Monetary Policy in an Equilibrium Portfolio Balance Model

Author/Editor:

Michael Kumhof ; Stijn van Nieuwerburgh

Publication Date:

March 1, 2007

Electronic Access:

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Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary:

Standard theory shows that sterilized foreign exchange interventions do not affect equilibrium prices and quantities, and that domestic and foreign currency denominated bonds are perfect substitutes. This paper shows that when fiscal policy is not sufficiently flexible in response to spending shocks, perfect substitutability breaks down and uncovered interest rate parity no longer holds. Government balance sheet operations can be used as an independent policy instrument to target interest rates. Sterilized foreign exchange interventions should be most effective in developing countries, where fiscal volatility is large and where the fraction of domestic currency denominated government liabilities is small.

Series:

Working Paper No. 07/72

Subject:

English

Publication Date:

March 1, 2007

ISBN/ISSN:

9781451866360/1018-5941

Stock No:

WPIEA2007072

Format:

Paper

Pages:

31

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