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Devaluation with Exchange rate Floor in a Small Open Economy

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  • David Svacina

    () (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic)

Abstract

In recent years, central banks in the Czech Republic and Switzerland used exchange rate floor commitment to use unlimited FX interventions to keep the exchange rate above the declared floor rate to persistently devalue their currency and stimulate inflation. Central banks in other small open economies, such as Sweden and Israel, faced similar challenges and could have chosen this instrument as well. In this paper, I develop an extension to dynamic stochastic general equilibrium (DSGE) models that could be used to esimate impact of such devaluations with exchange rate floor. As an illustration, I apply the extension to models estimated for Sweden and the Czech Republic. In particular, I simulate impact of a 5 percent devaluation with the exchange rate floor used as an unconventional monetary policy instrument with interest rates at the zero lower bound. In the first year after the devaluation, the annual consumer price in inflation increases by 0.8 percent in Sweden and 1.8 percent in the Czech Republic. The long-term exchange rate pass-through to consumer prices is 40 percent and 65 percent, respectively. The increase in inflation is highly dependent on the persistent nature of the devaluation.

Suggested Citation

  • David Svacina, 2018. "Devaluation with Exchange rate Floor in a Small Open Economy," Working Papers IES 2018/06, Charles University Prague, Faculty of Social Sciences, Institute of Economic Studies, revised Feb 2018.
    • Handle: RePEc:fau:wpaper:wp2018_06
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    References listed on IDEAS

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    1. Montoro, Carlos & Ortiz, Marco, 2016. "Foreign exchange intervention and monetary policy design: a market microstructure analysis," Working Papers 2016-008, Banco Central de Reserva del Perú.
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    More about this item

    Keywords

    Exchange Rate Floor; Devaluation of Currency; Unconventional Monetary Policy Instrument; Dynamic Stochastic General Equilibrium Models; Exchange Rate Pass-Through;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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