Optimal monetary policy, exchange rate misalignments and incomplete financial markets
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.
Citation
Senay , O & Sutherland , A J 2019 , ' Optimal monetary policy, exchange rate misalignments and incomplete financial markets ' , Journal of International Economics , vol. 117 , pp. 196-208 . https://doi.org/10.1016/j.jinteco.2018.12.001
Publication
Journal of International Economics
Status
Peer reviewed
ISSN
0022-1996Type
Journal article
Description
This research is supported by ESRC Award Number ES/I024174/1.Collections
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