Optimal Real Exchange Rate Targeting: A Stochastic Analysis

This paper extends the literature on real exchange rate targeting inside a stochastic optimization framework where the real exchange rate displays long run mean reversion while temporarily reflecting a “liquidity effect”. In a time-varying volatility framework, we detect two thresholds, respectively for long run volatility and the reaction of volatility to real exchange rate shocks, beyond which an active stabilization policy is welfare increasing. However, since the Garch literature relative to many developing countries provides quantitative estimates significantly below the above thresholds, this paper makes a rather strong case against the adoption of real exchange rate targeting in emerging market economies.