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Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy

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  • Tommaso Monacelli

    ()
    (Boston College)

Abstract

Industrial countries moving from fixed to floating exchange rate regimes experience dramatic rises in the variability of the real exchange rate. This evidence, forcefully documented by Mussa (1986), is a puzzle to the extent that it is hard to reconcile with the assumption of flexible prices. This paper shows that a model that combines nominal rigidities with a systematic behavior of monetary policy approximating a managed-fixed exchange rate regime is consistent with Mussa's findings: the real exchange rate is between three and six times more variable under floating than under fixed rates, and this holds independently of the underlying shocks. The impact of the change in regime on the volatility of other real macroeconomic variables, however, depends crucially on the specification of the monetary policy rule and on the source of fluctuations. The model takes also a theoretical stand on other issues raised in the empirical literature, like the so-called exchange rate anomaly, and the international monetary policy shock transmission sign.

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Bibliographic Info

Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 437.

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Length: 32 pages
Date of creation: 15 Jan 1999
Date of revision: 15 Sep 2000
Handle: RePEc:boc:bocoec:437

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Keywords: real exchange rate; sticky prices; endogenous monetary policy;

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  1. Stockman, Alan C. & Stockman, Alan C., 1983. "Real exchange rates under alternative nominal exchange-rate systems," Journal of International Money and Finance, Elsevier, vol. 2(2), pages 147-166, August.
  2. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  3. Mussa, Michael, 1986. "Nominal exchange rate regimes and the behavior of real exchange rates: Evidence and implications," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 25(1), pages 117-214, January.
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  8. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
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  18. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  19. Beaudry, Paul & Devereux, Michael B., 1995. "Money and the real exchange rate with sticky prices and increasing returns," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 43(1), pages 55-101, December.
  20. Stockman, Alan C., 1988. "Real exchange-rate variability under pegged and floating nominal exchange-rate systems: An equilibrium theory," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 259-294, January.
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