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Maintaining price stability under free-floating: a fearless way out of the corner?

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  • Detken, Carsten
  • Gaspar, Vítor

Abstract

The behaviour of the exchange rate under a floating exchange rate regime for a small open economy with perfect capital mobility may appear like a managed float or even a firmer peg. We present a canonical new neo-classical synthesis open economy model where the central bank follows a strategy directed at maintaining price stability. It is shown that the behaviour of the exchange rate depends on the structure of the economy and on the nature of the relevant shocks. In the case of very open economies the exchange rate will look quasi-fixed in response to shocks stemming from the international capital markets. It is also shown that the joined endogeneity of the interest rate and the exchange rate has important implications for the empirical testing of uncovered interest rate parity. JEL Classification: E58, E63, F41

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0241.

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Date of creation: Jul 2003
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Handle: RePEc:ecb:ecbwps:20030241

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Related research

Keywords: flexible exchange rates; managed floating; price stability; small open economy; uncovered interest rate parity;

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References

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Citations

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Cited by:
  1. Bennett T. McCallum, 2006. "A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap," NBER Chapters, in: Monetary Policy under Very Low Inflation in the Pacific Rim, NBER-EASE, Volume 15, pages 9-42 National Bureau of Economic Research, Inc.
  2. Jesús Rodríguez López & Hugo Rodríguez Mendizábal, 2006. "The optimal degree of exchange rate flexibility: A target zone approach," Working Papers 06.22, Universidad Pablo de Olavide, Department of Economics.
  3. Lucio Vinhas de Souza, 2004. "A Preliminary Evaluation of Monetary Policy Rules for Russia," Macroeconomics 0403017, EconWPA.
  4. Ramon Maria-Dolores & Jose Garcia-Solanes, 2004. "Exchange Rate Regimes for the New Member States of the European Union," Econometric Society 2004 Australasian Meetings 306, Econometric Society.
  5. Sánchez, Marcelo, 2005. "The link between interest rates and exchange rates: do contractionary depreciations make a difference?," Working Paper Series 0548, European Central Bank.
  6. José García-Solanes & Jesús Rodríguez-López & José Torres, 2011. "Demand Shocks and Trade Balance Dynamics," Open Economies Review, Springer, vol. 22(4), pages 739-766, September.
  7. Ascari, Guido & Rankin, Neil, 2004. "Perpetual youth and endogenous labour supply: a problem and a possible solution," Working Paper Series 0346, European Central Bank.
  8. Rita Lourenço, 2004. "Exchange Rate Regimes: A Global Picture Since the Emerging Market Crises in the Mid 1990s," Economic Bulletin and Financial Stability Report Articles, Banco de Portugal, Economics and Research Department.
  9. Sánchez, Marcelo, 2006. "How does information affect the comovement between interest rates and exchange rates?," Working Paper Series 0608, European Central Bank.
  10. Esanov, Akram & Merkl, Christian & Vinhas de Souza, Lúcio, 2004. "Monetary Policy Rules for Russia," BOFIT Discussion Papers 11/2004, Bank of Finland, Institute for Economies in Transition.

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