Two papers on exchange rate policy

FX Intervention in the New Keynesian Model

By Zineddine Alla, Raphael A Espinoza and Atish R. Ghosh

http://d.repec.org/n?u=RePEc:imf:imfwpa:17/207&r=dge

We develop an open economy New Keynesian Model with foreign exchange intervention in the presence of a financial accelerator mechanism. We obtain closed-form solutions for the optimal interest rate policy and FX intervention under discretionary policy, in the face of shocks to risk appetite in international capital markets. The solution shows that FX intervention can help reduce the volatility of the economy and mitigate the welfare losses associated with such shocks. We also show that, when the financial accelerator is strong, the risk of multiple equilibria (self-fulfilling currency and inflation movements) is high. We determine the conditions under which indeterminacy can occur and highlight how the use of FX intervention reinforces the central bank’s credibility and limits the risk of multiple equilibria.

The Exchange Rate as an Instrument of Monetary Policy

By Jonas Heipertz, Ilian Mihov and Ana Maria Santacreu

http://d.repec.org/n?u=RePEc:fip:fedlwp:2017-028&r=dge

Monetary policy research in small open economies has typically focused on “corner solutions”: either the currency rate is fixed by the central bank, or it is left to be determined by market forces. We build an open-economy model with external habits to study the properties of a new class of monetary policy rules in which the monetary authority uses the exchange rate as the instrument. Different from a Taylor rule, the monetary authority announces the rate of expected currency appreciation by taking into account inflation and output fluctuations. We find that the exchange rate rule outperforms a standard Taylor rule in terms of welfare, regardless of the policy parameter values. The differences are driven by: (i) the behavior of the nominal exchange rate and interest rates under each rule, and (ii) deviations from UIP due to a time-varying risk premium.

Lately, interesting papers seem to come in pairs in the weekly NEP-DGE reports. This time they are about exchange rate policy. The first one highlights that it can help with indeterminacy and multiplicity in monetary economies, and the second one shows that an optimal policy is mightily interesting and is not a corner solution.

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