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Giancarlo Corsetti

25 September 2023

WORKING PAPER SERIES - No. 2844

Abstract: We study a model in which policy aims at aggregate price stability. A fiscal imbalance materializes that, if uncorrected, must cause inflation, but the imbalance may get corrected in the future with some probability. By maintaining price stability in the near term, monetary policy can buy time for a correction to take place. The policy gamble may succeed, preserving price and fiscal stability, or fail, leading to a delayed, possibly large jump in the price level. The resulting dynamics resemble the models of a currency crisis following Krugman (1979) and Obstfeld (1986). Like in Obstfeld’s work, multiple equilibria arise naturally: whether or not price stability is preserved may depend on private agents’ expectations. The model can be reinterpreted as a model of partial default on public debt, in which case it is reminiscent of Calvo (1988).
JEL Code: E31 : Macroeconomics and Monetary Economics→Prices, Business Fluctuations, and Cycles→Price Level, Inflation, Deflation
F31 : International Economics→International Finance→Foreign Exchange
F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics

25 August 2023

WORKING PAPER SERIES - No. 2843

Abstract: How should monetary policy respond to excessive capital in•ows that appreciate the currency and widen the external de•cit? Using the workhorse two-country open-macro model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, and solve for the optimal targeting rules under cooperation. The optimal monetary stance is expansionary if the exchange rate pass-through (ERPT) on import prices is complete, contractionary if nominal rigidities attenuate ERPT. Excessive capital in•ows, however, may lead to currency undervaluation instead of overvaluation for some parameter values. The optimal stance is then invariably expansionary to support domestic demand.
JEL Code: E44 : Macroeconomics and Monetary Economics→Money and Interest Rates→Financial Markets and the Macroeconomy
E52 : Macroeconomics and Monetary Economics→Monetary Policy, Central Banking, and the Supply of Money and Credit→Monetary Policy
E61 : Macroeconomics and Monetary Economics→Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook→Policy Objectives, Policy Designs and Consistency, Policy Coordination
F41 : International Economics→Macroeconomic Aspects of International Trade and Finance→Open Economy Macroeconomics
F42 : International Economics→Macroeconomic Aspects of International Trade and Finance→International Policy Coordination and Transmission