Abstract
The two immediately preceding chapters provide a theory to explain the absence of observed effects on real and nominal exchange rates of monetary shocks. Under flexible exchange rates, central banks find it in the public interest, as well as their own interest, to continually finance demand-for-liquidity shocks by adjusting the stock of liquidity so as to prevent overshooting movements of the exchange rate. As a result, monetary conditions in all countries will tend to be the same, and all will experience roughly the same medium-term deviations of domestic inflation from its politically acceptable core rate and roughly the same business cycles to the extent that the latter are influenced by monetary conditions.1 By following this policy of neutralizing portfolio shocks to their exchange rates, countries simultaneously obtain the insulation properties of flexible exchange rates against asymmetric real shocks and at least some of the portfolio smoothing properties of fixed exchange rates against asymmetric monetary shocks. Because such ‘orderly markets’ or ‘even keel’ policies cannot be implemented without error, however, it will pay countries to adopt fixed exchange rates with respect to important trading partners if their real exchange rates with respect to those countries are sufficiently stable through time. In the absence of such real exchange rate stability, movements in real exchange rates in response to ongoing real shocks will be transmitted under a fixed exchange rate regime to output and employment and the domestic price level rather than being absorbed by nominal exchange rate movements.
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© 2010 Springer-Verlag Berlin Heidelberg
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Floyd, J.E. (2010). Corroborating and Other Evidence. In: Interest Rates, Exchange Rates and World Monetary Policy. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-642-10280-6_15
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DOI: https://doi.org/10.1007/978-3-642-10280-6_15
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Publisher Name: Springer, Berlin, Heidelberg
Print ISBN: 978-3-642-10303-2
Online ISBN: 978-3-642-10280-6
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