Working Paper Series no. 452: Optimal Exchange Rate Policy in a Growing Semi-Open Economy

Abstract

In this paper, we consider an alternative perspective to China's exchange rate policy. We study a semi-open economy where the private sector has no access to international capital markets but the central bank has full access. Moreover, we assume limited financial development generating a large demand for saving instruments by the private sector. We analyze the optimal exchange rate policy by modeling the central bank as a Ramsey planner. Our main result is that in a growth acceleration episode it is optimal to have an initial real depreciation of the currency combined with an accumulation of reserves, which is consistent with the Chinese experience. This depreciation is followed by an appreciation in the long run. We also show that the optimal exchange rate path is close to the one that would result in an economy with full capital mobility and no central bank intervention.

Philippe Bacchetta, Kenza Benhima, and Yannick Kalantzis
October 2013

Classification JEL : E58, F31 and F41

Keywords : China, exchange rate policy and international reserves