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- Title
EXTERNAL SHOCKS AND MONETARY POLICY. DOES IT PAY TO RESPOND TO EXCHANGE RATE DEVIATIONS?
- Authors
CAPUTO, RODRIGO
- Abstract
There is substantial evidence suggesting that central banks in open economies react to exchange rate fluctuations, in addition to expected inflation and output. In some developing countries this reaction is comparatively larger and it is nonlinear . In an estimated structural macromodel for Chile, this paper assesses the advantages and potential costs of adopting such a reaction function. We conclude that, in the face of most of the external shocks, a policy rule that responds to exchange rate misalignments smooths inflation and output variability, while marginally increasing interest rate fluctuations. On the other hand, for some domestic innovations such a rule performs poorly. When all the shocks are considered at the same time, this rule generates important welfare gains. Finally, when the volatility of external shocks rises, increasing the response to exchange rate misalignments brings welfare improvements. In fact, a more aggressive response to the exchange rate offsets the impact that greater external volatility has on output and inflation, at the cost of inducing higher interest rate fluctuations. In this way, one can interpret the nonlinear reaction to the exchange rate as an optimal response to a more volatile external environment.
- Subjects
CHILE; MONETARY policy; FOREIGN exchange rates; INTEREST rate risk; EFFECT of inflation on the banking industry; CENTRAL banking industry; DEVELOPING countries; ECONOMICS; ECONOMIC policy
- Publication
Economic Analysis Review / Revista de Análisis Económico, 2009, Vol 24, Issue 1, p55
- ISSN
0716-5927
- Publication type
Article