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Optimal Exchange Rate Regimes: Turning Mundell-Fleming's Dictum on its Head

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  • Amartya Lahiri

    ()
    (University of British Columbia, Department of Economics, Vancouver, Canada)

  • Rajesh Singh

    ()
    (Iowa State University, Department of Economics, USA)

  • Carlos A. Vegh

    ()
    (University of Maryland, Department of Economics and NBER, USA)

Abstract

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).

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Bibliographic Info

Article provided by Savez ekonomista Vojvodine, Novi Sad, Serbia in its journal Panoeconomicus.

Volume (Year): 54 (2007)
Issue (Month): 3 (September)
Pages: 249-270

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Handle: RePEc:voj:journl:v:54:y:2007:i:3:p:249-270

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Web page: http://www.panoeconomicus.rs/

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  1. Leslie Lipschitz, 1978. "Exchange Rate Policies for Developing Countries: Some Simple Arguments for Intervention (Les politiques de taux de change et les pays en voie de développement: quelques arguments simples en faveur ," IMF Staff Papers, Palgrave Macmillan, vol. 25(4), pages 650-675, December.
  2. Luis Felipe Cespedes & Roberto Chang & Andres Velasco, 2000. "Balance Sheets and Exchange Rate Policy," NBER Working Papers 7840, National Bureau of Economic Research, Inc.
  3. Rajesh Singh & Carlos Vegh & Amartya Lahiri, 2007. "Optimal Monetary Policy under Asset Market Segmentation," 2007 Meeting Papers 943, Society for Economic Dynamics.
  4. Singh, Rajesh & Lahiri, Amartya & Vegh, Carlos A, 2007. "Segmented Asset Markets and Optimal Exchange Rate Regimes," Staff General Research Papers 11446, Iowa State University, Department of Economics.
  5. Stephen Ching & Michael B. Devereux, 2003. "Mundell Revisited: a Simple Approach to the Costs and Benefits of a Single Currency Area," Review of International Economics, Wiley Blackwell, vol. 11(4), pages 674-691, 09.
  6. Casey B. Mulligan & Xavier Sala-i-Martin, 2000. "Extensive Margins and the Demand for Money at Low Interest Rates," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 961-991, October.
  7. repec:rus:hseeco:124089 is not listed on IDEAS
  8. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
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Cited by:
  1. Paul McNelis & Guay Lim, 2009. "Cyclical Government Spending, Income Inequality and Welfare in Small Open Economies," 2009 Meeting Papers 300, Society for Economic Dynamics.
  2. Ouchen, Mariam, 2013. "Optimal choice of an exchange rate regime: a critical literature review," MPRA Paper 43907, University Library of Munich, Germany, revised 19 Jan 2013.
  3. Dąbrowski, Marek A. & Śmiech, Sławomir & Papież, Monika, 2013. "Monetary policy options for mitigating the impact of the global financial crisis on emerging market economies," MPRA Paper 56337, University Library of Munich, Germany.
  4. Reinhart, Carmen & Vegh, Carlos & Velasco, Andres, 2008. "Money, Crises, and Transition Essays in Honor of Guillermo A. Calvo: An Introduction," MPRA Paper 13232, University Library of Munich, Germany.

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