DP8224 | Carry Trades, Monetary Policy and Speculative Dynamics

Publication Date

01/02/2011

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Abstract

We ask when currency carry trades are associated with destabilizing dynamics in the foreign exchange market, and investigate the role of monetary policy rules in setting of such dynamics. In a model where the exchange rate has a long-term fundamental anchor, we find that carry trades can be stabilizing or destabilizing at shorter horizons, depending on the propensity of capital inflows to overheat the recipient economy. In the destabilizing case, we solve for a unique equilibrium that exhibits the classic pattern of the carry trade recipient currency appreciating for extended periods, punctuated by sharp falls.