Exchange Rates, Monetary Policy, and Trade Policy

University Of Wisconsin-Madison, Madison WI

Investigators

Abstract

The proposal has three parts. The first examines real exchange rate behavior in sticky-price DSGE open-economy models. In particular, the research proposes to uncover the general attributes of models in which exchange rates react strongly to news about future fundamentals. In these models, the real exchange rate can be solved as a present value of current and expected future disturbances, real and monetary. In some standard models, however, when policy stabilizes inflation, the weight on future expected fundamentals is low. Models in which the real exchange rate is not the sole determinant of relative inflation rates across countries appear to allow scope for expected future fundamentals to influence exchange rates in a way that is consistent with empirical findings. The second part of the research will analyze optimal monetary policy when the exchange rate is forward looking. In particular, it will ask whether standard inflation-targeting prescriptions are optimal, or nearly so, in an environment in which real exchange rates react strongly to news. The third part of the proposal is to examine tariffs and trade policy under sticky nominal prices. It will address the positive effects of tariffs under different assumptions of how nominal prices are set. The proposed research will address the sense in which exchange-rate policy is analogous to protectionist trade policies. It will also examine optimal tariff policy under sticky prices. The three major areas of proposed work all involve applied general equilibrium modeling of open economies and are motivated by empirical work. Any work such as this will ultimately have broader impact in terms of promoting better understanding of the workings of the macroeconomy, and hence better policy making. The second and third parts of the proposal are directly related to policy questions, examining monetary policy and trade policy in economies with sticky nominal prices.