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Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy

  • Tommaso Monacelli

    ()

    (Boston College)

Industrial countries moving from fixed to floating exchange rate regimes experience dramatic rises in the variability of the real exchange rate. This evidence, forcefully documented by Mussa (1986), is a puzzle to the extent that it is hard to reconcile with the assumption of flexible prices. This paper shows that a model that combines nominal rigidities with a systematic behavior of monetary policy approximating a managed-fixed exchange rate regime is consistent with Mussa's findings: the real exchange rate is between three and six times more variable under floating than under fixed rates, and this holds independently of the underlying shocks. The impact of the change in regime on the volatility of other real macroeconomic variables, however, depends crucially on the specification of the monetary policy rule and on the source of fluctuations. The model takes also a theoretical stand on other issues raised in the empirical literature, like the so-called exchange rate anomaly, and the international monetary policy shock transmission sign.

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Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 437.

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Date of creation: 15 Jan 1999
Date of revision: 15 Sep 2000
Handle: RePEc:boc:bocoec:437
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