IDEAS home Printed from https://ideas.repec.org/p/cpr/ceprdp/12137.html
   My bibliography  Save this paper

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
    as

    Download full text from publisher

    File URL: http://www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12137
    Download Restriction: CEPR Discussion Papers are free to download for our researchers, subscribers and members. If you fall into one of these categories but have trouble downloading our papers, please contact us at subscribers@cepr.org

    As the access to this document is restricted, you may want to look for a different version below or search for a different version of it.

    Other versions of this item:

    References listed on IDEAS

    as
    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.
    2. Williamson, John, 1998. "Crawling Bands or Monitoring Bands: How to Manage Exchange Rates in a World of Capital Mobility," International Finance, Wiley Blackwell, vol. 1(1), pages 59-79, October.
    3. Amador, Manuel & Bianchi, Javier & Bocola, Luigi & Perri, Fabrizio, 2017. "Exchange Rate Policies at the Zero Lower Bound," CEPR Discussion Papers 11928, C.E.P.R. Discussion Papers.
    4. Santacreu, Ana Maria, 2015. "Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules," Review, Federal Reserve Bank of St. Louis, vol. 97(3), pages 217-232.
    5. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2008. "If exchange rates are random walks, then almost everything we say about monetary policy is wrong," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Jul, pages 2-9.
    6. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    7. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
    8. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
    9. Adrien Verdelhan, 2010. "A Habit-Based Explanation of the Exchange Rate Risk Premium," Journal of Finance, American Finance Association, vol. 65(1), pages 123-146, February.
    10. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    11. De Paoli, Bianca & Sondergaard, Jens, 2009. "Foreign exchange rate risk in a small open economy," Bank of England working papers 365, Bank of England.
    12. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
    13. Menzie D. Chinn & Saad Quayyum, 2012. "Long Horizon Uncovered Interest Parity Re-Assessed," NBER Working Papers 18482, National Bureau of Economic Research, Inc.
    14. Eric Parrado, 2004. "Singapore's Unique Monetary Policy; How Does it Work?," IMF Working Papers 04/10, International Monetary Fund.
    15. Chow, Hwee Kwan & Lim, G.C. & McNelis, Paul D., 2014. "Monetary regime choice in Singapore: Would a Taylor rule outperform exchange-rate management?," Journal of Asian Economics, Elsevier, vol. 30(C), pages 63-81.
    16. Bennett T. McCallum, 2005. "Monetary policy and the term structure of interest rates," Economic Quarterly, Federal Reserve Bank of Richmond, issue Fall, pages 1-21.
    17. repec:wsi:serxxx:v:52:y:2007:i:01:n:s0217590807002531 is not listed on IDEAS
    18. David K. Backus & Federico Gavazzoni & Christopher Telmer & Stanley E. Zin, 2010. "Monetary Policy and the Uncovered Interest Parity Puzzle," NBER Working Papers 16218, National Bureau of Economic Research, Inc.
    19. repec:hrv:faseco:34721963 is not listed on IDEAS
    Full references (including those not matched with items on IDEAS)

    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

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:cpr:ceprdp:12137. 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: (). General contact details of provider: .

    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 CitEc recognized a reference but did not link an item in RePEc 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 RePEc Author Service 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.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.