Abstract

Abstract This paper builds a DSGE model for a small open economy (SOE) in which the central bank intervenes the domestic currency bond and FX markets using two policy rules: a Taylortype rule and a rule that determines the rate of nominal depreciation. The 2 ‘corner’ regimes, in which only one policy rule is used, are particular cases. The model is calibrated and implemented in Dynare for simple and optimal simple policy rules, and optimal policy under commitment. Numerical losses are obtained for ad-hoc loss functions for different sets of central bank preferences. The results show that the losses are lower when both policy rules are used. This is due to the central bank’s enhanced ability, when it uses the two policy rules, to influence private capital flows through the effects of its actions on the endogenous risk premium in the risk-adjusted uncovered interest parity equation.

Highlights

  • According to John Williamsonthe overwhelming conventional view in the profession is that it is a mistake to try to manage exchange rates' (Williamson 2007), he does not subscribe this view

  • This paper tries to bridge the gap between the fact that many central banks systematically intervene both in the domestic bond market and in the foreign exchange (FX) market, and the absence of any generally accepted model for the representation and analysis of this practice

  • The alternative policy regimes are studied under simple policy rules, optimal simple policy rules, and optimal policy in a linear-quadratic optimal control framework under commitment and full information

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Summary

Introduction1

According to John Williamsonthe overwhelming conventional view in the profession is that it is a mistake to try to manage exchange rates' (Williamson 2007), he does not subscribe this view. While there is overall scal consistency (since the Treasury is assumed to be able to collect enough lump-sum taxes each period to nance its expenditures in excess of the qusi- scal surplus), the CB has a constraint each period on its two instruments (rt and bt) given by its balance sheet: etrt = mt + bt This equation implicitly de nes how much the CBsterilizes' (through the issuance of domestic currency bonds) any unwanted monetary effect of its simultaneous and systematic monetary and exchange policy. Appendix 2 shows a selection of the impulse response functions in the context of optimal policy under commitment

Households
Domestic goods rms
The nonlinear system of equations
Numerical solution in Dynare
Basic Blanchard-Kahn stability analysis
Effects of policy coef cients on the volatility of selected variables
Optimal simple rules
Optimal policy under commitment
Monetary and exchange rate policy and capital ows in the SOE
Intuition on the superiority of using two policy rules through IRFs
An extension
Some additional robustness checks
Findings
Conclusion

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