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Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response?

Author

Listed:
  • Giancarlo Corsetti

    (Centre for Economic Policy Research
    Centre for Macroeconomics (CFM)
    University of Cambridge)

  • Luca Dedola

    (Centre for Economic Policy Research
    European Central Bank)

  • Sylvain Leduc

    (Federal Reserve Bank of San Francisco)

Abstract

How should monetary policy respond to capital inflows that appreciate the currency, widen the current account deficit and cause domestic overheating? Using the workhorse open-macro monetary model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, solve for the optimal targeting rules under cooperation and characterize the constrained-optimal allocation. The answer is sharp: the optimal monetary stance is contractionary if the exchange rate pass-through (ERPT) on import prices is incomplete, expansionary if ERPT is complete – implying that misalignment and exchange rate volatility are higher in economies where incomplete pass through contains the effects of exchange rates on price competitiveness.

Suggested Citation

  • Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2020. "Exchange Rate Misalignment and External Imbalances: What is the Optimal Monetary Policy Response?," Discussion Papers 2008, Centre for Macroeconomics (CFM).
    • Handle: RePEc:cfm:wpaper:2008
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    More about this item

    Keywords

    Currency misalignments; Trade imbalances; Asset markets and risk sharing; Optimal targeting rules; International policy cooperation; Exchange rate pass-through;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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