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

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  • Roc Armenter
  • Martin Bodenstein

Abstract

Lack of commitment in monetary policy leads to the well known Barro-Gordon inflation bias. In this paper, we argue that two phenomena associated with the time inconsistency problem have been overlooked in the exchange rate debate. We show that, absent commitment, independent monetary policy can also induce expectation traps-that is, welfare-ranked multiple equilibria-and perverse policy responses to real shocks-that is, an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply higher macroeconomic volatility under flexible exchange rates than under fixed exchange rates.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 230.

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Date of creation: 2005
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Handle: RePEc:fip:fednsr:230

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Keywords: Foreign exchange rates ; Equilibrium (Economics) ; Monetary policy;

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References

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  1. Arellano, Cristina & Heathcote, Jonathan, 2010. "Dollarization and financial integration," Journal of Economic Theory, Elsevier, vol. 145(3), pages 944-973, May.
  2. Stefania Albanesi & V.V. Chari & Lawrence J. Christiano, . "Expectation Traps and Monetary Policy," Working Papers 198, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  3. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  4. Andres Velasco & Roberto Chang, 2000. "Exchange-Rate Policy for Developing Countries," American Economic Review, American Economic Association, vol. 90(2), pages 71-75, May.
  5. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," CFS Working Paper Series 2004/22, Center for Financial Studies (CFS).
  6. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  7. V.V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectations, traps and discretion," Working Papers in Applied Economic Theory 96-04, Federal Reserve Bank of San Francisco.
  8. Duarte, Margarida & Obstfeld, Maurice, 2008. "Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 949-957, October.
  9. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
  10. David Romer, 1991. "Openness and inflation: theory and evidence," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
  11. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Working Papers 0016, University of Washington, Department of Economics.
  12. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  13. 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.
  14. 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.
  15. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc.
  16. Kenneth Rogoff, 2003. "Globalization and global disinflation," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 45-78.
  17. 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.
  18. 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.
  19. 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.
  20. Armenter, Roc & Bodenstein, Martin, 2008. "Can The U.S. Monetary Policy Fall (Again) In An Expectation Trap?," Macroeconomic Dynamics, Cambridge University Press, vol. 12(05), pages 664-693, November.
  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.
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Citations

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Cited by:
  1. 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.).
  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.
  3. Michael D. Bordo & Barry Eichengreen, 2008. "Bretton Woods and the Great Inflation," NBER Working Papers 14532, National Bureau of Economic Research, Inc.
  4. Roc Armenter & Martin Bodenstein, 2006. "Of nutters and doves," International Finance Discussion Papers 885, Board of Governors of the Federal Reserve System (U.S.).

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