Exchange Rates and Policy Coordination in an Asymmetric Model

This paper extends earlier work (Kenen, 1987a, 1987b) on the ranking of exchange rate regimes. Using a two-country portfolio-balance model, it asks how pegged and floating exchange rates affect each country's ability to achieve its domestic policy objectives independently, without having to coordinate its monetary policy with that of the other country. In other words, it uses the game-theoretic framework commonly employed to study policy coordination to look anew at an old question, whether a floating exchange rate can confer policy autonomy on the governments of interdependent economies. I find that it cannot. On the contrary, a pegged but adjustable exchange rate dominates a floating rate, by minimizing the need for policy coordination.In the earlier papers cited above, the two countries were identical in size and perfectly symmetrical in behaviour. Here, they differ in size and behaviour. But the differences do not matter for most of the main results. In three of the five cases studied - a permanent switch in demand between the countries' bonds, a balanced-budget change in one government's spending, and a permanent change in desired wealth leading to a temporary change in saving - a pegged exchange rate is fully optimal. Each government is able to stabilize its country's output and price level by a once-and-for-all open-market operation. There is no need for policy coordination. In the other two cases - a temporary tax change leading to a permanent change in the stock of debt, and a switch in demand between the countries' goods a pegged rate is not optimal (and does not facilitate the use of tax or exchange rate changes to offset the effects of those two disturbances, which it did when the two countries were perfectly symmetrical). But a floating rate is never fully optimal; policy coordination is clearly required for governments to minimize the welfare losses resulting from the output and price effects of all five disturbances.The paper extends the earlier analysis in two other ways. It examines the workings of the symmetrical model under conditions of perfect capital mobility, showing that fiscal policies can sometimes substitute for monetary policies when the latter must be used exclusively for exchange rate stabilization. It also compares the price and output effects of fiscal disturbances under pegged and floating rates, showing that a tax change in one country will have more effect on the other country's output under a floating rate, but more effect on its price level under a pegged rate.