The impact of monetary policy on the exchange rate: evidence from three small open economies

This paper studies the impact effect of monetary policy shocks on the exchange rate in Australia, Canada, and New Zealand during the 1990s. Shocks are identified by the reaction of three month market interest rates to policy announcements that were not themselves endogenous to economic news on the same day. The main result is that a 100 basis point contractionary shock will appreciate the exchange rate by 2-3 percent on impact. The association of interest rate hikes with depreciations that is sometimes observed during periods of exchange market pressure is mainly attributable to reverse causality.     

Inventories and optimal monetary policy in a small open economy

We study how inventory investment affects the design of optimal monetary policy in a New Keynesian small open economy model. We find that under producer currency pricing, when the intratemporal elasticity of substitution is smaller than 1, optimal monetary policy in our model with inventories is similar to a standard model without inventories. However, when the intratemporal elasticity of substitution is larger than 1, inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories. The importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution.     

Financial globalization and monetary policy

Recent data show substantial increases in the size of gross external asset and liability positions. The implications of these developments for optimal conduct of monetary policy are analyzed in a standard open economy model which is augmented to allow for endogenous portfolio choice. The model shows that monetary policy takes on new importance due to its impact on nominal asset returns. Nevertheless, the case for price stability as an optimal monetary rule remains. In fact, it is reinforced. Even without nominal price rigidities, price stability is optimal because it enhances the risk sharing properties of nominal bonds.     

Real exchange rate persistence and monetary policy rules

The objective of this paper is to analyze the effects of alternative monetary rules on real exchange rate persistence. Using a two-country stochastic dynamic general equilibrium with nominal price stickiness and local currency pricing, we will show how the persistence of purchasing power parity deviations can be related to a monetary theory of these deviations. When monetary policy lean against the wind, there is no relationship of proportionality between the time during which prices remain sticky and the persistence of the response of the real exchange rate: in this case high nominal price rigidity is not sufficient, per se, in generating any persistence following a monetary shock. Moreover, we emphasize the role of interest rates smoothing policies and relative price stickiness within countries in understanding the relationship between the real exchange rate and monetary shocks. With reasonable parameters values, a wide range of monetary policy rules can generate real exchange rate autocorrelations around the ones observed in the data.     

International dimensions of optimal monetary policy

This paper provides a baseline general equilibrium model of optimal monetary policy among interdependent economies with monopolistic firms and nominal rigidities. An inward-looking policy of domestic price stabilization is not optimal when firms’ markups are exposed to currency fluctuations. Such a policy raises exchange rate volatility, leading foreign exporters to charge higher prices vis-à-vis increased uncertainty in the export market. As higher import prices reduce the purchasing power of domestic consumers, optimal monetary rules trade off a larger domestic output gap against lower consumer prices. Optimal rules in a world Nash equilibrium lead to less exchange rate volatility relative to both inward-looking rules and discretionary policies, even when the latter do not suffer from any inflationary (or deflationary) bias. Gains from international monetary cooperation are related in a non-monotonic way to the degree of exchange rate pass-through.     

Tracking U.S. inflation expectations with domestic and global indicators

Are foreign variables important for tracking U.S. inflation expectations? This paper estimates a reduced-form model that takes both domestic and global indicators of economic slack and inflationary pressures into account. Our main findings point towards the instability of the estimated parameters over the last four decades. In particular, global indicators appear to have played a statistically significant role in shaping forecasters’ expectations until the mid-1980s. By contrast, the U.S. monetary policy stance turns out to be relevant in the 1980s and 1990s. We relate this finding to the more aggressive monetary policy conduct implemented by the Fed since the end of the Volcker experiment.     

Designing targeting rules for international monetary policy cooperation

This study analyzes a two-country dynamic general equilibrium model with nominal rigidities, monopolistic competition and producer currency pricing. A quadratic approximation to the utility of the consumers is derived and assumed as the policy objective function of the policymakers.It is shown that only under special conditions there are no gains from cooperation and moreover that the paths of the exchange rate and prices in the constrained-efficient solution depend on the kind of disturbance that affects the economy. Despite this result, simple targeting rules that involve only targets for the growth of output and for both domestic GDP and CPI inflation rates can replicate the cooperative allocation.     

International welfare effects of monetary policy

In this paper, I examine the international welfare effects of monetary policy. I develop a New Keynesian two-country model, where central banks in both countries follow the Taylor rule. I show that a decrease in the domestic interest rate, under producer currency pricing, is a beggar-thyself policy that reduces domestic welfare and increases foreign welfare in the short term, regardless of whether the cross-country substitutability is high or low. In the medium term, it is a beggar-thy-neighbour (beggar-thyself) policy, if the Marshall-Lerner condition is satisfied (violated). Under local currency pricing, a decrease in the domestic interest rate is a beggar-thy-neighbour policy in the short term, but a beggar-thyself policy in the medium term. Both under producer and local currency pricing, a monetary expansion increases world welfare in the short term, but reduces it in the medium term.     

External shocks, U.S. monetary policy and macroeconomic fluctuations in emerging markets

Estimated structural VARs show that external shocks are an important source of macroeconomic fluctuations in emerging markets. Furthermore, U.S. monetary policy shocks affect interest rates and the exchange rate in a typical emerging market quickly and strongly. The price level and real output in a typical emerging market respond to U.S. monetary policy shocks by more than the price level and real output in the U.S. itself. These findings are consistent with the idea that “when the U.S. sneezes, emerging markets catch a cold.” At the same time, U.S. monetary policy shocks are not important for emerging markets relative to other kinds of external shocks.     

Optimal monetary policy in a small open economy with staggered wage and price contracts

We study optimal monetary policy for a small open economy in a model where both domestic prices and wages are sticky due to staggered contracts. The simultaneous presence of the two forms of nominal rigidities introduces an additional trade-off between domestic inflation and the output gap. We derive a second-order approximation to the average welfare losses that can be expressed in terms of the unconditional variances of the output gap, domestic price inflation, and wage inflation. As a consequence, the optimal policy seeks to minimize a weighted average of these variances. We analyze welfare implications of several alternative simple policy rules, and find that domestic price inflation targeting generates relatively large welfare losses, whereas CPI inflation targeting performs nearly as well as the optimal rule.     

Home bias,exchange rate disconnect,and optimal exchange rate policy

This paper examines how much the central bank should adjust the interest rate in response to real exchange rate fluctuations. The paper first demonstrates, in a two-country Dynamic Stochastic General Equilibrium (DSGE) model, that home bias in consumption is important to replicate the exchange rate volatility and exchange rate disconnect documented in the data. When home bias is high, the shock to Uncovered Interest rate Parity (UIP) can substantially drive up exchange rate volatility while leaving the volatility of real macroeconomic variables, such as GDP, almost untouched. The model predicts that the volatility of the real exchange rate relative to that of GDP increases with the extent of home bias. This relation is supported by the data. A second-order accurate solution method is employed to find the optimal operational monetary policy rule. Our model suggests that the monetary authority should not seek to vigorously stabilize exchange rate fluctuations. In particular, when the central bank does not take a strong stance against the inflation rate, exchange rate stabilization may induce substantial welfare loss. The model does not detect welfare gain from international monetary cooperation, which extends Obstfeld and Rogoff's [Obstfeld, M., Rogoff, K.,2002. Global implications of self-oriented national monetary rules, Quarterly Journal of Economics May, 503–535] findings to a DSGE model.     

The high-frequency response of exchange rates to monetary policy actions and statements

This paper investigates the impact of US monetary policy on the level and volatility of exchange rates using an event study with intraday data for five currencies (the US dollar exchange rate versus the euro, the Canadian dollar, the British pound, the Swiss franc, and the Japanese yen). I construct two indicators of news about monetary policy stemming separately from policy decisions and from balance of risk statements. Estimation results show that both policy decisions and communication have economically large and highly significant effects on the exchange rates, with the surprise component of statements accounting for most of the explainable variation in exchange rate returns in response to monetary policy. This paper also shows that exchange rates tend to absorb FOMC monetary surprises within 30-40 min from the announcement release.     

Discretionary monetary policy and inflation persistence

Rational expectations models of staggered price/wage contracts have failed to replicate the observed persistence in inflation and unemployment during disinflationary periods. The current literature on this persistency puzzle has focused on augmenting the nominal contract model with imperfect credibility and learning. In this paper, I re-examine the persistency puzzle by focusing on the discretionary nature of monetary policy. I show that when the central bank is allowed to re-optimize a quadratic loss function each period, imperfect credibility and learning, even in the absence of staggered contracts, can generate a significant amount of inflation persistence and employment losses during a disinflationary period.     

Rational expectations,changing monetary policy rules,and real exchange rate dynamics

This paper reexamines the explanatory power of Taylor rule fundamentals for real exchange rate determination. We assume the agents know the time-varying parameters in central bank policy rules. The empirical results suggest that a monetary policy rule with regime switching is better able to explain the real Deutschemark/dollar exchange rate from 1976 to 1998 compared with a fixed-regime monetary policy rule. The findings show the importance of accounting for the expectation formation effect in changing policy rules as emphasized by the Lucas critique. Ignoring these effects can undermine the value of the rational expectations models.     

Optimal monetary policy under low trend inflation

In the monetary policy literature it is common to assume that trend inflation is zero, despite overwhelming evidence that zero inflation is neither empirically relevant nor a practical objective for central bank policy. We therefore extend the standard New Keynesian model to allow for positive trend inflation, showing that even low trend inflation has strong effects on optimal monetary policy and the dynamics of inflation, output and interest rates. Under discretion, the efficient policy deteriorates and there is no guarantee of determinacy. Even with commitment, targeting non-zero trend inflation leads to substantial welfare losses. Our results serve as a warning against indiscriminate use of models assuming zero trend inflation.     

Do the ECB and the fed really need to cooperate? Optimal monetary policy in a two-country world

A two-country model with monopolistic competition and price stickiness is employed to investigate the implications for macroeconomic stability and the welfare properties of three international policy arrangements: (a) cooperative, (b) non-cooperative and (c) monetary union. I characterize the conditions under which there is scope for policy cooperation and quantify the costs of non-cooperation and monetary union. The non-cooperative equilibrium may be suboptimal because of terms of trade spillover effects, while monetary union may be suboptimal because of the sluggishness of relative prices. Both the costs of policy competition and of a monetary union are sensitive to the values assumed for the intertemporal and international demand elasticity and the degree of openness of the economy. Independently of the calibration scenario adopted, the ECB has little to gain by coordinating with the Fed.     

Unconditionally optimal monetary policy

We develop a simple and intuitive approach for analytically deriving unconditionally optimal (UO) policies, a topic of enduring interest in optimal monetary policy analysis. The approach can be employed in both general linear-quadratic problems and in the underlying non-linear environments. A detailed example is provided using a canonical New Keynesian framework.     

Optimal monetary policy with durable consumption goods

We document that the durable goods sector is much more interest-sensitive than the nondurables sector, and then investigate the implications of these sectoral differences for monetary policy. We formulate a two-sector general equilibrium model that is calibrated both to match the sectoral responses to a monetary shock derived from our empirical VAR and to imply an empirically realistic degree of sectoral output volatility and comovement. While the social welfare function involves sector-specific output gaps and inflation rates, the performance of the optimal policy rule can be closely approximated by a simple rule that targets a weighted average of aggregate wage and price inflation. In contrast, a rule that stabilizes a more narrow measure of final goods price inflation performs poorly in terms of social welfare.     

Implications of habit formation for optimal monetary policy

We study the implications for optimal monetary policy of introducing habit formation in consumption into a general equilibrium model with sticky prices. Habit formation affects the model's endogenous dynamics through its effects on both aggregate demand and households’ supply of output. We show that the objective of monetary policy consistent with welfare maximization includes output stabilization, as well as inflation and output gap stabilization. We find that the variance of output increases under optimal policy, even though it acquires a higher implicit weight in the welfare function. We also find that a simple interest rate rule nearly achieves the welfare-optimal allocation, regardless of the degree of habit formation. In this rule, the optimal responses to inflation and the lagged interest rate are both declining in the size of the habit, although super-inertial policies remain optimal.     

Optimal monetary policy with imperfect common knowledge

This paper determines optimal nominal demand policy in a flexible price economy in which firms pay limited attention to aggregate variables. Firms’ inattentiveness gives rise to idiosyncratic information errors and imperfect common knowledge about the shocks hitting the economy. This is shown to have strong implications for optimal nominal demand policy. In particular, if firms’ prices are strategic complements and economic shocks display little persistence, monetary policy has strong real effects, making it optimal to stabilize the output gap. Weak complementarities or sufficient shock persistence, however, cause price level stabilization to become increasingly optimal. With persistent shocks, optimal monetary policy shifts from output gap stabilization in initial periods following the shock to price level stabilization in later periods, potentially rationalizing the medium-term approach to price stability adopted by some central banks.