External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?

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, th...

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Autor principal:	Caputo,Rodrigo
Lenguaje:	English
Publicado:	ILADES. Universidad Alberto Hurtado. 2009
Materias:	Small Open Economy Optimal Monetary Policy Taylor Rules Exchange Rate
Acceso en línea:	http://www.scielo.cl/scielo.php?script=sci_arttext&pid=S0718-88702009000100004
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spelling	oai:scielo:S0718-887020090001000042011-08-29External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?Caputo,Rodrigo Small Open Economy Optimal Monetary Policy Taylor Rules Exchange Rate 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.info:eu-repo/semantics/openAccessILADES. Universidad Alberto Hurtado.Revista de análisis económico v.24 n.1 20092009-06-01text/htmlhttp://www.scielo.cl/scielo.php?script=sci_arttext&pid=S0718-88702009000100004en10.4067/S0718-88702009000100004
institution	Scielo Chile
collection	Scielo Chile
language	English
topic	Small Open Economy Optimal Monetary Policy Taylor Rules Exchange Rate
spellingShingle	Small Open Economy Optimal Monetary Policy Taylor Rules Exchange Rate Caputo,Rodrigo External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
description	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.
author	Caputo,Rodrigo
author_facet	Caputo,Rodrigo
author_sort	Caputo,Rodrigo
title	External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
title_short	External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
title_full	External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
title_fullStr	External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
title_full_unstemmed	External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?
title_sort	external shocks and monetary policy: does it pay to respond to exchange rate deviations?
publisher	ILADES. Universidad Alberto Hurtado.
publishDate	2009
url	http://www.scielo.cl/scielo.php?script=sci_arttext&pid=S0718-88702009000100004
work_keys_str_mv	AT caputorodrigo externalshocksandmonetarypolicydoesitpaytorespondtoexchangeratedeviations
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External Shocks and Monetary Policy: Does it Pay to Respond to Exchange Rate Deviations?

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