A major monetary policy problem: Exchange rate depreciation reduces production

Recent theoretical studies 1 confirm the observation of recent developments: exchange rate depreciation leads to a loss of production (of GDP). The reason is that, given the low price elasticities of foreign trade in volume terms, the dominant effect of an exchange rate depreciation is to cause a loss of real income due to the rise in import prices, and therefore to depress domestic demand more than it improves foreign trade. This situation complicates monetary policy choices, since an expansionary monetary policy, if it leads to a depreciation of the exchange rate, weakens production through this mechanism. 1 A. Auclert, M. Rognlie, M. Souchier, L. Straub, “Exchange Rates and Monetary Policy with Heterogeneous Agents: Sizing up the Real Income Channel”, CEPR Discussion Paper no. 16198, May 2021.