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UBC Theses and Dissertations

Essays on exchange rate volatility and optimal monetary policy Xu, Juanyi

Abstract

This thesis consists of three essays on exchange rate behavior and optimal monetary policy in open economy. The first essay proposes a framework to explain why the nominal and real exchange rates are highly volatile and seem to be disconnected from macroeconomic fundamentals. Two types of foreign exchange traders, rational traders and noise traders with erroneous stochastic beliefs, are introduced into a dynamic general equilibrium model with sticky prices. The presence of noise traders creates deviations from uncovered interest parity. As a result, exchange rates can diverge significantly from fundamental values. Combined with local currency pricing and consumption smoothing behavior in an infinite horizon model, the presence of noise traders can help to explain the "exchange rate disconnect puzzle". The second essay explores the optimal monetary policy response to domestic and foreign technology shocks in an open economy with vertical structure of production and trade. Through the vertical linkage in production, any stage-specific productivity shock in one country has a trans-border spillover effect on the other country via vertical trade. So when choosing the optimal monetary rules, each monetary authority should respond to both home and foreign productivity shocks. Another finding is that the flexible exchange rate can not replicate the flexible price equilibrium even under producer currency pricing due to price stickiness in multiple stages. Finally, the exchange rate in such an environment will be more stable than that of an economy without vertical structure of production and trade. The third essay analyzes the determination of monetary policy in a world with a dollar standard, defined here as an environment in which all traded goods prices are set in US dollars. This generates an asymmetry whereby exchange rate pass-through into the US CPI is zero, while pass-through to other countries will be positive. I find that in such an economy, the US is essentially indifferent to exchange rate volatility in setting monetary policy, while the rest of the world places a high weight on exchange rate volatility. More importantly, in a Nash equilibrium of the monetary policy game between the US and the rest of the world, the preferences of the US dominate. Despite this, the US loses from the dollar's role as an international currency due to the absence of exchange rate pass-through even though US preferences dominate world monetary policy.

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