Lunch Seminar: Fabrizio Perri - Federal Reserve Bank of Minneapolis
2016-07-25 13:00 - 14:00 UTC
Exchange Rate Policies at the Zero Lower Bound (with Manuel Amador, Javier Bianchi and Luigi Bocola)
Abstract:
This paper studies how the Central Bank of a small open economy achieves an exchange rate objective in an environment that features a zero lower bound (ZLB) constraint on nominal interest rates and limits to arbitrage in international capital markets. If the nominal interest rate that is consistent with interest parity is positive, the Central Bank can achieve its exchange rate objectives at the cost of losing its monetary independence, a well know result in international finance. However, if the nominal interest rate consistent with interest rate parity is negative, the pursue of an exchange rate objective necessarily results in zero nominal interest rates, deviations from interest rate parity, capital inflows, and welfare costs associated to the accumulation of foreign reserves by the Central Bank. In this ZLB environment, reductions in the foreign interest rates, increases in financial integration and expectational mistakes by private agents unambiguously reduce welfare, the opposite of what happens when interest rates are positive. Negative nominal interest rates help the Central Bank by restoring interest rate parity and hindering the capital flows. Our framework also provides a simple tool to measure the losses by Central Banks that have accumulated large amounts of foreign reserves while pursuing exchange rate policies.
