David Romer’s reflections on macroeconomics after the crisis are excellent, but I didn’t understand one sub-point here about monetary policy:
The simple “one instrument/one target” view of monetary policy (where the instrument is a short-term interest rate and the target is inflation, or a weighted average of inflation and the output gap) is too simple. There are other instruments (exchange market intervention, capital controls, margin requirements, down payment requirements, capital requirements, and more), and other potential targets (notably the exchange rate and indicators of financial risks).
Why would a central bank target the exchange rate over and above inflation and output?
Imagine a country with low and stable inflation and steady real growth with no output gap. Firms in the tradable sector are still going to be wanting a cheaper currency (to increase demand for their products) while firms in the non-tradable sector will want a more expensive one (to increase their consumption possibilities) but why would the central bank get itself sucked into that? If you’re hitting output and inflation goals, it seems to me that you’re doing it right.
Now of course if you’re not hitting your goals, the exchange rate could be the mechanism by which you adjust. Nominal yuan appreciation would reduce inflation in China, and currency depreciation was used to increase output in Israel during the crisis. But I don’t see how this becomes an independent consideration.