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Monetary Policy, Real Exchange Rate, and the Current Account in a Small Open Economy

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  • Claudio Soto

Abstract

Using a sticky price model for small open economy this paper compares the consequences of two alternative monetary policies over a set of variables. The baseline case assumes a policy rule for the Central Bank that has inflation forecast and output as a target. The alternative policy is a rule that also includes a target for the real exchange rate. The inclusion of a target for the real exchange rate in the policy reaction function of the Central Bank could be important if the monetary authority is concerned about fluctuations in the current account. The results show that the alternative policy can help to reduce the volatility of the external accounts and in some case it can also help to reduce the volatility of the output gap. However, this policy introduces more volatility in inflation and it also makes the convergence of this variable to its steady state level slower.

Suggested Citation

  • Claudio Soto, 2003. "Monetary Policy, Real Exchange Rate, and the Current Account in a Small Open Economy," Working Papers Central Bank of Chile 253, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:253
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    File URL: https://www.bcentral.cl/documents/33528/133326/DTBC_253.pdf
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    1. E.O. Svensson, Lars, 1994. "Why exchange rate bands? : Monetary independence in spite of fixed exchange rates," Journal of Monetary Economics, Elsevier, vol. 33(1), pages 157-199, February.
    2. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters, in: Monetary Policy Rules, pages 127-156, National Bureau of Economic Research, Inc.
    3. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999.
    4. Juan Pablo Medina & Rodrigo O. Valdés, 2002. "Optimal MOnetary Policy Rules when the Current Account Matters," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.),Monetary Policy: Rules and Transmission Mechanisms, edition 1, volume 4, chapter 4, pages 047-064, Central Bank of Chile.
    5. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    6. Yun, Tack, 1996. "Nominal price rigidity, money supply endogeneity, and business cycles," Journal of Monetary Economics, Elsevier, vol. 37(2-3), pages 345-370, April.
    7. Mr. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 2004/021, International Monetary Fund.
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    6. Yang Zhang & Mengling Li & Wai-Mun Chia, 2014. "Foreign interest rate shocks and exchange rate regimes in East Asia," Applied Economics, Taylor & Francis Journals, vol. 46(21), pages 2488-2501, July.
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