Munich Personal RePEc Archive

Monetary policy in oil exporting countries with fixed exchange rate and open capital account: expectations matter

CHAFIK, Omar (2019): Monetary policy in oil exporting countries with fixed exchange rate and open capital account: expectations matter.

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Abstract

Nominal interest rate is generally assumed to follow an UIP condition when the exchange rate is fixed, and the capital account is opened. Consequently, domestic interest rate is determined by foreign rates and the risk premium. This paper shows that for an oil exporting country like UAE, adjusting nominal interest rate only to foreign rate could be economically inconsistent. In fact, what really matters with exchange rate is expectations, and for an oil exporter country like UAE these expectations are significantly impacted by oil prices. By incorporating a market-expected exchange rate mechanism in a semi-structural New Keynesian Model, this paper highlights the importance of this mechanism and provides a consistent analytical framework.

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