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Exchange rate flexibility under the zero lower bound

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  • Cook, David
  • Devereux, Michael B

Abstract

An independent monetary policy and a flexible exchange rate generally help a country in adjusting to macroeconomic shocks. But recently in many countries, interest rates have been pushed down close to the lower bound, limiting the ability of policy-makers to accommodate shocks, even with flexible exchange rates. This paper argues that when the zero bound constraint on nominal interest rates is binding and policy lacks an effective ‘forward guidance’ mechanism, a flexible exchange rate system may be inferior to a single currency area. With monetary policy constrained by the zero bound, a flexible exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries are constrained by the zero bound, and other countries optimally adjust their interest rate targets. For a regime of multiple currencies to dominate a single currency in a zero bound environment, it is necessary to have effective forward guidance in monetary policy.

Suggested Citation

  • Cook, David & Devereux, Michael B, 2016. "Exchange rate flexibility under the zero lower bound," Journal of International Economics, Elsevier, vol. 101(C), pages 52-69.
  • Handle: RePEc:eee:inecon:v:101:y:2016:i:c:p:52-69
    DOI: 10.1016/j.jinteco.2016.03.011
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Giancarlo Corsetti & Keith Kuester & Gernot J. Müller, 2017. "Fixed on Flexible: Rethinking Exchange Rate Regimes after the Great Recession," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 65(3), pages 586-632, August.
    2. Nikolaos Antonakakis & David Gabauer & Rangan Gupta, 2018. "International Monetary Policy Spillovers: Evidence from a TVP-VAR," Working Papers 201806, University of Pretoria, Department of Economics.
    3. repec:spr:annopr:v:260:y:2018:i:1:d:10.1007_s10479-017-2530-3 is not listed on IDEAS
    4. Groll, Dominik & Monacelli, Tommaso, 2016. "The Inherent Benefit of Monetary Unions," Annual Conference 2016 (Augsburg): Demographic Change 145807, Verein für Socialpolitik / German Economic Association.
    5. Brendon, Charles & Corsetti, Giancarlo, 2016. "COEURE Survey: Fiscal and Monetary Policies after the Crises," CEPR Discussion Papers 11088, C.E.P.R. Discussion Papers.
    6. Kuvshinov, Dmitry & Müller, Gernot J. & Wolf, Martin, 2016. "Deleveraging, deflation and depreciation in the euro area," European Economic Review, Elsevier, vol. 88(C), pages 42-66.
    7. Talmain, Gabriel, 2017. "Two-country Model and Foreign Exchange Dynamics," MPRA Paper 85192, University Library of Munich, Germany.
    8. Vadym Lepetyuk & Lilia Maliar & Serguei Maliar, 2017. "Should Central Banks Worry About Nonlinearities of their Large-Scale Macroeconomic Models?," Staff Working Papers 17-21, Bank of Canada.
    9. repec:eee:ecmode:v:69:y:2018:i:c:p:58-66 is not listed on IDEAS

    More about this item

    Keywords

    Zero lower bound; Monetary policy; Optimal currency area; Forward guidance;

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook

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