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Exchange rates as an instrument of monetary policy

Author

Listed:
  • Ana Santacreu

    (INSEAD)

  • Ilian Mihov

    (INSEAD)

Abstract

We analyze, in the context of a small open economy, the welfare effects of a monetary rule in which the central bank targets the nominal exchange rate. We show that, if the uncovered interest parity (UIP) holds, this rule is equivalent to the standard Taylor rule in terms of impulse responses to exogenous shocks, the time series properties of aggregate variables, and optimal monetary rules. We then introduce endogenous deviations from the UIP condition, by modelling a time-varying risk premium that generates a wedge between the interest rate differential and the rate of exchange rate depreciation. Our aim is to show that in this case, using the change in the exchange rate might be a welfare improving policy for the central bank, because in this situation of more stable exchange rates, the risk premium is reduced. We then analyze how the volatility of the main endogenous variables behaves when this policy is followed.

Suggested Citation

  • Ana Santacreu & Ilian Mihov, 2013. "Exchange rates as an instrument of monetary policy," 2013 Meeting Papers 773, Society for Economic Dynamics.
    • Handle: RePEc:red:sed013:773
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    Cited by:

    1. Parrado, Eric, 2023. "An Exchange Rate Policy Rule," IDB Publications (Working Papers) 13347, Inter-American Development Bank.
    2. Ali, Syed Zahid & Anwar, Sajid, 2022. "Risk-premium shocks and the prudent exchange rate policy," International Review of Economics & Finance, Elsevier, vol. 77(C), pages 97-122.
    3. Boniface Pepino Yemba, 2017. "Tax and monetary policy rules in a small open economy with disaggregated government purchases," International Journal of Monetary Economics and Finance, Inderscience Enterprises Ltd, vol. 10(2), pages 144-182.
    4. Yoshino, Naoyuki & Kaji, Sahoko & Asonuma, Tamon, 2016. "Exchange rate regime switching in Malaysia and Singapore in response to China’s move to a basket peg: A DSGE analysis," Journal of Asian Economics, Elsevier, vol. 46(C), pages 17-37.
    5. International Monetary Fund, 2015. "Singapore: Staff Report for 2015 Article IV Consultation," IMF Staff Country Reports 2015/199, International Monetary Fund.
    6. Ana Maria Santacreu, 2015. "Monetary Policy in Small Open Economies: The Role of Exchange Rate Rules," Review, Federal Reserve Bank of St. Louis, vol. 97(3), pages 217-232.
    7. Peter Wilson, 2015. "Monetary Policy And Financial Sector Development," The Singapore Economic Review (SER), World Scientific Publishing Co. Pte. Ltd., vol. 60(03), pages 1-25.

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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