Abstract
This paper considers optimal monetary stabilization policy under flexible exchange rates in a model where exchange rate expectations are generated regressively. The analysis highlights the intimate relationship that exists between: (a) the direction of the optimal monetary feedback rule, (b) the amount of initial overshooting of the exchange rate following an exogenous monetary expansion, (c) the subsequent speed of adjustment to the new equilibrium. The optimal policy may either involve leaning against the wind, thereby reducing the size of the initial jump and the speed of the subsequent adjustment, relative to a passive policy. Alternatively it may involve leaning with the wind, in which case both the size of the initial jump and the speed of subsequent adjustment are increased.
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