Optimal monetary policy, exchange rate misalignments and incomplete financial markets

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    Abstract

    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.
    Original languageEnglish
    Pages (from-to)196-208
    Number of pages13
    JournalJournal of International Economics
    Volume117
    Early online date27 Dec 2018
    DOIs
    Publication statusPublished - Mar 2019

    Keywords

    • Optimal monetary policy
    • Financial market structure
    • Country Portfolios

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