Amartya Lahiri () (University of British Columbia, Department of Economics, Vancouver, Canada) Rajesh Singh () (Iowa State University, Department of Economics, USA) Carlos A. Vegh () (University of Maryland, Department of Economics and NBER, USA)
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A famous dictum in open economy macroeconomics - which obtains in the Mundell-Fleming world of sticky prices and perfect capital mobility - holds that the choice of the optimal exchange rate regime should depend on the type of shock hitting the economy. If shocks are predominantly real, a flexible exchange rate is optimal, whereas if shocks are mainly monetary, a fixed exchange rate is optimal. There is no obvious reason, however, why this paradigm should be the most appropriate one to think about this important issue. Arguably, asset market frictions may be as pervasive as goods market frictions (particularly in developing countries). In this light, we show that in a model with flexible prices and asset market frictions, the Mundell-Fleming dictum is turned on its head: flexible rates are optimal in the presence of monetary shocks, whereas fixed rates are optimal in response to real shocks. We thus conclude that the choice of an optimal exchange rate regime should depend not only on the type of shock (real versus monetary) but also on the type of friction (goods versus asset market).
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Paper provided by Faculty of economics, Department of Economics in its series Working Papers with number
200731.
Length: 21 pages Date of creation: Nov 2006 Date of revision:
Dec 2006 Publication status: Published in NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge. Paper 12684 http://www.nber.org/papers/w12684. Carlos A. Vegh: Money, Crises, and Transition: Essays in Honor of Guillermo Calvo, edited by Carmen M. Reinhart, Carlos A. Vegh, and Andres Velasco, The MIT Press-a, 2007. Serbian translation published in Panoeconomicus, September 2007, pages 249-270 Handle: RePEc:voj:wpaper:200731
Find related papers by JEL classification: F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
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