Aspects of the optimal management of exchange rates

Australian Economic Papers, 2002

Exchange rates have been given increasing consideration in the conduct of monetary policy. This article develops a model of the determination of the exchange rate, interest rate, price level, and level of output to derive the optimal response ofmonetary authorities to exchange rate movements. The relative magnitudes and persistence of disturbances, as well as the structure of the economy, are shown to play roles. Advocates ofusing monetary policy to maintain greater fixity of exchange rates view monetary shocks as the predominant source of disturbances to the economy.

2006

A famous dictum in open economy macroeconomics --which obtains in the Mundell-Fleming world of sticky prices and perfect capital mobility --holds that the choice of the optimal exchange rate regime should depend on the type of shock hitting the economy. If shocks are predominantly real, a flexible exchange rate is optimal, whereas if shocks are mainly monetary, a fixed exchange rate is optimal. There is no obvious reason, however, why this paradigm should be the most appropriate one to think about this important issue. Arguably, asset market frictions may be as pervasive as goods market frictions (particularly in developing countries). In this light, we show that in a model with flexible prices and asset market frictions, the Mundell-Fleming dictum is turned on its head: flexible rates are optimal in the presence of monetary shocks, whereas fixed rates are optimal in response to real shocks. We thus conclude that the choice of an optimal exchange rate regime should depend not only on the type of shock (real versus monetary) but also on the type of friction (goods versus asset market).

American Economic Review, 2000

Journal of Economic Dynamics and Control, 1979

This paper considers optimal monetary stabilization policy under flexible exchange rates in a model where exchange rate expectations are generated regressively. The analysis highlights the intimate relationship that exists between: (a) the direction of the optimal monetary feedback rule, (b) the amount of initial overshooting of the exchange rate following an exogenous monetary expansion, (c) the subsequent speed of adjustment to the new equilibrium. The optimal policy may either involve leaning against the wind, thereby reducing the size of the initial jump and the speed of the subsequent adjustment, relative to a passive policy. Alternatively it may involve leaning with the wind, in which case both the size of the initial jump and the speed of subsequent adjustment are increased.

2002

Economic theory refers to several notions of the exchange rate equilibrium value in a flexible exchange rate regime. It has been defined as that consistent with : a) the equilibrium of trade balance; b)the equilibrium of current account; c) the overall equilibrium of the balance of payments; d) the absence of speculative attacks on foreign exchange markets; e) the absence of a beggar thy neighbour" dispute at an international level; f) the achievement of price stability; g) the pursuit of a monetary policy rule. Through a literature survey we have seen that different exchange rates have effects on output and employment both in the short and in the long run. However the major conclusion was reached by an extension of recent studies, according to which, even if the central bank strictly controls the inflation rate, the absence of a precise objective in terms of price level makes the exchange rate indeterminate.

American Economic Review, 2001

For a country that chooses not to "permanently" fix its exchange rate through a currency board, or a common currency, or some kind of dollarization, the only alternative monetary policy that can work well in the long run is one based on the trinity of (i) a flexible exchange rate, (ii) an inflation target, and (iii) a monetary policy rule.' While not often put into this threepart format, the desirability of such a monetary policy in an open economy is, in my view, the clear implication of three corresponding strands of recent monetary research: (i) research on fixed-exchange-rates regimes, including the influential 1995 article "The Mirage of Fixed Exchange Rates" by Maurice Obstfeld and Kenneth Rogoff and the many analyses of the breakdown of fixed-exchange-rate regimes in the late 1990's; (ii) research on the practical success with inflation targeting by Ben Bernanke et al. (1999); and (iii) research on the benefits of simple monetary-policy rules (see e.g., Taylor, 1999a). This clear policy implication, however, does not end the debate about how exchange rates should be taken into account in formulating monetary policy. Even if one excludes capital controls and sterilized exchange-market intervention from consideration because they are not effective or attractive ways to de-link exchangerate movements from the domestic interest rate, a crucial question remains: "How should the instruments of monetary policy (the interest rate

European Economic Review, 2010

The literature has identified at least five approaches to the determinants of the choice of exchange rate regimes: i) optimal currency area theory; ii) exchange rate policy and the absortion of real and nominal shocks; iii) exchange rate rules as a policy crutch in credibility-challenged economies; iv) the impossible trinity in light of increasing financial globalization; and v) the balance sheet exposure to exchange rate changes in financially dollarized economies. Using both a de facto and a de jure regime classification, we test the empirical relevance of these approaches simultaneously. We find overall empirical support for all of them, although their relative relevance varies substantially between industrial and non-industrial economies. We show that regime choices, as well as deviations between actual and reported policies, can be accurately predicted by a small number of economic and political characteristics of each country. When regimes are correctly characterized, they display no time trend, suggesting that the trends typically highlighted in the exchange rate regime debate can be traced back to the evolution of their natural determinants.

2010

During the birth and infancy of the Bretton Woods system, the debate on exchange rate regimes was dominated by systemic arguments and concerns. The fathers of Bretton Woods believed that a centrally supervised system of fixed exchange rates was key to postwar prosperity, as it would shield international trade both from exchange rate volatility and from exchange rate manipulation by individual countries. Against this view, a classic 1953 article by Milton Friedman argued that exchange rate volatility was a symptom rather than a cause of economic imbalances. Fixing the exchange rate would not remove these problems but merely suppresses them, until they became so virulent that they erupted, in the form of a currency crisis, or painful domestic adjustment. Flexible exchange rates, in contrast, provided a mechanism for adjustment on an ongoing basis. "Changes in it occur rapidly, automatically, and continuously and so tend to produce corrective movements before tensions can accumulate and a crisis develop." Friedman also argued that with good macroeconomic management, exchange rates were unlikely to be very volatile, and very unlikely to burden trade in goods and services, which in any case could avail itself from futures markets to hedge exchange rate risk. More than half a century after Friedman's article, and over 30 years after the end of the Bretton Woods era, many of Friedman's claims have been clearly proven either right or wrong. One the one hand, floating exchange rates did in fact turn out to be much more volatile than Friedman anticipated. A celebrated article by Michael Mussa (1986) documented conclusively that flexible exchange rate regimes do indeed display much higher real exchange rate variability than pegged regimes-especially for advanced economies, where exchange rates were driven mainly by capital flows. On the other hand, Friedman turned out to be right in his conjecture that flexible exchange rates would, at most, impose a modest burden on trade. Though currency unions retained their fans and triumphed in 1 The views in this paper are the authors' only, and should not be attributed to the International Monetary Fund. We thank, without implication, Olivier Jeanne, Jonathan Ostry, Charles Wyplosz, and seminar participants at the IMF and the Geneva Graduate Institute for International and Development Studies for comments and discussions. This paper is part of a larger project examining the macroeconomic implications of exchange rate regimes.

Journal of International Economics, 1995

We examine the effects of monetary policy on the real exchange rate. In a cross-country analysis, we find that the variability of money shocks and the degree of informativeness of the exchange rate are important determinants of the magnitude of the real exchange rate effects of domestic money shocks. Our results are consistent with previous cross-country evidence on the output effects of money shocks but also highlight the role of the exchange rate regime.