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The interest rate - exchange rate nexus: exchange rate regimes and policy equilibria

  • Christoph Himmels
  • Tatiana Kirsanova

We study a credible Markov-perfect monetary policy in an open New Keynesian economy with incomplete financial markets. We demonstrate the existence of two discretionary equilibria. Following a shock the economy can be stabilised either 'quickly' or 'slow', both dynamic paths satisfy conditions of optimality and time-consistency. The model can help us to understand sudden change of the interest rate and exchange rate volatility in 'tranquil' and 'volatile' regimes even under a fully credible 'soft peg' of the nominal exchange rate in developing countries.

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Paper provided by Economics, The University of Manchester in its series The School of Economics Discussion Paper Series with number 1219.

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Date of creation: 2012
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Handle: RePEc:man:sespap:1219
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