Working Paper: NBER ID: w31933
Authors: Oleg Itskhoki; Dmitry Mukhin
Abstract: We develop a general policy analysis framework for an open economy that features nominal rigidities and financial frictions giving rise to endogenous PPP and UIP deviations. The efficient allocation can be implemented with monetary policy closing the output gap and FX interventions eliminating UIP deviations. When the “natural” real exchange rate is stable, both goals can be achieved solely by monetary policy that fixes the exchange rate — an open-economy divine coincidence. More generally, optimal policy features a managed float/crawling peg complemented with FX forward guidance and macroprudential accumulation of FX reserves, in line with the “fear of floating” observed in the data. Capital controls are not necessary to achieve the frictionless allocation, but they facilitate the extraction of rents in the currency market. Constrained unilateral policies are not optimal from the global perspective, and international cooperation features a complementary use of FX interventions across countries.
Keywords: No keywords provided
JEL Codes: F30; F40; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| stable exchange rates (F31) | enhanced economic efficiency (D61) |
| FX interventions (F31) | risk-sharing capabilities of the economy (D16) |
| optimal exchange rate policy (F31) | stabilize the economy (E63) |
| capital controls (F38) | facilitate extraction of rents in the currency market (F31) |
| FX interventions (F31) | reduce welfare losses associated with UIP deviations (F16) |