalances" and Low Interest Rates," American Economic Review, American Economic Association, vol. 98(1), pages 358-93, March.
    6. Maurice Obstfeld & Kenneth Rogoff, 2004. "The Unsustainable US Current Account Position Revisited," NBER Working Papers 10869, National Bureau of Economic Research, Inc.
    7. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, vol. 48(1), pages 55-80, August.
    8. David Backus & Espen Henriksen & Frederic Lambert & Chris Telmer, 2005. "Current Account Fact and Fiction," 2005 Meeting Papers 115, Society for Economic Dynamics.
    9. Andrea Ferrero, 2007. "The long-run determinants of U.S. external imbalances," Staff Reports 295, Federal Reserve Bank of New York.
    10. Martin Bodenstein, 2006. "Closing open economy models," International Finance Discussion Papers 867, Board of Governors of the Federal Reserve System (U.S.).
    11. Mark Gertler & Simon Gilchrist & Fabio M. Natalucci, 2001. "External constraints on monetary policy and the financial accelerator," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
    12. Monacelli, Tommaso, 2003. "Monetary policy in a low pass-through environment," Working Paper Series 0227, European Central Bank.
    13. Nir Jaimovich & Sergio Rebelo, 2006. "Can News About the Future Drive the Business Cycle?," NBER Working Papers 12537, National Bureau of Economic Research, Inc.
    14. Obstfeld, Maurice & Rogoff, Kenneth, 2001. "Global Implications of Self-Oriented National Monetary Rules," Center for International and Development Economics Research, Working Paper Series qt6412m5b7, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
    15. Michele Cavallo & Cédric Tille, 2006. "Current account adjustment with high financial integration: a scenario analysis," Economic Review, Federal Reserve Bank of San Francisco, pages 31-45.
    16. Clarida, Richard & Galí, Jordi & Gertler, Mark, 2002. "A Simple Framework for International Monetary Policy Analysis," CEPR Discussion Papers 3355, C.E.P.R. Discussion Papers.
    17. Jose Manuel Campa & Linda S. Goldberg, 2006. "Distribution margins, imported inputs, and the sensitivity of the CPI to exchange rates," Staff Reports 247, Federal Reserve Bank of New York.
    18. Mendoza, Enrique G & Quadrini, Vincenzo & Ríos-Rull, José-Víctor, 2007. "Financial Integration, Financial Deepness and Global Imbalances," CEPR Discussion Papers 6149, C.E.P.R. Discussion Papers.
    19. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers 2755, C.E.P.R. Discussion Papers.
    20. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
    21. Vasco Cúrdia, 2008. "Optimal monetary policy under sudden stops," Staff Reports 323, Federal Reserve Bank of New York.
    22. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
    23. Richard Clarida & Jordi Gali & Mark Gertler, 1997. "Monetary Policy Rules in Practice: Some International Evidence," NBER Working Papers 6254, National Bureau of Economic Research, Inc.
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