Exchange rates and monetary spillovers

When does the combination of flexible exchange rates and domestic inflation-oriented monetary policy guarantee insulation from global financial conditions? We examine a dynamic global game model of international portfolio flows where, for some combination of parameters, the unique equilibrium exhibits the observed empirical feature that currency appreciation goes hand-in-hand with lower domestic interest rates and higher credit growth. When reversed, tighter monetary conditions go hand-in-hand with capital outflows and currency depreciation.

JEL classification: F32, F33, F34

Keywords: currency appreciation, capital flows, global games