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What to stabilize in the open economy

  • Valerie R. Bencivenga

    (University of Texas at Austin)

  • Elisabeth Huybens

    (World Bank)

  • Bruce D. Smith

    (University of Texas at Austin)

We consider the question how "best" to maintain price-level stability in an open economy, and evaluate three possible policy choices: (a) a constant money growth rate rule; (b) a fixed exchange rate; and (c) a policy of explicit commitment to a price-level target. In each case we assume that policy is conducted by injecting reserves into or withdrawing reserves from the "banking system." In evaluating the three regimes, we adopt the criterion that the "best" policy should leave the least scope for indeterminacy and "excessive" economic volatility. In a steady-state equilibrium, the choice of regime is largely irrelevant; any steady-state equilibrium under one regime can be duplicated by an appropriate choice of the "control" variable under any other regime. However, we show that the "sets of equilibria" under the three regimes are dramatically different. When all countries follow the policy of fixing a constant rate of money growth, there are no equilibria displaying endogenously arising volatility and there is no indeterminacy of equilibrium. Under a regime of fixed exchange rates, indeterminacies and endogenously arising fluctuations are impossible if and only if the country with the low "reserve-to-deposit" ratio is charged with maintaining the fixed rate. Finally, when one country targets the time path of its price level, under very weak conditions, there will be indeterminacy of equilibrium and endogenously arising volatility driven by expectations. Copyright 2002 by the Economics Department of the University of Pennsylvania and Osaka University Institute of Social and Economic Research Association

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Article provided by Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association in its journal International Economic Review.

Volume (Year): 43 (2002)
Issue (Month): 4 (November)
Pages: 1289-1307

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Handle: RePEc:ier:iecrev:v:43:y:2002:i:4:p:1289-1307
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