IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this paper or follow this series

The Optimal Monetary Policy Response to Exchange Rate Misalignments

  • Simon Wren-Lewis
  • Campbell Leith

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.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper305.pdf
Download Restriction: no

Paper provided by University of Oxford, Department of Economics in its series Economics Series Working Papers with number 305.

as
in new window

Length:
Date of creation: 01 Jan 2007
Date of revision:
Handle: RePEc:oxf:wpaper:305
Contact details of provider: Postal: Manor Rd. Building, Oxford, OX1 3UQ
Web page: http://www.economics.ox.ac.uk/
Email:


More information through EDIRC

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Ben Bernanke & Mark Gertler, 2000. "Monetary Policy and Asset Price Volatility," NBER Working Papers 7559, National Bureau of Economic Research, Inc.
  2. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
  3. Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona Graduate School of Economics.
  4. Bergin, Paul R., 2006. "How well can the New Open Economy Macroeconomics explain the exchange rate and current account?," Journal of International Money and Finance, Elsevier, vol. 25(5), pages 675-701, August.
  5. Campbell Leith & Jim Malley, 2007. "A Sectoral Analysis of Price-Setting Behavior in U.S. Manufacturing Industries," The Review of Economics and Statistics, MIT Press, vol. 89(2), pages 335-342, May.
  6. Giancarlo Corsetti & Luca Dedola & Sylvain Leduc, 2008. "International Risk Sharing and the Transmission of Productivity Shocks," Review of Economic Studies, Oxford University Press, vol. 75(2), pages 443-473.
  7. Nooman Rebei & Eva Ortega, 2005. "A Two Sector Small Open Economy Model. Which Inflation to Target?," Computing in Economics and Finance 2005 298, Society for Computational Economics.
  8. Gianluca Benigno & Christoph Thoenissen, 2004. " Consumption and Real Exchange Rates with Incomplete Markets and Non-traded Goods," CDMA Conference Paper Series 0405, Centre for Dynamic Macroeconomic Analysis, revised Dec 2006.
  9. Kollmann, Robert, 2002. "Monetary Policy Rules in the Open Economy: Effects on Welfare and Business Cycles," CEPR Discussion Papers 3279, C.E.P.R. Discussion Papers.
  10. 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.
  11. David Bowman & Brian M. Doyle, 2003. "New Keynesian, open-economy models and their implications for monetary policy," International Finance Discussion Papers 762, Board of Governors of the Federal Reserve System (U.S.).
  12. Giancarlo Corsetti & Paolo Pesenti, 2001. "International Dimensions of Optimal Monetary Policy," NBER Working Papers 8230, National Bureau of Economic Research, Inc.
  13. Dupor, Bill, 2005. "Stabilizing non-fundamental asset price movements under discretion and limited information," Journal of Monetary Economics, Elsevier, vol. 52(4), pages 727-747, May.
  14. 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 F208-F231, 06.
  15. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  16. Bennett T. McCallum & Edward Nelson, 2001. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," NBER Working Papers 8175, National Bureau of Economic Research, Inc.
  17. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
  18. Kollmann, Robert, 2005. "Macroeconomic effects of nominal exchange rate regimes: new insights into the role of price dynamics," Journal of International Money and Finance, Elsevier, vol. 24(2), pages 275-292, March.
  19. Jordi Gali & Tommaso Monacelli, 2005. "Optimal fiscal policy in a monetary union," Proceedings, Federal Reserve Bank of San Francisco.
  20. Riccardo Cristadoro & Andrea Gerali & Stefano Neri & Massimiliano Pisani, 2006. "Nominal Rigidities in an Estimated Two Country," Computing in Economics and Finance 2006 162, Society for Computational Economics.
  21. Campbell Leith & Simon Wren-Lewis, 2006. "The Costs of Fiscal Inflexibility - Extended," Working Papers 2005_23, Business School - Economics, University of Glasgow.
  22. Campbell Leith & Simon Wren-lewis, 2006. "The Costs of Fiscal Inflexibility," WEF Working Papers 0005, ESRC World Economy and Finance Research Programme, Birkbeck, University of London.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:oxf:wpaper:305. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Monica Birds)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.