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The Optimal Monetary Policy Response to Exchange Rate Misalignments

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  • Simon Wren-Lewis
  • Campbell Leith

Abstract

A common feature of exchange rate misalignments is that they produce a divergence between traded and non-traded goods sectors, leading to pressures on monetary policy makers to react. In this paper we develop a small open economy model which features traded and non-traded goods sectors with which to assess the extent to which monetary policy should respond to exchange rate misalignments. To do so we initially contrast the efficient outcome of the model with that under flexible prices and find that the flex-price equilibrium exhibits an excessive exchange rate appreciation in the face of a positive UIP shock. By introducing sticky prices in both sectors we provide a role for policy in the face of UIP shocks. We then derive a quadratic approximation to welfare which comprises quadratic terms in the output gaps in both sectors as well as sectoral rates of inflation. These can be rewritten in terms of the usual aggregate variables, but only after including terms in relative sectoral prices and/or the terms of trade to capture the sectoral composition of aggregates. We derive optimal policy analytically before giving numerical examples of the optimal response to UIP shocks. Finally, we contrast the optimal policy with a number of alternative policy stances and assess the robustness of results to changes in model parameters.

Suggested Citation

  • Simon Wren-Lewis & Campbell Leith, 2007. "The Optimal Monetary Policy Response to Exchange Rate Misalignments," Economics Series Working Papers 305, University of Oxford, Department of Economics.
  • Handle: RePEc:oxf:wpaper:305
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    File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper305.pdf
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    References listed on IDEAS

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    1. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, pages 235-266.
    2. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2008. "International Risk Sharing and the Transmission of Productivity Shocks," Review of Economic Studies, Oxford University Press, pages 443-473.
    3. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
    4. McCallum, Bennett T & Nelson, Edward, 2000. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," Oxford Review of Economic Policy, Oxford University Press, vol. 16(4), pages 74-91, Winter.
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    7. Tatiana Kirsanova & Campbell Leith & Simon Wren-Lewis, 2006. "Should Central Banks Target Consumer Prices or the Exchange Rate?," Economic Journal, Royal Economic Society, vol. 116(512), pages 208-231, June.
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    Citations

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    Cited by:

    1. Fernando Alexandre & Pedro Bação & John Driffill, 2007. "Optimal monetary policy with a regime-switching exchange rate in a forward-looking model," GEMF Working Papers 2007-09, GEMF, Faculty of Economics, University of Coimbra.
    2. Chung-Fu Lai, 2016. "Tariff, Consumption Home Bias and Macroeconomic Dynamics," Asian Economic and Financial Review, Asian Economic and Social Society, vol. 6(8), pages 425-444, August.
    3. Adam Cagliarini & Mariano Kulish, 2013. "Solving Linear Rational Expectations Models with Predictable Structural Changes," The Review of Economics and Statistics, MIT Press, pages 328-336.
    4. Povoledo, Laura, 2009. "The Volatility of the Tradeable and Nontradeable Sectors: Theory and Evidence," MPRA Paper 14852, University Library of Munich, Germany, revised Feb 2009.
    5. Wang, Jian, 2010. "Home bias, exchange rate disconnect, and optimal exchange rate policy," Journal of International Money and Finance, Elsevier, vol. 29(1), pages 55-78, February.
    6. Charles Engel, 2011. "Currency Misalignments and Optimal Monetary Policy: A Reexamination," American Economic Review, American Economic Association, pages 2796-2822.
    7. Brams, S.J. & Kaplan, T.R., 2002. "Dividing the Indivisible: Procedures for Allocating Cabinet Ministries to Political Parties in a Parliamentary System," Working Papers 02-06, C.V. Starr Center for Applied Economics, New York University.
    8. Leith, Campbell & Wren-Lewis, Simon, 2009. "Taylor rules in the open economy," European Economic Review, Elsevier, vol. 53(8), pages 971-995, November.
    9. Adriana Soares Sales & João Barata Ribeiro Blanco Barroso, 2012. "Coping with a Complex Global Environment: a Brazilian perspective on emerging market issues," Working Papers Series 292, Central Bank of Brazil, Research Department.
    10. Charles Engel, 2011. "Currency Misalignments and Optimal Monetary Policy: A Reexamination," American Economic Review, American Economic Association, pages 2796-2822.

    More about this item

    Keywords

    Exchange Rate Misalignment; Monetary Policy; Non-Traded Goods;

    JEL classification:

    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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