Should monetary policy react to current account imbalances?

Abstract

Should monetary policy be preoccupied with large current account imbalances and extremely volatile exchange rates? Using a standard open economy model of pricing-to-market with incomplete asset markets and nominal rigidities, we show that the answer is yes. In our framework, supply shocks trigger important movements in demand via changes in wealth, which lead to large changes in current accounts and currency values, in line with the data. These substantial wealth effects also work to bring about significant departures from complete risk sharing and thus, combined with nominal rigidities, create a second distortion that pushes the economy away from the first-best allocation. We show that under cooperation, the optimal monetary policy largely corrects the distortions due to incomplete risk sharing, by reducing the shocks' wealth effects, and thus the movements in current account balances and exchange rates. In addition, we show that a simple Taylor rule that also responds to movements in the exchange rate comes close to replicating the optimal policy. Overall, our model suggests that a large current account deficit combined with an appreciating currency is a sign of excessive demand (relative to first best) and that monetary policy should be more restrictive as a result.