Optimal monetary policy under heterogeneity in currency trade

Abstract

PurposeQuestionnaire surveys made at currency markets around the world reveal that currency trade to a large extent not only is determined by an economy's performance or expected performance. Indeed, a fraction is guided by technical trading, which means that past exchange rates are assumed to provide information about future exchange rate movements. The purpose of this paper is to ask how a successful monetary policy should be designed when technical trading in the form of trend following is used in currency trading.Design/methodology/approachThe paper embeds an optimal policy rule into Galí and Monacelli's dynamic stochastic general equilibrium (DSGE) model for a small open economy, which is augmented with trend following in currency trading, to examine the prerequisites for a successful monetary policy. Specifically, the conditions for a determinate rational expectations equilibrium (REE) that also is stable under least squares learning are in focus. The paper also computes impulse‐response functions for key variables to study how the economy returns to steady state after being hit by a shock.FindingsThe paper finds that a determinate REE that also is stable under least squares learning often is the outcome when there is a limited amount of trend following in currency trading, but that a more flexible inflation rate targeting in monetary policy sometimes cause an indeterminate REE in the economy. Thus, strict, or almost strict, inflation rate targeting in monetary policy is recommended also when there is technical trading in currency trading and not only when all currency trading is guided by fundamental analysis (in the form of rational expectations). This result is a new result in the literature.Originality/valueThere are already models in the literature on monetary policy design that incorporate technical trading in currency trading into an otherwise standard DSGE model. There is also a huge amount of DSGE models in the literature in which monetary policy is optimal. However, the model in this paper is the first model, to the best of the author's knowledge, where technical trading in currency trading and optimal monetary policy are combined in the same DSGE model.