July

The article at a glance: In this article, Naoki Yago discusses how central banks should optimally combine monetary and exchange rate stabilisation policies. Naoki completed his PhD in Economics at the University of Cambridge in 2025. He was a former PhD scholar at the Cambridge Endowment for Research in Finance. He will join the Henley Business School, University of Reading, as a Lecturer in Finance this September.

Monetary and Exchange Rate Policies in a Global Economy?

By Naoki Yago, PhD in Economics, University of Cambridge and Former CERF Scholar

Policy Mix for Inflation and Exchange Rate Stabilisation

The classical “trilemma” (Mundell 1957, Fleming 1962) suggests that, under free capital mobility, monetary authorities cannot simultaneously pursue inflation/output and exchange rate stabilisation. In a modern, financially globalised world, countries increasingly rely on unconventional policy tools to manage the capital account and insulate themselves from international spillovers of shocks and crises to preserve their monetary autonomy (Rey 2015, Kalemli-Ozkan 2019, Miranda-Agrippino and Rey 2020). In particular, foreign exchange intervention (FXI), i.e., purchases or sales of foreign currency reserves, is a popular policy tool among central banks to stabilise exchange rates.

While much of the literature focuses on a small-open economy, taking international prices as given, data shows that FXI is widely used on a global scale, even among larger emerging or even advanced economies. My recent paper studies whether monetary and exchange rate policies should respond to domestic inflation and output gap or global business cycle conditions and imbalances beyond domestic objectives.

Domestic and Global Policy Objectives

I develop a two-country model in which macroeconomic policies balance internal and external objectives. In the model, limits to arbitrage in international capital markets allow FXI to affect the exchange rate via changes in the demand and supply of bonds in different currencies (Gabaix and Maggiori 2015, Itskhoki and Mukhin 2021). The policy is cooperative in the sense that a single global social planner maximises the global welfare.

The key finding of my paper is that monetary and exchange rate policies can be jointly used to achieve a higher level of global efficiency as long as the international risk-sharing is imperfect. “Risk-sharing” implies that the exchange rate adjusts to diversify the risks to income and consumption with other countries. To put it intuitively, a positive supply shock in the home country increases consumption for home households and depreciates the home currency at the same time. This cheaper home currency decreases the import prices for foreign households and increases their consumption.

Whether this risk-sharing holds or not crucially depends on the elasticity of substitution of goods across different countries. When goods in the two countries are highly substitutable, as supported by recent literature on international trade, the exchange rate moves “too little” relative to the perfect risk-sharing allocation and has a limited role in smoothing consumption across countries.

As long as the international risk-sharing is imperfect, global demand misallocation leads to a non-trivial monetary policy trade-off between inflation and output. In this case, FXI can be used as a second policy instrument that complements the monetary policy. FXI manipulates the exchange rate, which in turn affects the import prices and consumption demand for goods in different countries and currencies.

In my paper, I first provide a full analytical characterisation of optimal monetary policy and FXI rules. Next, I calibrate the model to match the data on FXI and carry trade returns (deviations from the uncovered interest rate parity condition) for major currencies. The key policy implication is that the optimal FXI allows the monetary authority to stabilise inflation and output at the same time with little changes in the monetary policy rate. The model thus suggests a novel complementarity between conventional monetary policy and unconventional exchange rate policy tools and provides a rationale for their combined use.

Policy Mix for Inflation and Exchange Rate Stabilisation

The classical “trilemma” (Mundell 1957, Fleming 1962) suggests that, under free capital mobility, monetary authorities cannot simultaneously pursue inflation/output and exchange rate stabilisation. In a modern, financially globalised world, countries increasingly rely on unconventional policy tools to manage the capital account and insulate themselves from international spillovers of shocks and crises to preserve their monetary autonomy (Rey 2015, Kalemli-Ozkan 2019, Miranda-Agrippino and Rey 2020). In particular, foreign exchange intervention (FXI), i.e., purchases or sales of foreign currency reserves, is a popular policy tool among central banks to stabilise exchange rates.

While much of the literature focuses on a small-open economy, taking international prices as given, data shows that FXI is widely used on a global scale, even among larger emerging or even advanced economies. My recent paper studies whether monetary and exchange rate policies should respond to domestic inflation and output gap or global business cycle conditions and imbalances beyond domestic objectives.

Domestic and Global Policy Objectives

I develop a two-country model in which macroeconomic policies balance internal and external objectives. In the model, limits to arbitrage in international capital markets allow FXI to affect the exchange rate via changes in the demand and supply of bonds in different currencies (Gabaix and Maggiori 2015, Itskhoki and Mukhin 2021). The policy is cooperative in the sense that a single global social planner maximises the global welfare.

The key finding of my paper is that monetary and exchange rate policies can be jointly used to achieve a higher level of global efficiency as long as the international risk-sharing is imperfect. “Risk-sharing” implies that the exchange rate adjusts to diversify the risks to income and consumption with other countries. To put it intuitively, a positive supply shock in the home country increases consumption for home households and depreciates the home currency at the same time. This cheaper home currency decreases the import prices for foreign households and increases their consumption.

Whether this risk-sharing holds or not crucially depends on the elasticity of substitution of goods across different countries. When goods in the two countries are highly substitutable, as supported by recent literature on international trade, the exchange rate moves “too little” relative to the perfect risk-sharing allocation and has a limited role in smoothing consumption across countries.

As long as the international risk-sharing is imperfect, global demand misallocation leads to a non-trivial monetary policy trade-off between inflation and output. In this case, FXI can be used as a second policy instrument that complements the monetary policy. FXI manipulates the exchange rate, which in turn affects the import prices and consumption demand for goods in different countries and currencies.

In my paper, I first provide a full analytical characterisation of optimal monetary policy and FXI rules. Next, I calibrate the model to match the data on FXI and carry trade returns (deviations from the uncovered interest rate parity condition) for major currencies. The key policy implication is that the optimal FXI allows the monetary authority to stabilise inflation and output at the same time with little changes in the monetary policy rate. The model thus suggests a novel complementarity between conventional monetary policy and unconventional exchange rate policy tools and provides a rationale for their combined use.

Exchange Rate Stabilisation in a Dollarized World

Having highlighted the interaction between monetary and exchange rate policies, my next contribution is to establish a novel relationship between capital flow management in international finance and the US dollar’s dominance in international trade. These two strands of literature are often discussed in separate contexts, and my paper attempts to bridge the gap between them. Recent evidence suggests that the majority of world trade is denominated in a small number of dominant currencies, particularly the US dollar (Gopinath et al., 2020). Motivated by this evidence, I consider a case where all goods traded in international markets are priced in dollars (dollar pricing).

There are two key findings. First, the optimal FXI has an additional target under dollar pricing. When the dollar appreciates, identical domestic goods are more expensive when denominated in US dollars than in the domestic currency. The optimal FXI targets inefficient dispersion of domestic good prices across countries, making it more responsive to shocks. Second, the transmission of FXI is asymmetric: it is particularly effective at stabilising domestic inflation with limited spillover on US inflation. These results explain why FXI is powerful in a dollarized economy.

Taking Stock

To summarise, my paper provides a general framework that studies non-trivial interactions between monetary and exchange rate policies. Future research is needed to characterise the strategic interaction of FXI between policymakers in dynamic games and study the political costs of nationally oriented monetary and exchange rate policies. Another policy question is how to combine FXI with other capital account management policies, including capital control and macroprudential policy, in the context of the IMF’s integrated policy framework (Basu et al. 2020).