Optimal Monetary Policy in a Regime-Switching Economy: The Response to Abrupt Shifts in Exchange Rate Dynamics

57 Pages Posted: 26 Sep 2006

See all articles by Fabrizio Zampolli

Fabrizio Zampolli

Bank for International Settlements (BIS) - Monetary and Economic Department

Date Written: June 2006

Abstract

This paper examines the trade-offs that a central bank faces when the exchange rate can experience sustained deviations from fundamentals and occasionally collapse. The economy is modelled as switching randomly between different regimes according to time-invariant transition probabilities. We compute both the optimal regime-switching control rule for this economy and optimised linear Taylor rules, in the two cases where the transition probabilities are known with certainty and where they are uncertain. The simple algorithms used in the computation are also of independent interest as tools for the study of monetary policy under general forms of (asymmetric) additive and multiplicative uncertainty. An interesting finding is that policies based on robust (minmax) values of the transition probabilities are usually more conservative.

Keywords: Monetary policy, regime-switching, uncertain probabilities

JEL Classification: C6, E5

Suggested Citation

Zampolli, Fabrizio, Optimal Monetary Policy in a Regime-Switching Economy: The Response to Abrupt Shifts in Exchange Rate Dynamics (June 2006). Bank of England Working Paper No. 297, Available at SSRN: https://ssrn.com/abstract=932564 or http://dx.doi.org/10.2139/ssrn.932564

Fabrizio Zampolli (Contact Author)

Bank for International Settlements (BIS) - Monetary and Economic Department ( email )

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