Tobin's Q channel and monetary policy rules under incomplete exchange rate pass-through

a r t i c l e i n f o JEL classification: E52 E58 F41 Keywords: Monetary policy rule Incomplete exchange rate pass-through Tobin's Q channel Asset prices This paper focuses on the role of the Tobin's Q channel in a two-country framework in which exporting firms set their prices on the basis of local currency pricing. Incomplete exchange rate pass-through significantly affects the Tobin's Q channel in each country compared with the case of complete exchange rate pass-through. We explore whether different specifications of monetary policy enhance social welfare. Regardless of the degree of home bias, a monetary policy rule that stabilizes domestic asset prices attains preferable outcomes to several alternative policy rules considered in our analysis. Notably, there are large gains from employing a domestic asset price rule when the home bias is large. A monetary policy rule that stabilizes the asset prices of both countries results in worse outcomes. Our simulation results suggest that stabilizing asset prices is important in an open economy with incomplete exchange rate pass-through. Should central banks respond to asset price fluctuations? The literature discusses how the central bank should conduct its monetary policy when asset prices fluctuate in a closed economy framework. Bernanke and Gertler (1999, 2001) stress that the central bank should not react to asset price fluctuations because a monetary policy rule that incorporates asset prices may destabilize the economy if asset prices respond to a non-fundamental shock. 1 Alternatively, others argue that an interest rate rule with asset price stabilization results in preferable outcomes even if the monetary authority cannot precisely observe the deviation of asset prices from their fundamental values (e.g., Cecchetti et al., 2003). 2 In particular, the recent financial crisis, which originated in the US, might reveal that asset price fluctuations in one country affect other countries, and that central banks should at least consider asset price fluctuations from a global perspective. Therefore, exchange rate fluctuations matter when we consider the role of asset prices at a global level. The standard new open economy macroeconomics (NOEM) model assumes that exchange rate pass-through is complete. Thus, the NOEM model is based on the assumption of producer-currency pricing (PCP) in which firms set prices on the basis of their own national currency (e.g., Clarida et al., 2002; Gali and Monacelli, 2005). Conversely, previous studies refer to the presence of pricing-to-market (PTM) in which firms differentiate their prices …