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Monetarist Monetary Policy, Exchange Risk, and Exchange Rate Variability

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Author Info
David H. Papell

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Abstract

This paper investigates the relationship between the new monetary control procedures, implemented by the Federal Reserve Board in October 1979, and the subsequent increase in exchange rate variability for the United States. It shows that, in the context of a stochastic, rational expectations model,exchange rate variability minimizing monetary policy is identical to the policy which, in a deterministic, perfect foresight model, would place the economy on the borderline between exchange rate overshooting and undershooting. The model is estimated for the United States since generalized floating began in 1973. The new monetary control procedures have had two opposite effects. Monetary policy has become less accommodative, increasing exchange rate variability through overshooting. On the other hand ,systematic deviations from uncovered interest rate parity, which can be attributed to exchange risk, have also increased. These increase exchange rate variability through undershooting. It is shown that the latter dominate the former, providing an explanation of increased exchange rate variability consistent with undershooting, not with overshooting.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1306.

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Date of creation: Mar 1984
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Handle: RePEc:nbr:nberwo:1306

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  1. Maurice Obstfeld & Kenneth Rogoff, 1983. "Exchange rate dynamics with sluggish prices under alternative price- adjustment rules," International Finance Discussion Papers 223, Board of Governors of the Federal Reserve System (U.S.).
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  2. Meese, Richard A & Singleton, Kenneth J, 1983. "Rational Expectations and the Volatility of Floating Exchange Rates," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 24(3), pages 721-33, October. [Downloadable!] (restricted)
  3. David H. Papell, 1985. "Activist Monetary Policy and Exchange Rate Overshooting: The Deutsche Mark/Dollar Rate," NBER Working Papers 1195, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Black, Stanley W, 1982. "The Effects of Alternative Monetary Control Procedures on Exchange Rates and Output," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 14(4), pages 746-60, November. [Downloadable!] (restricted)
  5. Frenkel, Jacob A & Mussa, Michael L, 1980. "The Efficiency of Foreign Exchange Markets and Measures of Turbulence," American Economic Review, American Economic Association, vol. 70(2), pages 374-81, May. [Downloadable!] (restricted)
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  1. Campos, M. Isabel & Herrera, Julio & Jimenez-Ridruejo, Zenon, 1999. "Censured Exchange Rates in a Discrete Time Target Zones Model: The Spanish Peseta/Deutsche Mark Case," ERSA conference papers ersa99pa183, European Regional Science Association. [Downloadable!]
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