Exchange Rate Policies at the Zero Lower Bound (with Manuel Amador, Javier Bianchi and Luigi Bocola)< /p>
Abstract:
This paper studies how t
he Central Bank of a small open economy achieves an exchange rate objective
in an environment that features a zero lower bound (ZLB) constraint on nom
inal interest rates and limits to arbitrage in international capital market
s. 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 internation
al finance. However, if the nominal interest rate consistent with interest
rate parity is negative, the pursue of an exchange rate objective necessari
ly results in zero nominal interest rates, deviations from interest rate pa
rity, capital inflows, and welfare costs associated to the accumulation of
foreign reserves by the Central Bank. In this ZLB environment, reductions i
n the foreign interest rates, increases in financial integration and expect
ational mistakes by private agents unambiguously reduce welfare, the opposi
te of what happens when interest rates are positive. Negative nominal inter
est rates help the Central Bank by restoring interest rate parity and hinde
ring the capital flows. Our framework also provides a simple tool to measur
e the losses by Central Banks that have accumulated large amounts of foreig
n reserves while pursuing exchange rate policies.