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Flexible exchange rates and insulation: A reexamination

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  • Fels, Joachim
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    Abstract

    Will a country embedded in an integrated world economy be able to completely insulate its economy from foreign economic disturbances by letting its currency float freely in the foreign exchange market? Both theoretical considerations and the actual experience after the movement to flexible exchange rates among the major currencies in 1973 suggest that the answer is no. According to conventional wisdom, however, the early advocates of flexible exchange rates in the 1950s and 1960s believed in the ability of floating rates to completely insulate an economy from disturbances originating abroad. This statement is frequently cited to show that the case for flexible exchange rates may not be as strong as it originally seemed to be, since part of the case appears to have rested on an erroneous belief. It is one purpose of this paper to point out that, contrary to a widespread view, the outstanding early advocates of flexible exchange rates like Milton Friedman (1953), Egon Sohmen (1961; 1969) and Harry Johnson (1969) never promised complete and automatic insulation from all kinds of foreign economic disturbances. In fact, their argument was more refined. The main purpose of the paper is to contrast Sohmen's true promise, as well as that of other theorists', with the empirical evidence from the period of floating exchange rates since 197 3 and to discuss several explanations for some remaining discrepancies between predictions and outcome.

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    Paper provided by Kiel Institute for the World Economy in its series Kiel Working Papers with number 444.

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    Date of creation: 1990
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    Handle: RePEc:kie:kieliw:444

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    1. Jacob A. Frenkel & Assaf Razin, 1987. "The Mundell-Fleming Model a Quarter Century Later: A Unified Exposition," IMF Staff Papers, Palgrave Macmillan, vol. 34(4), pages 567-620, December.
    2. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 90(358), pages 314-29, June.
    3. Frankel, Jeffrey A., 1989. "Quantifying International Capital Mobility in the 1980s," Department of Economics, Working Paper Series, Department of Economics, Institute for Business and Economic Research, UC Berkeley qt4fw7c7bh, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
    4. J. Marcus Fleming, 1962. "Domestic Financial Policies under Fixed and under Floating Exchange Rates (Politiques finacièrieures intérieures avec un système de taux de change fixe et avec un système de taux de change," IMF Staff Papers, Palgrave Macmillan, vol. 9(3), pages 369-380, November.
    5. Herbert Giersch, 1989. "Anmerkungen zum weltwirtschaftlichen denkansatz," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 125(1), pages 1-16, March.
    6. Gerlach, H M Stefan, 1988. "World Business Cycles under Fixed and Flexible Exchange Rates," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 20(4), pages 621-32, November.
    7. Michael D. Bordo & Anna J. Schwartz, 1988. "Transmission of Real and Monetary Disturbances under Fixed and Floating Rates," Cato Journal, Cato Journal, Cato Institute, vol. 8(2), pages 451-475, Fall.
    8. Rudiger Dornbusch & Ernesto Hernández-Catá & Willem H. Buiter, 1983. "Flexible Exchange Rates and Interdependence [with Comments] (Taux de change flexibles et interdépendance) (Tipos de cambio flexibles e interdependencia)," IMF Staff Papers, Palgrave Macmillan, vol. 30(1), pages 3-38, March.
    9. Alexander K. Swoboda & Jacob A. Frenkel & Jacques R. Artus, 1983. "Exchange Rate Regimes and European-U.S. Policy Interdependence [with Comments] (Régimes de taux de change et interdépendance des politiques économiques en Europe et aux Etats-Unis) (Régime," IMF Staff Papers, Palgrave Macmillan, vol. 30(1), pages 75-112, March.
    10. Cantor, Richard & Mark, Nelson C, 1988. "The International Transmission of Real Business Cycles," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 29(3), pages 493-507, August.
    11. Baxter, Marianne & Stockman, Alan C., 1989. "Business cycles and the exchange-rate regime : Some international evidence," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 377-400, May.
    12. Sohmen, Egon, 1974. "Exchange Rates, Terms of Trade and Employment: Pitfalls in Macroeconomic Models of Open Economies," Kyklos, Wiley Blackwell, vol. 27(3), pages 521-36.
    13. Choudhri, Ehsan U & Kochin, Levis A, 1980. "The Exchange Rate and the International Transmission of Business Cycle Disturbances: Some Evidence from the Great Depression," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 12(4), pages 565-74, November.
    14. Rudiger Dornbusch, 1982. "Flexible Exchange Rates and Interdependence," NBER Working Papers 1035, National Bureau of Economic Research, Inc.
    15. Darby, Michael R. & Lothian, James R. & Gandolfi, Arthur E. & Schwartz, Anna J., 1983. "The International Transmission of Inflation," National Bureau of Economic Research Books, University of Chicago Press, edition 0, number 9780226136417, March.
    16. Michael D. Bordo, 1989. "Introduction to "Money, History, and International Finance: Essays in Honor of Anna J. Schwartz"," NBER Chapters, in: Money, History, and International Finance: Essays in Honor of Anna J. Schwartz, pages 1-12 National Bureau of Economic Research, Inc.
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    Cited by:
    1. Klodt, Henning, 1990. "Government support for restructuring the East German economy," Kiel Working Papers 450, Kiel Institute for the World Economy.

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