Country-specific risk premium, Taylor rules, and exchange rates

The adoption of a Taylor-type monetary policy rule and an inflation target for emerging market economies that choose a flexible exchange rate regime is often advocated. This paper investigates the issue of exchange rate determination when interest-rate feedback rules are implemented in a continuous-time optimizing model of a small open economy facing an imperfect global capital market. It is demonstrated that when a risk premium on external debt affects the monetary policy transmission mechanism, the Taylor principle is not a necessary condition for determinacy of equilibrium. On the other hand, it is shown that exchange rate dynamics critically depend on whether monetary policy is active or passive. In terms of optimal monetary policy, it is demonstrated that the degree of responsiveness of the nominal interest rate to inflation should be related to the stock of foreign debt. Specifically, it is optimal to implement a more passive monetary policy stance in response to larger levels of the outstanding foreign-currency-denominated debt.