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Optimal Exchange Rate Policy and Business Cycles |
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Abstract: Implementation
and collapse of exchange rate pegging schemes are recurrent events. A currency crisis
(pegging) is usually followed by an economic downturn (boom). This essay explains why a
benevolent Central Bank should pursue a monetary policy that leads to those recurrent
currency crises and subsequent periods of pegging. It is shown that the optimal policy
induces a competitive equilibrium that displays a boom in periods of below average
devaluation and a recession in periods of above average devaluation. A currency crisis
(pegging) can be understood as an optimal policy answer to a recession (boom). |
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