Working Paper: CEPR ID: DP3431
Authors: Alan Sutherland
Abstract: This Paper considers the implications of incomplete exchange rate pass-through for optimal monetary and exchange rate policy. A two-country model is presented which allows an explicit derivation of welfare functions in terms of a weighted sum of the second moments of producer prices and the nominal exchange rate. From a single country perspective the optimal exchange rate variance depends on the degree of pass-through, the size and openness of the economy, the elasticity of labour supply and the volatility of foreign producer prices. The optimal coordinated equilibrium can be supported by requiring national central banks to minimize loss functions, which are a weighted sum of the variances of producer prices and the exchange rate, where the weight on the exchange rate variance depends on the degree of pass-through.
Keywords: exchange rate variability; monetary policy; passthrough
JEL Codes: E52; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| complete pass-through (Y20) | zero weight on exchange rate variance (F31) |
| incomplete pass-through (D52) | consider exchange rate volatility in optimal monetary policy (F31) |
| elastic labor supply and stabilizing foreign monetary policy (E63) | home welfare decreases with increased exchange rate volatility (F31) |
| inelastic labor supply (J22) | home welfare increases with greater exchange rate volatility (F31) |
| exchange rate volatility (F31) | optimal monetary policy varies (E63) |
| degree of pass-through (H22) | weight on exchange rate variance in welfare function (F31) |