Currency Misalignments and Optimal Monetary Policy: A Re-examination

This paper examines optimal monetary policy in an open-economy two-country model with sticky prices. Currency misalignments are shown to be inefficient and lower world welfare. Also, optimal policy must target not only inflation and the output gap, but also the currency misalignment. However, the interest rate reaction function that supports this targeting rule involves only the CPI inflation rate. This result illustrates how examination of ‘instrument rules’ may hide important trade-offs facing policy-makers that are incorporated in ‘targeting rules’. The model is a modified version of Clarida, Galí and Gertler’s (2002). The key change is to allow pricing to market or local-currency pricing and consider the policy implications of currency misalignments. Besides highlighting the importance of the currency misalignment, this model also gives a rationale for targeting CPI inflation, rather than producer price inflation as in Clarida, Galí and Gertler.