The Role of the Exchange Rate in Monetary-Policy Rules

Abstract

For country that chooses not to permanently fix its exchange rate through currency board, or common currency, or some kind of dollarization, only alternative monetary policy that can work well in long run is one based on trinity of (i) flexible exchange rate, (ii) an inflation target, and (iii) monetary policy rule.' While not often put into this threepart format, desirability of such monetary policy in an open economy is, in my view, clear implication of three corresponding strands of recent monetary research: (i) research on fixed-exchange-rates regimes, including influential 1995 article The Mirage of Fixed Exchange Rates by Maurice Obstfeld and Kenneth Rogoff and many analyses of breakdown of fixed-exchange-rate regimes in late 1990's; (ii) research on practical success with inflation targeting by Ben Bernanke et al. (1999); and (iii) research on benefits of simple monetary-policy rules (see e.g., Taylor, 1999a). This clear policy implication, however, does not end debate about how exchange rates should be taken into account in formulating monetary policy. Even if one excludes capital controls and sterilized exchange-market intervention from consideration because they are not effective or attractive ways to de-link exchangerate movements from domestic interest rate, crucial question remains: How should instruments of monetary policy (the interest rate or monetary aggregate) react to exchange rate? Should policymakers avoid any reaction and focus instead on domestic indicators such as inflation and real GDP? Or is the rule of thumb that a appreciation of real exchange rate . .. furnishes prima facie case for relaxing monetary policy, as characterized by Obstfeld and Rogoff (1995, p. 93), better monetary policy rule? Or perhaps policymakers should heed Obstfeld-Rogoff warning that substantial departures from PPP [purchasing-power parity], in short run and even over decades make such policy reaction to exchange rate undesirable. More generally, if one accepts trinity concept of monetary policy in an open economy, then what is role of exchange rate in monetarypolicy rule?