The Role of Exchange Rate in Monetary Policy Rules: A Welfare-Based Re-Examination

Abstract

Should monetary policy rule stabilize the exchange rate? In contrast to the conclusion from the optimal open-economy monetary policy literature, this papers show analytically, in a standard two-country new Keynesian model, that under monetary shocks and UIP shocks, stabilizing exchange rate in addition to standard inflation targeting can be welfare-improving. Thus, desirability of exchange rate stabilization critically depends on the relative magnitude of nominal and financial shocks, compared with those of demand shocks. Our quantitative analysis shows that exchange rate stabilization improves welfare at low values of exchange rate targeting strength, but too strong a response reverses the effect. The potential welfare gain from optimal exchange rate stabilization is sizable, but international cooperation in the sense of mutual willingness to stabilize the exchange rate is required to fully reap the gain.