DP2886 | Foreign Exchange Intervention, Policy Objectives and Macroeconomic Stability

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17/07/2001

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Abstract

Within a simple model of monetary policy for an open economy, we study how foreign exchange intervention may be used to condition agents' beliefs of the objectives of the policymakers. Differently from cheap talk foreign exchange intervention guarantees a unique equilibrium. Foreign exchange intervention does not bring about a systematic policy gain, such as an increase in employment or a reduction in the inflationary bias. It can, however, stabilise the national economy, for it drastically reduces the fluctuations of employment and output. Foreign exchange intervention is profitable, but a trade-off exists between these profits and the stability gain it brings about. Finally, an important normative conclusion of our analysis is that foreign exchange intervention and monetary policy should be kept separated, in that a larger stability gain is obtained when these two instruments of policy making are under the control of different governmental agencies.