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The advantage of tying one's hands: revisited

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  • Mirco Soffritti

    (Boston University, Department of Economics, USA)

  • Francesco Zanetti

    (Bank of England and EABCN, UK)

Abstract

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.

Suggested Citation

  • Mirco Soffritti & Francesco Zanetti, 2008. "The advantage of tying one's hands: revisited," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 13(2), pages 135-149.
  • Handle: RePEc:ijf:ijfiec:v:13:y:2008:i:2:p:135-149
    DOI: 10.1002/ijfe.321
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    References listed on IDEAS

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    Cited by:

    1. Groll, Dominik, 2013. "When do Countries Benefit from Forming a Monetary Union?," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79787, Verein für Socialpolitik / German Economic Association.
    2. Groll, Dominik & Monacelli, Tommaso, 2016. "The Inherent Benefit of Monetary Unions," Annual Conference 2016 (Augsburg): Demographic Change 145807, Verein für Socialpolitik / German Economic Association.
    3. Daniela Bragoli & Massimiliano Rigon & Francesco Zanetti, 2016. "Optimal Inflation Weights in the Euro Area," International Journal of Central Banking, International Journal of Central Banking, vol. 12(2), pages 357-383, June.
    4. Massimiliano Rigon & Francesco Zanetti, 2017. "Optimal Monetary Policy and Fiscal Policy Interaction in a non-Ricardian Economy," BCAM Working Papers 1708, Birkbeck Centre for Applied Macroeconomics.
    5. Groll, Dominik, 2014. "Monetary union and macroeconomic stabilization," Kiel Working Papers 1881, Kiel Institute for the World Economy (IfW).
    6. repec:kap:compec:v:50:y:2017:i:3:d:10.1007_s10614-016-9601-4 is not listed on IDEAS
    7. Hyuk Rhee & Nurlan Turdaliev, 2012. "Targeting Rules for an Open Economy," Open Economies Review, Springer, vol. 23(3), pages 447-471, July.

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