# Fixed on Flexible: Rethinking Exchange Rate Regimes after the Great Recession

- 161 Downloads

## Abstract

The zero lower bound problem during the Great Recession has exposed the limits of monetary autonomy, prompting a re-evaluation of the relative benefits of currency pegs and monetary unions (see, e.g., Cook and Devereux in* Journal of International Economics* 101:52–69, 2016). We revisit this issue from the perspective of a small open economy. While a peg can be beneficial when the recession originates domestically, we show that a float dominates in the face of deflationary demand shocks abroad. When the rest of the world is in a liquidity trap, the domestic currency depreciates in nominal and real terms even in the absence of domestic monetary stimulus (if domestic rates are also at the zero lower bound)—enhancing the country’s competitiveness and insulating to some extent the domestic economy from foreign deflationary pressure.

## JEL

F41 F42 E31## References

- Amador, Manuel, Javier Bianchi, Luigi Bocola, and Fabrizio Perri, 2016, "Exchange Rate Policies at the Zero Lower Bound,” Mimeo, Federal Reserve Bank of Minneapolis, Minneapolis.Google Scholar
- Benigno, Gianluca, Huigang Chen, Christopher Otrok, Alessandro Rebucci, and Eric R. Young, 2016, “Optimal Capital Controls and Real Exchange Rate Policies: A Pecuniary Externality Perspective,”
*Journal of Monetary Economics*, Vol. 84, pp. 147–165.CrossRefGoogle Scholar - Burstein, Ariel and Gita Gopinath, 2014, “Handbook of International Economics,” in
*International Prices and Exchange Rates*, edited by Gita Gopinath, Elhanan Helpman, and Kenneth Rogo (Amsterdam: Elsevier), Vol. 4, pp. 391–451.Google Scholar - Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas, 2015, “Global Imbalances and Currency Wars at the ZLB,” NBER Working Papers 21670. National Bureau of Economic Research, Inc.Google Scholar
- Casas, Camila, Federico Diez, Gita Gopinath, and Pierre-Olivier Gourinchas, 2016,
*Dominant Currency Paradigm*. NBER Working Paper No. 22943.Google Scholar - Christiano, Lawrence, Martin Eichenbaum, and Sergio Rebelo, 2011, “When is the Government Spending Multiplier Large?”
*Journal of Political Economy*, Vol. 119, No. 1, pp. 78–121.CrossRefGoogle Scholar - Clarida, Richard, Jordi Gali, and Mark Gertler, 2001, “Optimal Monetary Policy in Open Versus Closed Economies: An Integrated Approach,”
*American Economic Review*, Vol. 91, No. 2, pp. 248–252.CrossRefGoogle Scholar - Cook, David and Michael B. Devereux, 2013, “Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap,”
*American Economic Journal: Macroeconomics*, Vol. 5, No. 3, pp. 190–228.Google Scholar - Cook, David and Michael B. Devereux, 2016, “Exchange Rate Flexibility Under the Zero Lower Bound,”
*Journal of International Economics*, Vol. 101, pp. 52–69.CrossRefGoogle Scholar - Corsetti, Giancarlo, Luca Dedola, and Sylvain Leduc, 2008, “International Risk-Sharing and the Transmission of Productivity Shocks,”
*Review of Economic Studies*, Vol. 75, No. 2, pp. 443–473.CrossRefGoogle Scholar - Corsetti, Giancarlo, Luca Dedola, and Sylvain Leduc, 2010, “Optimal Monetary Policy in Open Economies,” in
*Handbook of Monetary Economics*, edited by Benjamin M. Friedman, and Michael Woodford (Amsterdam: Elsevier), Vol. 3, Chap. 16, pp. 861–933.Google Scholar - Corsetti, Giancarlo, André Meier, and Gernot J. Müuller, 2012, “Fiscal Stimulus with Spending Reversals,”
*Review of Economics and Statistics*, Vol. 94, No. 4, pp. 878–895.CrossRefGoogle Scholar - Corsetti, Giancarlo, Keith Kuester, and Gernot J. Müller, 2013a, “Floats, Pegs and the Transmission of Fiscal Policy,”
*Fiscal Policy and Macroeconomic Performance. Central Banking, Analysis, and Economic Policies Book Series*, ed. by Luis Felipe Cespedes and Jordi Gali (Central Bank of Chile, Santiago), Vol. 17, Chap. 7, pp. 235–281.Google Scholar - Corsetti, Giancarlo, Keith Kuester, André Meier, and Gernot J. Müller, 2013b, “Sovereign Risk, Fiscal Policy, and Macroeconomic Stability,”
*Economic Journal*, Vol. 123, No. 566, pp. F99–F132.CrossRefGoogle Scholar - Corsetti, Giancarlo, Keith Kuester, André Meier, and Gernot J. Müller, 2014, “Sovereign Risk and Belief-Driven Fluctuations in the Euro Area,”
*Journal of Monetary Economics*, Vol. 61, No. C, pp. 53–73.Google Scholar - Corsetti, Giancarlo, Eleonora Mavroeidi, Gregory Thwaites, and Martin Wolf, 2016, “Step Away from the Zero Lower Bound: Small Open Economies in a World of Secular Stagnation,” Mimeo (Cambridge University, Cambridge).Google Scholar
- De Paoli, Bianca, 2009, “Monetary Policy and Welfare in a Small Open Economy,”
*Journal of International Economics*, Vol. 77, pp. 11–22.CrossRefGoogle Scholar - Devereux, Michael B. and Charles Engel, 2003, “Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Exibility,”
*Review of Economic Studies*, Vol. 70, pp. 765–783.CrossRefGoogle Scholar - Dornbusch, Rudiger, 1976, “Expectations and Exchange Rate Dynamics,”
*The Journal of Political Economy*, Vol. 84, No. 6, pp. 1161–1176.Google Scholar - Duarte, Margarida and Maurice Obstfeld, 2008, “Monetary Policy in the Open Economy Revisited: The Case for Exchange-Rate Exibility Restored,”
*Journal of International Money and Finance*, Vol. 27, pp. 949–957.CrossRefGoogle Scholar - Eggertsson, Gauti B., Neil R. Mehrotra, Sanjay R. Singh, and Lawrence H. Summers, 2016, “A Contagious Malady? Open Economy Dimensions of Secular Stagnation,” NBER Working Papers 22299. National Bureau of Economic Research, Inc.Google Scholar
- Engel, Charles, 2014, “Chapter 8. Exchange Rates and Interest Parity,”
*Handbook of International Economics*, edited by Elhanan Helpman Gita Gopinath and Kenneth Rogoff (Amsterdam: Elsevier), Vol. 4, pp. 453–522.Google Scholar - Erceg, Christopher J. and Jesper Lindé, 2012, “Fiscal Consolidation in an Open Economy,”
*American Economic Review*, Vol.102, No. 3, pp. 186–91.CrossRefGoogle Scholar - Fahri, Emmanuel and Ivan Werning, 2016, “Fiscal Multipliers: Liquidity Traps and Currency Unions,” in
*Handbook of Macroeconomics*edited by John B. Taylor, and Harald Uhlig (Amsterdam: Elsevier).Google Scholar - Friedman, Milton, 1953, “The Case for Flexible Exchange Rates,” in
*Essays in Positive Economics*(Chicago: University of Chicago Press), pp. 157–203.Google Scholar - Fujiwara, Ippei and Kozo Ueda, 2013, “The Fiscal Multiplier and Spillover in a Global Liquidity Trap,”
*Journal of Economic Dynamics and Control*, Vol. 37, No. 7, pp. 1264–1283.CrossRefGoogle Scholar - Galí, Jordi, 2015,
*Monetary Policy, Inflation and the Business Cycle: An Introduction to the New Keynesian Framework*, 2nd ed. (Princeton, NJ: Princeton University Press).Google Scholar - Galí, Jordi and Tommaso Monacelli, 2005, “Monetary Policy and Exchange Rate Volatility in a Small Open Economy,”
*Review of Economic Studies*, Vol. 72, pp. 707–734.CrossRefGoogle Scholar - Groll, Dominik and Tommaso Monacelli, 2016, “The Inherent Benefit of Monetary Unions,” CEPR Discussion Papers 11416. C.E.P.R. Discussion Papers.Google Scholar
- Krugman, Paul, 2014, “Currency Regimes, Capital Flows, and Crises,”
*IMF Economic Review*, Vol. 62, No. 4, pp. 470–493.CrossRefGoogle Scholar - Obstfeld, Maurice and Kenneth S. Rogoff, 1996,
*Foundations of International Macroeconomics*, Vol. 1 (Cambridge, MA: The MIT Press).Google Scholar - Poole, William, 1970, “Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model,”
*Quarterly Journal of Economics*, Vol. 84, No. 2, pp. 197–216.CrossRefGoogle Scholar - Rey, Helene, 2016, “International Channels of Transmission of Monetary Policy and the Mundellian Trilemma,”
*IMF Economic Review*, Vol. 64, No. 1, pp. 6–35.CrossRefGoogle Scholar - Schmitt-Grohé, Stephanie and Martin Uribe, 2003, “Closing Small Open Economy Models,”
*Journal of International Economics*, Vol. 61, No. 1, pp. 163–185.CrossRefGoogle Scholar - Schmitt-Grohé, Stephanie and Martín Uribe, 2016, “Downward Nominal Wage Rigidity, Currency Pegs, and Involuntary Unemployment,”
*Journal of Political Economy*, Vol. 124, No. 5, pp. 1466–1514.Google Scholar - Sutherland, Alan, 2005, “Incomplete Pass-Through and the Welfare Effects of Exchange Rate Variability,”
*Journal of International Economics*, Vol. 65, No. 2, pp. 375–399.CrossRefGoogle Scholar - Woodford, Michael, 2011, “Simple Analytics of the Government Expenditure Multiplier,”
*American Economic Journal: Macroeconomics*, Vol. 3, No. 1, pp. 1–35.Google Scholar