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Current Account Dynamics and Monetary Policy

  • Andrea Ferrero
  • Mark Gertler
  • Lars E.O. Svensson

We explore the implications of current account adjustment for monetary policy within a simple two-country DSGE model. Our framework nests Obstfeld and Rogoff's (2005) static model of exchange rate responsiveness to current account reversals. It extends this approach by endogenizing the dynamic adjustment path and by incorporating production and nominal price rigidities in order to study the role of monetary policy. We consider two different adjustment scenarios. The first is a "slow burn" where the adjustment of the current account deficit of the home country is smooth and slow. The second is a "fast burn" where, owing to a sudden shift in expectations of relative growth rates, there is a rapid reversal of the home country's current account. We examine several different monetary policy regimes under each of these scenarios. Our principal finding is that the behavior of the domestic variables (for instance, output, inflation) is quite sensitive to the monetary regime, while the behavior of the international variables (for instance, the current account and the real exchange rate) is less so. Among different policy rules, domestic inflation targeting achieves the best stabilization outcome of aggregate variables. This result is robust to the presence of imperfect pass-through on import prices, although in this case stabilization of consumer price inflation performs similarly well.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13906.

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Date of creation: Apr 2008
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Publication status: published as Current Account Dynamics and Monetary Policy , Andrea Ferrero, Mark Gertler, Lars E. O. Svensson. in International Dimensions of Monetary Policy , Gali and Gertler. 2009
Handle: RePEc:nbr:nberwo:13906
Note: EFG IFM ME
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  18. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
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  20. Martin Bodenstein, 2006. "Closing open economy models," International Finance Discussion Papers 867, Board of Governors of the Federal Reserve System (U.S.).
  21. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
  22. Andrea Ferrero, 2007. "The long-run determinants of U.S. external imbalances," Staff Reports 295, Federal Reserve Bank of New York.
  23. Tommaso Monacelli, 2003. "Monetary Policy in a Low Pass-Through Environment," Working Papers 228, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  24. Benigno, Pierpaolo, 2004. "Optimal monetary policy in a currency area," Journal of International Economics, Elsevier, vol. 63(2), pages 293-320, July.
  25. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
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  27. Michele Cavallo & Cédric Tille, 2006. "Current account adjustment with high financial integration: a scenario analysis," Economic Review, Federal Reserve Bank of San Francisco, pages 31-45.
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