Welfare-based Evaluation of Real Exchange Stabilization in the Presence of News about the Future

The debate whether the nominal interest rate as the monetary policy instrument should react to the exchange rate in an open economy has continued for a long time without reaching a conclusion. One of the arguments opposing the reaction of the nominal interest rate to the exchange rate is based on its undesirable contribution to the stability of the economy. For instance, John Taylor (2001) states: "monetary-policy rules that react directly to the exchange rate, as well as to inflation and output, do not work much better in stabilizing inflation and real output and sometimes work worse than policy rules that do not react directly to the exchange rate." Such a conclusion has been reached in the setting where aggregate fluctuations are driven only by contemporaneous shocks, but news shocks about future economic conditions have recently been explored as the driving force of boom-bust business cycles (among others, Beaudry and Portier (2004) and Jaimovich and Rebelo (2008 and 2009)).When prices of consumption goods across countries are sticky in the local currency, the consumption-based real exchange rate moves closely with the nominal exchange rate whose movements reflect changes in expectations of future fundamentals caused by news about the future. Consequently, the movement of the real exchange rate can correctly inform the monetary policy authority of the impact of news shocks on the economy. This might be a rationale for real exchange rate stabilization as a goal of the monetary policy so as to eliminate the undesirable effects of news shocks about the future on the current economy.In this paper, I develop a two-country open economy Dynamic Stochastic General Equilibrium (DSGE) model in which both contemporaneous and news innovations to the technology level are incorporated and the monetary policy is modeled as an interest rate feedback rule. Then, I perform the welfare-based policy evaluation of real exchange rate stabilization.In the economy with sticky prices only, I show that the optimal policy rule requires real exchange rate stabilization as well as strong stance against inflation while it does not require reaction to the real exchange rate in the absence of news shocks. When both sticky wages and prices are taken into account, the inflation-targeting policy alone amplifies the response of the economy to news shocks, creating a large welfare loss. In this case, either real exchange rate stabilization or output gap stabilization is needed to prevent the economy from overreacting to news shocks. Under the optimal policy rule, however, the role of real exchange rate stabilization in dampening the impact of news shocks is dominated by output gap stabilization because the movement of the output gap is more informative about the impact of news shocks. This implies that if output gap is taken into account by the monetary policy authority, its reaction to the exchange rate is not necessary in the presence of news shocks.