No. 1398 - Make-up strategies and exchange rate pass-through in a low-interest-rate environment

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by Alessandro Cantelmo, Pietro Cova, Alessandro Notarpietro and Massimiliano PisaniDecember 2022

This paper evaluates the effectiveness of various monetary policy strategies, with a particular focus on the transmission of exchange rate fluctuations to inflation (exchange rate pass through, ERPT) when the monetary policy rate can reach its effective lower bound. For illustrative purposes, we simulate a canonical two-country New-Keynesian model, calibrated on the euro area and the rest of the world, in which the euro area is subject to both demand and supply shocks.

Price level targeting (PLT) and average inflation targeting (AIT) strategies provide better inflation stabilization than inflation targeting (IT) and lead to smaller exchange rate fluctuations and ERPT. PLT and AIT provide better macroeconomic stabilization than IT even if inflation expectations have an adaptive component on top of the rational one; nevertheless, in this case, the differences are reduced.