The development of a simple framework with optimizing agents and nominal rigidities is the point of departure for the analysis of three questions about fiscal and monetary policies in an open economy.
The first question concerns the optimal monetary policy targets in a world with trade and financial links. In the baseline model, the optimal cooperative monetary policy is fully inward-looking and seeks to stabilize a combination of domestic inflation and output gap. The equivalence with the closed economy case, however, ends if countries do not cooperate, if firms price goods in the currency of the market of destination, and if international financial markets are incomplete. In these cases, external variables that capture international misalignments relative to the first best become relevant policy targets.
The second question is about the empirical evidence on the international transmission of government spending shocks. In response to a positive innovation, the real exchange rate depreciates and the trade balance deteriorates. Standard open economy models struggle to match this evidence. Non-standard consumption preferences and a detailed fiscal adjustment process constitute two ways to address the puzzle.
The third question deals with the trade-offs associated with an active use of fiscal policy for stabilization purposes in a currency union. The optimal policy assignment mandates the monetary authority to stabilize union-wide aggregates and the national fiscal authorities to respond to country-specific shocks. Permanent changes of government debt allow to smooth the distortionary effects of volatile taxes. Clear and credible fiscal rules may be able to strike the appropriate balance between stabilization objectives and moral hazard issues.
Article
Fiscal and Monetary Policy in Open Economy
Andrea Ferrero
Article
Foreign Exchange Intervention
Helen Popper
The practice of central bank foreign exchange intervention for a time ran ahead of either compelling theoretical explanations of its use or persuasive empirical evidence of its effectiveness. Research accelerated when the emerging economy crises of the 1990s and the early 2000s brought fresh data in the form of urgent experimentation with foreign exchange intervention and related policies, and the financial crisis of 2008 propelled serious treatment of financial frictions into models of intervention.
Current foreign exchange intervention models combine financial frictions with relevant externalities: with the aggregate demand and pecuniary externalities that inform macroeconomic models more broadly, and with the trade-related learning externalities that are particularly relevant for developing and emerging economies. These models characteristically allow for normative evaluation of the use of foreign exchange intervention, although most (but not all) do so from a single economy perspective.
Empirical advances reflect the advantages of more variation in the use of foreign exchange intervention, better data, and novel econometric approaches to addressing endogeneity. Foreign exchange intervention is now widely viewed as influencing exchange rates at least to some extent, and sustained one-sided intervention; and its corresponding reserve accumulation appear to play a role in moderating exchange rate fluctuations and in reducing the likelihood of damaging consequences of financial crises.
Key avenues for future research include sorting out which frictions and externalities matter most, and where foreign exchange intervention—and perhaps international cooperation—properly fits (if at all) into the blend of policies that might appropriately address the externalities.
