Optimal monetary policy, exchange rate misalignments and incomplete financial markets
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Recent literature on monetary policy in open economies shows that, when international financial trade is restricted to a single non-contingent bond, there are significant internal and external trade-offs that prevent optimal policy from simultaneously closing all welfare gaps. This implies an optimal policy which deviates from inflation targeting in order to offset real exchange rate misalignments. These simple models are, however, not good representations of modern financial markets. This paper therefore develops a more general and realistic two-country model of incomplete markets, where, in the presence of a wide range of stochastic shocks, there is international trade in nominal bonds denominated in the currencies of the two countries and equity claims on profit streams in the two countries. The analysis shows that, as in the recent literature, optimal policy deviates from inflation targeting in order to offset exchange rate misalignments, but the welfare benefits of optimal policy relative to inflation targeting are quantitatively smaller than found in simpler models of financial incompleteness. It is nevertheless found that optimal policy implies quantitatively significant stabilisation of the real exchange rate gap and trade balance gap compared to inflation targeting.
Senay , O & Sutherland , A J 2016 ' Optimal monetary policy, exchange rate misalignments and incomplete financial markets ' School of Economics & Finance Discussion Paper , no. 1603 , University of St Andrews , St Andrews , pp. 1-29 .
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(c) Copyright 2016, the authors
DescriptionThis research is supported by ESRC award number ES/I024174/1.
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