External Shocks and Monetary Policy: Does It Pay to Respond to Exchange Rate Deviations?
affiliation not provided to SSRN
June 1, 2009
Revista de Análisis Económico - Economic Analysis Review, Vol. 24, No. 1, 2009
There is substantial evidence suggesting that central banks in open economies react to exchange rate fluctuations, in addition to expected inflation and output. In some developing countries this reaction is comparatively larger and it is nonlinear. In an estimated structural macromodel for Chile, this paper assesses the advantages and potential costs of adopting such a reaction function. We conclude that, in the face of most of the external shocks, a policy rule that responds to exchange rate misalignments smooths inflation and output variability, while marginally increasing interest rate fluctuations. On the other hand, for some domestic innovations such a rule performs poorly. When all the shocks are considered at the same time, this rule generates important welfare gains. Finally, when the volatility of external shocks rises, increasing the response to exchange rate misalignments brings welfare improvements. In fact, a more aggressive response to the exchange rate offsets the impact that greater external volatility has on output and inflation, at the cost of inducing higher interest rate fluctuations. In this way, one can interpret the nonlinear reaction to the exchange rate as an optimal response to a more volatile external environment.
Number of Pages in PDF File: 46
Keywords: Small Open Economy, Optimal Monetary Policy, Taylor Rules, Exchange Rate
JEL Classification: E52, E53Accepted Paper Series
Date posted: July 8, 2009
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