DP11198 | Optimal Monetary Policy, Exchange Rate Misalignments and Incomplete Financial Markets

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Recent literature on monetary policy shows that, when international financial trade is restricted to a single non-contingent bond, there are significant trade-offs that prevent optimal policy from simultaneously closing all internal and external welfare gaps. Optimal policy therefore deviates from inflation targeting in order to offset real exchange rate misalignments. These simple models are, however, not good representations of modern financial markets. This paper develops a more realistic two-country model of incomplete markets, where there is international trade in nominal bonds denominated in the currencies of the two countries and equity claims on profit streams in the two countries. The analysis shows that the welfare benefits of optimal policy relative to inflation targeting are quantitatively smaller than found in simpler models of financial incompleteness. It is nevertheless found that optimal policy implies quantitatively significant stabilisation of the real exchange rate gap and trade balance gap compared to inflation targeting.