Discussion paper

DP11198 Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets

Recent literature shows that, when international financial trade is restricted to autarky or a single bond, there are internal and external welfare trade-offs that imply optimal monetary policy, in principle, deviates from inflation targeting in order to offset real exchange rate misalignments. This paper develops a more realistic model of incomplete markets, where there is international trade in multiple assets. The analysis shows that the presence of multiple assets creates a potentially powerful interaction between monetary policy and household portfolio allocation. This interaction is, by definition, not present when there is financial autarky or a single tradeable bond and this paper shows that the interaction with portfolio allocation can imply that optimal monetary policy generates a quantitatively much more significant stabilisation of the real exchange rate gap than implied by simpler models of financial market incompleteness.

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Citation

Senay, O and A Sutherland (eds) (2016), “DP11198 Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets”, CEPR Press Discussion Paper No. 11198. https://new.cepr.org/publications/dp11198