RDP 2009-01: Currency Misalignments and Optimal Monetary Policy: A Re-examination 10. Conclusions

Policy-makers do not in general adhere to simple interest rate reaction functions. Instead, as Svensson (1999, 2002) has argued, they set targets for key economic variables. It has generally been believed, especially in light of CGG, that the key trade-offs in an open economy are the same as in a closed economy. That is, policy-makers should target a linear combination of inflation and the output gap. This paper shows that in fact, with a model that is rich enough to allow for currency misalignments, the trade-offs should involve not only inflation and the output gap but also the exchange rate misalignment. However, the interest rate reaction function that supports this policy has the nominal interest rate reacting only to CPI inflation.

The paper derives the policy-maker's loss function when there is home bias in consumption and deviations from the law of one price. The loss function does depend on the structure of the model, of course, but not on the specific nature of price setting. Currency misalignments may arise in some approaches for reasons other than LCP. For example, there may be nominal wage stickiness but imperfect pass-through that arises from strategic behaviour by firms as in the models of Atkeson and Burstein (2007, 2008) or Corsetti et al (forthcoming). Future work can still make use of the loss function derived here, or at least of the steps used in deriving the loss function.

The objective of this paper is to introduce LCP into a familiar and popular framework for monetary policy analysis. But the CGG model does not produce empirical outcomes that are especially plausible, even with the addition of LCP. In the model, if output gaps are eliminated, the reason a currency misalignment is inefficient is because consumption goods are misallocated between home and foreign households. In a richer framework, even with LCP as the source of currency misalignments, there are other potential misallocations that can occur when exchange rates are out of line. For example, an overvalued currency would lead to a movement in resources away from the traded sector to the non-traded sector. Or if countries import oil from the outside, a misaligned currency affects the real cost of oil in one importing country relative to the other.

Future work should also consider the difficult issue of policy-making in this environment when there is not cooperation. A separate but related issue is a closer examination of who bears the burden of currency misalignments. If a currency is overvalued, does it hurt consumers in one country more than another, both under optimal and sub-optimal policy?

While rich models that can be estimated and analysed numerically offer valuable insights, they seem to provide inadequate guidance to policy-makers for how they should react to exchange rate movements. Perhaps more basic work on simple models such as the one presented here, in concert with quantitative exploration of more detailed models, can be productive.