On the Use of Monetary Policy for Moderating Exchange Rate Movements

This paper considers the effects of monetary policy undertaken to moderate exchange rate movements under a managed floating exchange rate system. It is motivated by evidence that central banks have at times undertaken such a policy. Using the Dornbusch model as the analytical framework, I consider an initial monetary shock to the economy followed by an attempt by the central bank to use the rate of monetary growth to "lean against the wind." It turns out that monetary intervention increases the initial degree of exchange rate overshooting, increases the deviations of the exchange rate from its new longrun equilibrium level, and intensifies exchange rate movements.