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Optimal exchange rate policy in a low interest rate environment

  • Pavasuthipaisit, Robert

This paper examines optimal exchange policy when nominal interest rates are unusually low, as experienced by several Asian economies and Japan since July 2006. The paper finds that in such environments, it is optimal to create a nominal depreciation to offset contractionary disturbances. However, the limited scope of monetary policy easing may compromise the ability of the central bank to create a nominal depreciation especially if the central bank makes decisions on monetary policy making on a discretionary basis. In order to successfully create a nominal depreciation, the central bank needs to rely on the expectations channel, by making a credible promise to keep its currency weak going forward. Finally, trade liberalization, by enhancing the role of the exchange rate channel on the transmission mechanism, may allow the central bank to achieve lower average inflation.

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File URL: http://mpra.ub.uni-muenchen.de/3596/1/MPRA_paper_3596.pdf
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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 3596.

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Date of creation: May 2007
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Handle: RePEc:pra:mprapa:3596
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  9. Lawrence Summers, 1991. "Panel discussion: price stability ; How should long-term monetary policy be determined?," Proceedings, Federal Reserve Bank of Cleveland, pages 625-631.
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  11. John B. Taylor, 2001. "The Role of the Exchange Rate in Monetary-Policy Rules," American Economic Review, American Economic Association, vol. 91(2), pages 263-267, May.
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  16. Lars E.O. Svensson, 2004. "The Magic of the Exchange Rate: Optimal Escape from a Liquidity Trap in Small and Large OPen Economies," Working Papers 072004, Hong Kong Institute for Monetary Research.
  17. Hamid Faruqee & Douglas Laxton & Bart Turtelboom & Peter Isard & Eswar Prasad, 1998. "Multimod Mark III; The Core Dynamic and Steady State Model," IMF Occasional Papers 164, International Monetary Fund.
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