Currency Misalignments and Optimal Monetary Policy: A Reexamination

This paper examines optimal monetary policy in an open-economy two-country model with sticky prices. We find that optimal policy must target not only inflation and the output gap, but also the currency misalignment. However the interest rate reaction function that supports this targeting rule involves only the CPI inflation rate. This result highlights how examination of interest-rate reaction functions may hide important trade-offs facing policymakers. The loss from ignoring the currency misalignment can be large when countries are very open. The model is a modified version of Clarida, Gali, and Gertler’s (JME, 2002). The key change is that we allow local-currency pricing and consider the policy implications of currency misalignments. Email: [email protected]. Address: Department of Economics, 1080 Observatory Drive, Madison, WI, 53706-1393. I am indebted very much to Mick Devereux, Jon Faust, Lars Svensson and Mike Woodford for comments and suggestions that motivated this work. USC FBE DEPT. MACROECONOMICS presented by Charles Engel FRIDAY, Nov. 21, 2008 3:30 pm – 5:00 pm, Room: HOH-302 & INTERNATIONAL FINANCE WORKSHOP