Time inconsistency and the exchange rate channel of monetary policy

This paper analyses time-inconsistency problems related to the exchange rate channel of monetary policy. Within a simple open-economy macroeconomic model, where the exchange rate is the only forward-looking variable, we show that a difference emerges between optimal policy under discretion and under commitment. Moreover, the nature of the time-inconsistency problem resembles that resulting from standard New Keynesian models: when cost-push shocks occur, the exchange rate channel gives rise to excessive output stabilisation and insufficient inertia in monetary policy under a discretionary policy.