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The advantage of tying one's hands: revisited

  • Mirco Soffritti

    (Boston University, Department of Economics, USA)

  • Francesco Zanetti

    (Bank of England and EABCN, UK)

Fixing the exchange rate is often seen as an appealing strategy to gain credibility and keep inflation under control. But what is the impact of this policy on welfare? We answer this question using a microfounded, New Keynesian monetary model for a small open economy, to study the outcome of three alternative strategies for a central bank that targets both output and inflation: a policy of pure commitment; a discretionary policy where the exchange rate is free to fluctuate; and a strategy that pegs the nominal exchange rate. We first compare their impact on the policymaker's rule-of-thumb, quadratic objective and then on the agent's utility. In contrast to previous work, in which the policymaker maximizes a rule-of-thumb function, time-consistent monetary policy leads to a lower loss than a policy that ties the policymaker's hands by stabilizing the exchange rate. However, the strategy that fixes the exchange rate is ranked first when the policymaker maximizes the agent's utility. Copyright © 2007 John Wiley & Sons, Ltd.

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Article provided by John Wiley & Sons, Ltd. in its journal International Journal of Finance & Economics.

Volume (Year): 13 (2008)
Issue (Month): 2 ()
Pages: 135-149

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Handle: RePEc:ijf:ijfiec:v:13:y:2008:i:2:p:135-149
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