This paper develops a two-sector, two-agent New-Keynesian model of a small open economy with financial frictions and foreign currency debt in balance sheets. Focusing on an adverse foreign interest rate shock, the distributional consequences of alternative monetary-policy rules are analyzed to account for the exchange-rate stabilization motive in emerging market economies (EMEs). Under an inflation targeting regime, the depreciation of the domestic currency associated with the shock has an expansionary impact on the tradable sector via the expenditure switching channel. However, in the presence of nominal wage rigidities, the ensuing higher inflation associated with the depreciation reduces real wages, which makes households in the non-tradable sector worse off. Partially stabilizing the exchange rate, however, reverses the distributional consequences. Managed exchange rate regimes improve welfare of households in the non-tradable sector at the expense of households in the tradable sector; moreover, these policy regimes can improve aggregate welfare as long as the response to the exchange rate is not too strong. Strongly stabilizing (or fixing) the exchange rate reduces the welfare of both types of households. In an inflation-targeting regime, the use of capital controls or sterilized foreign-exchange interventions is considered as a second instrument. Solving for (Ramsey) optimal policy, we find that capital controls are effective in enhancing macroeconomic stability, while sterilized interventions are nearly ineffective in this environment.
