Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets
39 Pages Posted: 18 Apr 2016 Last revised: 17 Dec 2018
Date Written: March 2016
Abstract
Recent literature shows that, when international financial trade is restricted to autarky or a single bond, there are internal and external welfare trade-offs that imply optimal monetary policy, in principle, deviates from inflation targeting in order to offset real exchange rate misalignments. This paper develops a more realistic model of incomplete markets, where there is international trade in multiple assets. The analysis shows that the presence of multiple assets creates a potentially powerful interaction between monetary policy and household portfolio allocation. This interaction is, by definition, not present when there is financial autarky or a single tradeable bond and this paper shows that the interaction with portfolio allocation can imply that optimal monetary policy generates a quantitatively much more significant stabilisation of the real exchange rate gap than implied by simpler models of financial market incompleteness.
Keywords: Country portfolios, Financial market structure, Optimal monetary policy
JEL Classification: E52, E58, F41
Suggested Citation: Suggested Citation