Central Banks Face Tough Choices as Risk Shocks Disrupt Exchange Rates
The article explores how an economy can handle a sudden increase in risk premiums. It shows that a managed exchange rate policy can help stabilize inflation and output, but there may be a trade-off between the two. When monetary policy or supply-side effects are present, the central bank may need to balance stabilizing output and inflation. Using a different rule for monetary policy, linked to changes in terms of trade, can help reduce exchange rate volatility.