Globalisation, Pass-through and the Optimal Policy Response to Exchange Rates
In this paper we examine how monetary policy should respond to nominal exchange rates in a New Keynesian open economy model that allows for a non-trivial role for sterilised intervention. The paper develops the argument against the backdrop of the evolving policy-making environment of Asian economies. Sterilised intervention can be a potent tool that offers policymakers an additional degree of freedom in maximising global welfare. We show that the gains to sterilised intervention are greater when goods market integration is low and exchange rate pass-through is high. However, increased financial internationalisation reduces the effectiveness of sterilised intervention, as the international policy trilemma becomes more relevant. Unsterilised intervention may also have a role to play, although the potential welfare gains from this are generally smaller.
Most central banks in Asia have actively used sterilised foreign exchange intervention as a policy tool to smooth exchange rates. But, over time, declining exchange rate pass-through and the increasing international integration of financial and goods markets will tend to reduce the efficacy of sterilised intervention. Given the limited effectiveness of unsterilised intervention, our model implies that the role of exchange rate movements in the optimal setting of monetary policy in Asia is decreasing.
University of British Columbia, Vancouver, BC V6T 1Z1, Canada and Bank for International Settlements, 78th Floor, Two IFC, 8 Finance Street, Central, Hong Kong. The opinions in this paper are those of the authors are not necessarily shared by the Bank for International Settlements. We thank Lillie Lam, Pablo Garcia-Luna, Giovanni Sgro and Bat-el Berger for excellent research assistance and Aaron Mehrotra, Ippei Fujiwara and participants of seminars at the Reserve Bank of Australia and University of Canterbury and conferences hosted by the People's Bank of China-BIS, Reserve Bank of New Zealand and City University of Hong Kong-JIMF for helpful comments. Any remaining errors are solely our responsibility. This research was partly supported by ESRC research grant RES-062-23-3080. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
Devereux, Michael B. & Yetman, James, 2014. "Globalisation, pass-through and the optimal policy response to exchange rates," Journal of International Money and Finance, Elsevier, vol. 49(PA), pages 104-128. citation courtesy of