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Monetary Policy in an Equilibrium Portfolio Balance Model

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  • Michael Kumhof
  • Stijn van Nieuwerburgh

Abstract

Standard theory shows that sterilized foreign exchange interventions do not affect equilibrium prices and quantities, and that domestic and foreign currency denominated bonds are perfect substitutes. This paper shows that when fiscal policy is not sufficiently flexible in response to spending shocks, perfect substitutability breaks down and uncovered interest rate parity no longer holds. Government balance sheet operations can be used as an independent policy instrument to target interest rates. Sterilized foreign exchange interventions should be most effective in developing countries, where fiscal volatility is large and where the fraction of domestic currency denominated government liabilities is small.

Suggested Citation

  • Michael Kumhof & Stijn van Nieuwerburgh, 2007. "Monetary Policy in an Equilibrium Portfolio Balance Model," IMF Working Papers 07/72, International Monetary Fund.
  • Handle: RePEc:imf:imfwpa:07/72
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    Cited by:

    1. Lucio Sarno & Giorgio Valente, 2009. "Exchange Rates and Fundamentals: Footloose or Evolving Relationship?," Journal of the European Economic Association, MIT Press, vol. 7(4), pages 786-830, June.
    2. Roberto Chang, 2008. "Inflation Targeting, Reserves Accumulation, and Exchange Rate Management in Latin America," Borradores de Economia 487, Banco de la Republica de Colombia.

    More about this item

    Keywords

    Economic models; Foreign exchange; Monetary policy; Sterilized foreign exchange intervention; imperfect asset substitutability; uncovered interest parity; portfolio balance theory; exchange rate; inflation; exchange rate volatility; Open Economy Macroeconomics;

    JEL classification:

    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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