Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-Offs

47 Pages Posted: 12 Apr 2018

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Luca Dedola

Bank of Italy; European Central Bank (ECB)

Sylvain Leduc

Government of Canada - Bank of Canada

Date Written: April 2018

Abstract

What determines the optimal monetary trade-off between internal objectives (inflation, and output gap) and external objectives (competitiveness and trade imbalances) when inefficient capital flows cause exchange rate misalignment and distort current account positions? We characterize this trade-off analytically, using the workhorse model of modern monetary theory in open economies under incomplete markets--where inefficient capital flows and exchange rate misalignments can arise independently of nominal distortions. We derive a quadratic approximation of the utility-based global policy loss function under fairly general assumptions on preferences and openness, and solve for the optimal targeting rules under co-operation. We show that, in economies with a low degree of exchange rate pass-through, the optimal response to inefficient capital inflows associated with real appreciation is contractionary, above and beyond the natural rate: the optimal policy curbs excessive demand at the cost of exacerbating currency overvaluation. In contrast, a high degree of pass-through, and/or low trade elasticities, warrants expansionary policies that lean against exchange rate appreciation and competitive losses, at the cost of inefficient inflation.

Keywords: asset markets and risk sharing, Currency misalignments, exchange rate pass-through, international policy cooperation, optimal targeting rules, trade imbalances

JEL Classification: E44, E52, E61, F41, F42

Suggested Citation

Corsetti, Giancarlo and Dedola, Luca and Leduc, Sylvain, Exchange Rate Misalignment, Capital Flows, and Optimal Monetary Policy Trade-Offs (April 2018). CEPR Discussion Paper No. DP12850, Available at SSRN: https://ssrn.com/abstract=3159153

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Luca Dedola

Bank of Italy ( email )

Via Nazionale 91
Rome, 00184
Italy

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Sylvain Leduc

Government of Canada - Bank of Canada ( email )

234 Wellington Street
Ontario, Ottawa K1A 0G9
Canada

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
0
Abstract Views
462
PlumX Metrics