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

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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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File URL: http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp241.pdf
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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 241.

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Length: 28 pages
Date of creation: Jul 2003
Date of revision:
Handle: RePEc:ecb:ecbwps:20030241

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Related research

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

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References

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Citations

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Cited by:
  1. Jes�s Rodríguez López & Hugo Rodríguez Mendizábal, 2007. "The Optimal Degree of Exchange Rate Flexibility: a Target Zone Approach," Review of International Economics, Wiley Blackwell, vol. 15(4), pages 803-822, 09.
  2. José García-Solanes & Jesús Rodríguez López & José Luis Torres Chacón, 2007. "Demand Shocks and Trade Balance Dynamics," Working Papers 07.10, Universidad Pablo de Olavide, Department of Economics.
  3. Bennett T. McCallum, 2005. "A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap," NBER Working Papers 11056, National Bureau of Economic Research, Inc.
  4. Lucio Vinhas de Souza, 2004. "A Preliminary Evaluation of Monetary Policy Rules for Russia," Macroeconomics 0403017, EconWPA.
  5. Esanov, Akram & Merkl, Christian & Vinhas de Souza, Lucio, 2005. "Monetary policy rules for Russia," Journal of Comparative Economics, Elsevier, vol. 33(3), pages 484-499, September.
  6. Guido Ascari & Neil Rankin, 2004. "Perpetual youth and endogenous labour supply: a problem and a possible solution," Working Paper Series 346, European Central Bank.
  7. 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.
  8. Marcelo Sánchez, 2005. "The link between interest rates and exchange rates - do contractionary depreciations make a difference?," Working Paper Series 548, European Central Bank.
  9. Marcelo Sánchez, 2006. "How does information affect the comovement between interest rates and exchange rates?," Working Paper Series 608, European Central Bank.
  10. 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.

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