Journal article
Risk-premium shocks and the prudent exchange rate policy
International Review of Economics & Finance, Vol.77, pp.97-122
2022
Abstract
Using a medium-size New Keynesian open economy model, we examine the issue of a prudent exchange rate policy when the economy encounters an adverse risk-premium shock. We show that the shock leads to terms of trade (ToT) deterioration and an increase in both the aggregate output and inflation. While examining the choice of an appropriate exchange rate policy to deal with the effects of the shock, analytical results of our baseline model show that neither a fully flexible nor a fully pegged exchange rate policy can yield the desired outcome. In the absence of the supply-side effects of ToT and a cost channel of monetary policy, a managed exchange rate policy can stabilize both domestic inflation and aggregate output. However, in the presence of either a cost channel of monetary policy or supply-side effects of the ToT or both, the central bank faces a trade-off between aggregate output and domestic inflation stabilization. We find that the presence of a cost channel of monetary policy gives rise to a pro-cyclical exchange rate policy. Simulation of a more general model suggests that, instead of using the conventional Taylor rule, the central bank should follow a ToT-augmented Taylor rule, which involves further monetary tightening as the ToT deteriorates. We find that the need for monetary tightening is linked to both the nominal and real rigidities in economy, which gives rise to increased exchange rate volatility. We also briefly consider the case of a productivity shock.
Details
- Title
- Risk-premium shocks and the prudent exchange rate policy
- Authors
- Syed Zahid Ali (Author) - Lahore University of Management SciencesSajid Anwar (Author) - University of the Sunshine Coast, Queensland, School of Business and Creative Industries
- Publication details
- International Review of Economics & Finance, Vol.77, pp.97-122
- Publisher
- Elsevier BV
- DOI
- 10.1016/j.iref.2021.08.004
- ISSN
- 1873-8036
- Copyright note
- Copyright © 2021. This manuscript version is made available under the CC-BY-NC-ND 4.0 license http://creativecommons.org/licenses/by-nc-nd/4.0/
- Organisation Unit
- Indigenous and Transcultural Research Centre; School of Business and Creative Industries; University of the Sunshine Coast, Queensland
- Language
- English
- Record Identifier
- 99564008302621
- Output Type
- Journal article
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