Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets

39 Pages Posted: 18 Apr 2016 Last revised: 17 Dec 2018

See all articles by Ozge Senay

Ozge Senay

University of St. Andrews

Alan Sutherland

University of St. Andrews - School of Management; Centre for Economic Policy Research (CEPR)

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

Senay, Ozge and Sutherland, Alan J., Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets (March 2016). CEPR Discussion Paper No. DP11198, Available at SSRN: https://ssrn.com/abstract=2766506

Ozge Senay (Contact Author)

University of St. Andrews ( email )

North St
Saint Andrews, Fife KY16 9AJ

Alan J. Sutherland

University of St. Andrews - School of Management ( email )

Castlecliffe
St. Andrews, Fife KY16 9AL
United Kingdom
+44 1334 462446 (Phone)
+44 1334 462444 (Fax)

HOME PAGE: http://www.st-and.ac.uk/~ajs10/home.html

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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