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The Exchange Rate as an Instrument of Monetary Policy

Author

Listed:
  • Heipertz, Jonas
  • Mihov, Ilian
  • Santacreu, Ana Maria

Abstract

Most of the theoretical research in small open economies has typically focused on corner solutions regarding the exchange rate: either the currency rate is fixed by the central bank or it is left to be freely determined by market forces. We build an open-economy model with external habits in consumption to study the properties of a new class of monetary policy rules, in which the exchange rate serves as the instrument for stabilizing business cycle fluctuations. Instead of using a short-term interest rate, the monetary authority announces a path for currency appreciation or depreciation as a reaction to fluctuations in inflation and the output gap. We find that, under a wide range of modeling assumptions, the exchange rate rule outperforms a standard Taylor rule in terms of stabilizing both output and inflation. The reduction in volatility is more pronounced for more open economies and for economies with lower sensitivity to movements in the interest rate. We show that differences between the two rules are driven by two key factors: (i) paths of the nominal exchange rate and the interest rate under each rule, and (ii) the time variation in the risk premium, which leads to deviations from uncovered interest parity.

Suggested Citation

  • Heipertz, Jonas & Mihov, Ilian & Santacreu, Ana Maria, 2017. "The Exchange Rate as an Instrument of Monetary Policy," CEPR Discussion Papers 12137, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:12137
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    References listed on IDEAS

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    1. van Binsbergen, Jules H. & Fernández-Villaverde, Jesús & Koijen, Ralph S.J. & Rubio-Ramírez, Juan, 2012. "The term structure of interest rates in a DSGE model with recursive preferences," Journal of Monetary Economics, Elsevier, vol. 59(7), pages 634-648.
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    More about this item

    Keywords

    Exchange rate management; External habit; monetary policy rules; Risk premium;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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