The Exchange Rate as an Instrument of Monetary Policy

Most of the theoretical research in small open economies has typically focused on corner solutions regarding the exchange rate: either the currency rate is fixed by the central bank or it is left to be freely determined by market forces. We build an open-economy model with external habits in consumption to study the properties of a new class of monetary policy rules, in which the exchange rate serves as the instrument for stabilizing business cycle fluctuations. Instead of using a short-term interest rate, the monetary authority announces a path for currency appreciation or depreciation as a reaction to fluctuations in inflation and the output gap. We find that, under a wide range of modeling assumptions, the exchange rate rule outperforms a standard Taylor rule in terms of stabilizing both output and inflation. The reduction in volatility is more pronounced for more open economies and for economies with lower sensitivity to movements in the interest rate. We show that differences between the two rules are driven by two key factors: (i) paths of the nominal exchange rate and the interest rate under each rule, and (ii) the time variation in the risk premium, which leads to deviations from uncovered interest parity.