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Optimal Monetary Policy with Non-Zero Net Foreign Wealth

By Olena Mykhaylova

Abstract

I study the impact of net foreign wealth on the optimal monetary policy of an open economy in a two-country DSGE model with incomplete markets, sticky prices and deviations from the Law of One Price. I find that by optimally manipulating monetary policy, central banks can affect the timing of interest receipts (or payments) and therefore increase the risk-sharing role of the internationally traded asset. In particular, debtor nations find it optimal to allow their currency to float relatively more freely than do creditor nations. In order to maximize consumer welfare, in most specifications of the model central bank should target a weighted average of CPI inflation and changes in the nominal exchange rate.Optimal monetary policy; welfare; open economy; net foreign wealth.

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