Monetary Policy Reaction Function, Exchange Rate Misalignment, and Foreign Shocks: Implications for Policy Effectiveness

Monetary Policy Reaction Function, Exchange Rate Misalignment, and Foreign Shocks: Implications for Policy Effectiveness | Research Square window.SnipcartSettings = { analytics: { enabled: false } }; (function() { var accessVector = localStorage.getItem('access_vector') || ''; window.dataLayer = window.dataLayer || []; if (accessVector) { window.dataLayer.push({ user: { profile: { profileInfo: { snid: accessVector } } } }); } })(); (function(w,d,s,l,i){w[l]=w[l]||[];w[l].push({'gtm.start':new Date().getTime(),event:'gtm.js'});var f=d.getElementsByTagName(s)[0],j=d.createElement(s),dl=l!='dataLayer'?'&l='+l:'';j.async=true;j.src='https://www.googletagmanager.com/gtm.js?id='+i+dl;f.parentNode.insertBefore(j,f);})(window,document,'script','dataLayer','GTM-K279D39R'); Browse Preprints In Review Journals COVID-19 Preprints AJE Video Bytes Research Tools Research Promotion AJE Professional Editing AJE Rubriq About Preprint Platform In Review Editorial Policies Our Team Advisory Board Help Center Sign In Submit a Preprint Cite Share Download PDF Research Article Monetary Policy Reaction Function, Exchange Rate Misalignment, and Foreign Shocks: Implications for Policy Effectiveness Mtendere Chilolo Chikonda, Takondwa Chauma, Kisu Simwaka, Rafiazka Millanida Hilman This is a preprint; it has not been peer reviewed by a journal. https://doi.org/ 10.21203/rs.3.rs-9097927/v1 This work is licensed under a CC BY 4.0 License Status: Under Review Version 1 posted 4 You are reading this latest preprint version Abstract This paper examines the macroeconomic consequences of incorporating the exchange rate into the monetary policy reaction function, an approach often proposed for small open economies exposed to frequent external shocks but insufficiently evaluated in the literature. Using a structural general equilibrium framework, we show that responding to exchange rate misalignment systematically redirects monetary transmission toward external margins. The policy rule strengthens the influence of shocks on the real exchange rate, trade flows, and terms of trade, thereby enhancing short run absorption of foreign disturbances through relative price and quantity adjustments. However, these external sector gains come with important domestic costs: the rule weakens the transmission of monetary policy to inflation, increases output and price volatility, and results in lower welfare relative to a regime in which the exchange rate is allowed to adjust freely. By contrast, a conventional rule that excludes the exchange rate preserves a stronger nominal anchor and moderates passthrough, but provides more muted real side stabilization. Overall, the results suggest that monetary policy in small open economies should prioritize price stability while employing exchange rate related tools only in a targeted and temporary manner. The findings highlight the need for further research on how capital flow openness, financial market depth, nonlinear transmission mechanisms, expectations formation, and crosscountry heterogeneity shape the optimal degree of exchange rate responsiveness in monetary policy frameworks. Exchange rate misalignment monetary policy reaction function monetary policy trade-offs transmission mechanism foreign shocks macroeconomic stability welfare effects Full Text Supplementary Files SupplementaryMaterial.pdf Cite Share Download PDF Status: Under Review Version 1 posted Reviewers agreed at journal 03 May, 2026 Reviewers invited by journal 01 May, 2026 Editor assigned by journal 13 Mar, 2026 First submitted to journal 12 Mar, 2026 You are reading this latest preprint version Research Square lets you share your work early, gain feedback from the community, and start making changes to your manuscript prior to peer review in a journal. As a division of Research Square Company, we’re committed to making research communication faster, fairer, and more useful. We do this by developing innovative software and high quality services for the global research community. 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Also discoverable on Platform About Our Team In Review Editorial Policies Advisory Board Help Center Resources Author Services Accessibility API Access RSS feed Manage Cookie Preferences © Research Square 2026 | ISSN 2693-5015 (online) Privacy Policy Terms of Service Do Not Sell My Personal Information {"props":{"pageProps":{"initialData":{"identity":"rs-9097927","acceptedTermsAndConditions":true,"allowDirectSubmit":false,"archivedVersions":[],"articleType":"Research Article","associatedPublications":[],"authors":[{"id":633079144,"identity":"433190c6-7a02-4d68-9b00-8f155bd675b2","order_by":0,"name":"Mtendere Chilolo Chikonda","email":"","orcid":"","institution":"International Monetary Fund","correspondingAuthor":false,"prefix":"","firstName":"Mtendere","middleName":"Chilolo","lastName":"Chikonda","suffix":""},{"id":633079145,"identity":"b62b69b6-e663-45e9-b81d-70fbe5189d39","order_by":1,"name":"Takondwa Chauma","email":"","orcid":"","institution":"Reserve Bank of 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