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Exchange rate misalignment, capital flows, and optimal monetary policy trade-offs

Corsetti, Giancarlo, Dedola, Luca and Leduc, Sylvain (2018) Exchange rate misalignment, capital flows, and optimal monetary policy trade-offs. CFM Discussion Paper Series (CFM-DP2018-06). Centre For Macroeconomics, London, UK.

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Abstract

What determines the optimal monetary trade-o§ between internal objectives (inflation, and output gap) and external objectives (competitiveness and trade imbalances) when inefficient capital flows cause exchange rate misalignment and distort current account positions? We characterize this trade-o§ analytically, using the workhorse model of modern monetary theory in open economies under incomplete markets–where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive a quadratic approximation of the utility-based global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under cooperation. We show that, in economies with a low degree of exchange rate pass-through, the optimal response to inefficient capital inflows associated with real appreciation is contractionary, above and beyond the natural rate: the optimal policy curbs excessive demand at the cost of exacerbating currency overvaluation. In contrast, a high degree of pass-through, and/or low trade elasticities, warrants expansionary policies that lean against exchange rate appreciation and competitive losses, at the cost of inefficient inflation.

Item Type: Monograph (Discussion Paper)
Official URL: http://www.centreformacroeconomics.ac.uk/Discussio...
Additional Information: © 2018 The Authors
Divisions: Centre for Macroeconomics
Subjects: H Social Sciences > HB Economic Theory
H Social Sciences > HF Commerce
JEL classification: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E44 - Financial Markets and the Macroeconomy
E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy (Targets, Instruments, and Effects)
E - Macroeconomics and Monetary Economics > E6 - Macroeconomic Policy Formation, Macroeconomic Aspects of Public Finance, Macroeconomic Policy, and General Outlook > E61 - Policy Objectives; Policy Designs and Consistency; Policy Coordination
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F41 - Open Economy Macroeconomics
F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance > F42 - International Policy Coordination and Transmission
Sets: Research centres and groups > Centre for Macroeconomics
Date Deposited: 19 Mar 2018 14:34
Last Modified: 10 Sep 2019 23:27
URI: http://eprints.lse.ac.uk/id/eprint/87290

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