Working Paper: CEPR ID: DP12850
Authors: Giancarlo Corsetti; Luca Dedola; Sylvain Leduc
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: currency misalignments; trade imbalances; asset markets and risk sharing; optimal targeting rules; international policy cooperation; exchange rate passthrough
JEL Codes: E44; E52; E61; F41; F42
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimal monetary response to inefficient capital inflows (F32) | degree of exchange rate passthrough (F31) |
| low exchange rate passthrough (F31) | contractionary monetary policy response to capital inflows (F32) |
| high exchange rate passthrough (F31) | expansionary monetary policy response to capital inflows (F32) |
| inefficient capital inflows (F21) | currency overvaluation (F31) |
| expansionary monetary policy (E52) | mitigate exchange rate appreciation (F31) |
| optimal monetary policy design (E63) | balance trade-offs of capital flows (F32) |