Abstract
We revisit Friedman’s case for flexible exchange rates in a small open economy with several distortions and rigidities and a variety of domestic and external shocks. We find that, for external shocks, the flexible exchange rate regime outperforms the fixed regime independent of the source of domestic nominal rigidities provided that the monetary authorities pursue a policy of strict inflation targeting. For domestic supply shocks, a joint policy of a flexible exchange rate and strict inflation targeting fares well when the main source of nominal rigidities is in the domestic goods markets, but not if rigidities arise in the labor markets.
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Notes
We restrict attention to a perfectly flexible and a perfectly fixed regime. This is not only in for reasons of comparability with the literature but also because the intermediate case of a managed float (which can be easily accommodated) would not bring any new insights to our analysis. Some form of managed floating would always weakly dominate the considered extreme cases.
Dellas (2006), addresses more explicitly the informational limitations involved in the conduct of monetary policy.
In the foreign economy, indexed by f, the demand for the domestic good is \(x_{t}^\textsc{f}=\left(\left(P_{xt}/s_t\right)/P_{t}^\star\right)^{\frac{1}{\rho-1}}(1-\omega^\star)y_{t}^{\star},\) where s is the nominal exchange rate, P ⋆ is the foreign currency general price index, and y ⋆ the foreign output. Variables with a star denote world variables.
See the next section for the calculation of the discount factors.
We could easily include an exchange rate targeting term in the policy rule. As mentioned earlier, little would be learned from this specification as a managed float with the degree of flexibility (targeting) chosen appropriately would always weakly dominate the two limiting regimes, that is, the perfectly flexible and the perfectly fixed.
This procedure is implemented by assuming k y = 0 and a suitably large value for k π .
See Cuche-Curti et al. (2009), for an application to the Swiss economy.
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Acknowledgements
We thank Patrick Fuchs, Marcel Savioz, and Alan Stockman for valuable comments and discussions. The views expressed are solely the responsibility of the authors and should not be interpreted as reflecting the views of their affiliations or of any other person associated with them.
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Cuche-Curti, N.A., Dellas, H. & Natal, JM. Price Stability and the Case for Flexible Exchange Rates. Open Econ Rev 21, 3–16 (2010). https://doi.org/10.1007/s11079-009-9153-5
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DOI: https://doi.org/10.1007/s11079-009-9153-5