Discussion paper

DP11928 Exchange Rate Policies at the Zero Lower Bound

We study how a monetary authority pursues an exchange rate objective
in an environment that features a zero lower bound (ZLB) constraint
on nominal interest rates and limits to international arbitrage.
If the nominal interest rate that is consistent with interest rate parity is positive, the central bank can achieve it
exchange rate objective by choosing that interest rate, a well-known
result in international finance. However, if the rate consistent with
parity is negative, pursuing an exchange rate objective necessarily
results in zero nominal interest rates, deviations from parity, capital
inflows, and welfare costs associated with the accumulation of foreign
reserves by the central bank. In this latter case, all changes in
external conditions that increase inflows of capital toward the country
are detrimental, while policies such as negative nominal interest
rates or capital controls can reduce the costs associated with an
exchange rate policy. We provide a simple way of measuring these costs,
and present empirical support for the key implications of our framework:
when interest rates are close to zero, violations in covered interest
parity are more likely, and those violations are associated with reserve
accumulation by central banks.


Perri, F, M Amador and J Bianchi (2017), ‘DP11928 Exchange Rate Policies at the Zero Lower Bound‘, CEPR Discussion Paper No. 11928. CEPR Press, Paris & London. https://cepr.org/publications/dp11928