Country-Specific Risk Premium, Taylor Rules, and Exchange Rates

32 Pages Posted: 10 Nov 2010

See all articles by Barbara Annicchiarico

Barbara Annicchiarico

University of Rome, Tor Vergata - Department of Economics and Finance; University of Rome, Tor Vergata - Centre for International Studies on Economic Growth (CEIS)

Alessandro Piergallini

Tor Vergata University

Date Written: November 9, 2010

Abstract

The adoption of a Taylor-type monetary policy rule and an inflation target for emerging market economies that choose a flexible exchange rate regime is often advocated. This paper investigates the issue of exchange rate determination when interest-rate feedback rules are implemented in a continuous-time optimizing model of a small open economy facing an imperfect global capital market. It is demonstrated that when a risk premium on external debt affects the monetary policy transmission mechanism, the Taylor principle is not a necessary condition for determinacy of equilibrium. On the other hand, it is shown that exchange rate dynamics critically depends on whether monetary policy is active or passive. In terms of optimal monetary policy, it is demonstrated that the degree of responsiveness of the nominal interest rate to inflation should be related to the stock of foreign debt. Specifically, it is optimal to implement a more passive monetary policy stance in response to larger levels of the outstanding foreign-currency-denominated debt.

Keywords: Risk Premium on Foreign Debt; Taylor Rules, Exchange Rate Dynamics

JEL Classification: F31, F32, E52

Suggested Citation

Annicchiarico, Barbara and Piergallini, Alessandro, Country-Specific Risk Premium, Taylor Rules, and Exchange Rates (November 9, 2010). CEIS Working Paper No. 174. Available at SSRN: https://ssrn.com/abstract=1705945 or http://dx.doi.org/10.2139/ssrn.1705945

Barbara Annicchiarico (Contact Author)

University of Rome, Tor Vergata - Department of Economics and Finance ( email )

Rome, I-00133
Italy

University of Rome, Tor Vergata - Centre for International Studies on Economic Growth (CEIS) ( email )

Via Columbia, 2
Rome, I-00133
Italy

Alessandro Piergallini

Tor Vergata University ( email )

Via Columbia 2
Rome, Rome 00133
Italy
+390672595431 (Phone)
+39062020500 (Fax)

HOME PAGE: http://www.economia.uniroma2.it/piergallini

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