Exchange rate misalignment and external imbalances : what is the optimal monetary policy response?

Abstract

How should monetary policy respond to excessive capital in‡ows that appreciate the currency, widen the external de…cit and cause overheating? Using the workhorse open-macro model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, and solve for the optimal targeting rules under cooperation. The optimal monetary stance is expansionary if the exchange rate pass-through (ERPT) on import prices is complete, contractionary if nominal rigidities reduce the ERPT. Excessive capital in‡ows, however, may lead to currency undervaluation instead of overvaluation for some parameter values. The optimal stance is then invariably expansionary to support domestic demand.