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Exchange Rate Policies at the Zero Lower Bound

Listed author(s):
  • Manuel Amador
  • Javier Bianchi
  • Luigi Bocola
  • Fabrizio Perri

We study how a monetary authority pursues an exchange rate objective in an environment that features a zero lower bound (ZLB) constraint on nominal interest rates and limits to arbitrage in international capital markets. If the nominal interest rate that is consistent with interest rate parity is positive, the central bank can achieve its exchange rate objective by choosing that interest rate, a well-known result in international finance. However, if the rate consistent with parity is negative, pursuing an exchange rate objective necessarily results in zero nominal interest rates, deviations from parity, capital inflows, and welfare costs associated with the accumulation of foreign reserves by the central bank. In this latter case, all changes in external conditions that increase inflows of capital toward the country are detrimental, while policies such as negative nominal interest rates or capital controls can reduce the costs associated with an exchange rate policy. We provide a simple way of measuring these costs, and present empirical support for the key implications of our framework: when interest rates are close to zero, violations in covered interest parity are more likely, and those violations are associated with reserve accumulation by central banks.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 23266.

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Date of creation: Mar 2017
Handle: RePEc:nbr:nberwo:23266
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  1. Amador, Manuel & Bianchi, Javier & Bocola, Luigi & Perri, Fabrizio, 2016. "Reverse speculative attacks," Journal of Economic Dynamics and Control, Elsevier, vol. 72(C), pages 125-137.
  2. Willem H. Buiter & Nikolaos Panigirtzoglou, 2003. "Overcoming the zero bound on nominal interest rates with negative interest on currency: gesell's solution," Economic Journal, Royal Economic Society, vol. 113(490), pages 723-746, October.
  3. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
  4. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-325, August.
  5. Devereux, Michael B. & Yetman, James, 2014. "Globalisation, pass-through and the optimal policy response to exchange rates," Journal of International Money and Finance, Elsevier, vol. 49(PA), pages 104-128.
  6. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
  7. Emmanuel Farhi & Ivan Werning, 2012. "Dealing with the Trilemma: Optimal Capital Controls with Fixed Exchange Rates," NBER Working Papers 18199, National Bureau of Economic Research, Inc.
  8. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2009. "Time-Varying Risk, Interest Rates, and Exchange Rates in General Equilibrium," Review of Economic Studies, Oxford University Press, vol. 76(3), pages 851-878.
  9. Corsetti, Giancarlo & Mackowiak, Bartosz, 2006. "Fiscal imbalances and the dynamics of currency crises," European Economic Review, Elsevier, vol. 50(5), pages 1317-1338, July.
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