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Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-offs

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  • Corsetti, G.
  • Dedola, L.
  • Leduc, S.

Abstract

What determines the optimal monetary trade-offs 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-offs 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.

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  • Corsetti, G. & Dedola, L. & Leduc, S., 2018. "Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-offs," Cambridge Working Papers in Economics 1822, Faculty of Economics, University of Cambridge.
  • Handle: RePEc:cam:camdae:1822
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    5. Ca' Zorzi, Michele & Dedola, Luca & Georgiadis, Georgios & Jarociński, Marek & Stracca, Livio & Strasser, Georg, 2020. "Monetary policy and its transmission in a globalised world," Working Paper Series 2407, European Central Bank.
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    12. Corsetti, G. & Han, L. & Crowley, M. & Song, H., 2018. "Markets and Markups: Evidence on the Rising Market Power of Exporters from China," Cambridge Working Papers in Economics 1815, Faculty of Economics, University of Cambridge.
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    More about this item

    Keywords

    Currency misalignments; trade imbalances; asset markets and risk sharing; optimal targeting rules; international policy cooperation; exchange rate pass-through;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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