Exchange Rate Stabilization and Welfare

This article considers recent literature on optimal monetary policy in simple open-economy models. The presence of pricing to market, incomplete financial markets, and differences in preferences among households (in different countries) introduces some fundamental differences between closed- and open-economy New Keynesian models. In addition to the goals of stabilizing inflation and the output gap, policy makers may target currency misalignments and global imbalances. Optimal policies may involve targeting the exchange rate both directly, because of currency misalignments, and indirectly, because of the effects of exchange rates on imbalances, inflation, and output gaps.