How should monetary policy respond to capital inflows that appreciate the currency, widen the current account deficit and cause domestic overheating? Using the workhorse open-macro monetary model, we derive a quadratic approximation of the utility-based global loss function in incomplete market economies, solve for the optimal targeting rules under cooperation and characterize the constrained-optimal allocation. The answer is sharp: the optimal monetary stance is contractionary if the exchange rate pass-through (ERPT) on import prices is incomplete, expansionary if ERPT is complete -- implying that misalignment and exchange rate volatility are higher in economies where incomplete pass through contains the effects of exchange rates on price competitiveness.
Keywords: Currency misalignments; trade imbalances; asset markets and risk sharing; optimal targeting rules; international policy cooperation; exchange rate pass-through
Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.