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Does the time inconsistency problem make flexible exchange rates look worse than you think?

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Author Info
Roc Armenter
Martin Bodenstein

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Abstract

The Barro-Gordon inflation bias has provided the most influential argument for fixed exchange rate regimes. However, with low inflation rates now widespread, credibility concerns seem no longer relevant. Why give up independent monetary policy to contain an inflation bias that is already under control? We argue that credibility problems do not end with the inflation bias and they are a larger drawback for flexible exchange rates than usually thought. Absent commitment, independent monetary policy can induce expectation traps---that is, welfare ranked multiple equilibria---and perverse policy responses to real shocks, i.e., an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply that flexible exchange rates feature unnecessary macroeconomic volatility.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 865.

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Date of creation: 2006
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Keywords: Foreign exchange rates ; Inflation (Finance) ; Monetary policy;

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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  2. Obstfeld, Maurice & Duarte, Margarida, 2005. "Monetary Policy in the Open Economy Revisited: The Case for Exchange-Rate Flexibility Restored," 2005 Meeting Papers 386, Society for Economic Dynamics.
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  3. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  4. Mendoza, Enrique G, 2001. "The Benefits of Dollarization When Stabilization Policy Lacks Credibility and Financial Markets Are Imperfect," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 440-74, May.
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  5. Maurice Obstfeld, 1997. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. Chari, V. V. & Christiano, Lawrence J. & Eichenbaum, Martin, 1998. "Expectation Traps and Discretion," Journal of Economic Theory, Elsevier, vol. 81(2), pages 462-492, August. [Downloadable!] (restricted)
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  7. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August. [Downloadable!] (restricted)
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  8. Roc Armenter, 2008. "A General Theory (and Some Evidence) of Expectation Traps in Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 867-895, 08. [Downloadable!] (restricted)
  9. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May. [Downloadable!] (restricted)
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  10. Thomas F. Cooley & Vincenzo Quadrini, 2001. "The costs of losing monetary independence: the case of Mexico," Proceedings, Federal Reserve Bank of Cleveland, pages 370-403.
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  11. Svensson, Lars E O, 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," CEPR Discussion Papers 1249, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  12. Kenneth S. Rogoff, 2003. "Globalization and global disinflation," Proceedings, Federal Reserve Bank of Kansas City, pages 77-112. [Downloadable!]
  13. Roc Armenter & Martin Bodenstein, 2006. "Can the U.S. monetary policy fall (again) in an expectation trap?," International Finance Discussion Papers 860, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  14. Roberto Chang & Andres Velasco, 2000. "Exchange-Rate Policy for Developing Countries," American Economic Review, American Economic Association, vol. 90(2), pages 71-75, May. [Downloadable!] (restricted)
  15. Kenneth Rogoff, 2003. "Globalization and global disinflation," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 45-78. [Downloadable!]
  16. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  17. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  18. Robert G. King & Alexander L.Wolman, 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 343, European Central Bank. [Downloadable!]
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  19. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September. [Downloadable!] (restricted)
  20. Cristina Arellano & Jonathan Heathcote, 2007. "Dollarization and financial integration," Staff Report 385, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  21. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  22. Romer, David, 1993. "Openness and Inflation: Theory and Evidence," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 869-903, November. [Downloadable!] (restricted)
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Roc Armenter & Martin Bodenstein, 2006. "Of nutters and doves," International Finance Discussion Papers 885, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  2. Roc Armenter & Martin Bodenstein, 2005. "Can U.S. monetary policy fall (again) into an expectation trap?," Staff Reports 229, Federal Reserve Bank of New York. [Downloadable!]
  3. Dudley Cooke, 2006. "Openness and Inflation," Economics Discussion Papers 621, University of Essex, Department of Economics. [Downloadable!]
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  4. Michael D. Bordo & Barry Eichengreen, 2008. "Bretton Woods and the Great Inflation," NBER Working Papers 14532, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  5. Roc Armenter & Martin Bodenstein, 2006. "Can the U.S. monetary policy fall (again) in an expectation trap?," International Finance Discussion Papers 860, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
    Other versions:
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