The interest rate - exchange rate nexus: exchange rate regimes and policy equilibria
Paper number: 09/04
Paper date: November 2, 2009
Paper Category: Working Paper
Christoph Himmels and Tatiana Kirsanova
We study a credible Markov-perfect monetary policy in an open New Keynesian economy with incomplete financial markets. We demonstrate the existence of two discretionary equilibria. Following a shock the economy can be stabilised either 'quickly' or 'slow', both dynamic paths satisfy conditions of optimality and time-consistency. The model can help us to understand sudden change of the interest rate and exchange rate volatility in 'tranquil' and 'volatile' regimes even under a fully credible 'soft peg' of the nominal exchange rate in developing countries.