Optimal Exchange Rate Policy and Business Cycles

Abstract

Implementation and collapse of exchange rate pegging schemes are recurrent events. A currency crisis (pegging) is often followed by an economic downturn (boom). In this essay I study why a benevolent Central Bank should pursue a monetary policy that leads to those recurrent currency crises and subsequent periods of pegging. I show that the optimal policy induces a competitive equilibrium that displays a boom in periods of below average devaluation and a recession in periods of above average devaluation. Therefore, a currency crisis (pegging) can be understood as an optimal policy answer to a recession (boom).