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Macroeconomic Stabilization: Fixed Exchange Rates Vs Inflation Targeting Vs Price Level Targeting

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  • Dehejia, Vivek
  • Rowe, Nicholas

Abstract

We argue that the traditional question 'fixed vs. flexible exchange rates?' is not well-defined, because 'flexible exchange rates' does not explicitly specify any particular monetary policy. In traditional analyses, 'flexible exchange rates' was interpreted as implying a fixed money supply. But fixing the money supply (or fixing its growth rate at k%) is rarely advocated nowadays. To reflect today's policy debate, the traditional question should be replaced by the question 'fixed exchange rates vs. inflation targeting vs. price level targeting?'. We then build a simple macroeconomic model of a small open economy. The model incorporates an 'outside lag' in the effect of monetary policy on aggregate demand, so that inflation targeting and price level targeting are always imperfect. We use this model to compare the stabilization properties of three different monetary rules: a fixed exchange rate, a fixed inflation target, and a fixed price level target. We show that price level targeting is best for stabilizing output, the real exchange rate and the real interest rate, relative to their natural rates.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2460.

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Date of creation: May 2000
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Handle: RePEc:cpr:ceprdp:2460

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Keywords: Fixed Exchange Rates; Inflation Targeting; Price Level Targeting; Stabilization;

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References

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  1. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies.
  2. Laidler, David, 1999. "The Exchange Rate Regime and Canada's Monetary Order," Working Papers 99-7, Bank of Canada.
  3. Srour, Gabriel, 1999. "Inflation Targeting under Uncertainty," Technical Reports 85, Bank of Canada.
  4. Patrick Osakwe & Lawrence Schembri, 1998. "Currency crises and fixed exchange rates in the 1990s: A review," Bank of Canada Review, Bank of Canada, vol. 1998(Autumn), pages 23-38.
  5. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1045-55, December.
  6. Don E. Roper & Stephen J. Turnovsky, 1980. "Optimal Exchange Market Intervention in a Simple Stochastic Macro Model," Canadian Journal of Economics, Canadian Economics Association, vol. 13(2), pages 296-309, May.
  7. Michael B. Devereux & Charles Engel, 2001. "The Optimal Choice of Exchange Rate Regime: Price-Setting Rules and Internationalized Production," NBER Chapters, in: Topics in Empirical International Economics: A Festschrift in Honor of Robert E. Lipsey, pages 163-194 National Bureau of Economic Research, Inc.
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Cited by:
  1. Angelos Kanas & Georgios Tsiotas, 2005. "Real interest rates linkages between the USA and the UK in the postwar period," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 10(3), pages 251-262.
  2. Przemek Kowalski & Wojciech Paczynski & Lukasz Rawdanowicz, 2003. "Exchange rate regimes and the real sector: a sectoral analysis of CEE Countries," Post-Communist Economies, Taylor & Francis Journals, vol. 15(4), pages 533-555.

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