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The Case for Flexible Exchange Rates in a Great Recession

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  • Corsetti, Giancarlo
  • Kuester, Keith
  • Müller, Gernot

Abstract

We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show that for the economy to remain isolated from the shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited. Still, in this case there is a ``benign coincidence": fiscal policy is particularly effective in stabilizing economic activity. Under fixed exchange rates, instead, the impact of the external shock is particularly severe and the effectiveness of fiscal policy reduced.

Suggested Citation

  • Corsetti, Giancarlo & Kuester, Keith & Müller, Gernot, 2016. "The Case for Flexible Exchange Rates in a Great Recession," CEPR Discussion Papers 11432, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:11432
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    References listed on IDEAS

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    1. Manuel Amador & Javier Bianchi & Luigi Bocola & Fabrizio Perri, 2017. "Exchange Rate Policies at the Zero Lower Bound," NBER Working Papers 23266, National Bureau of Economic Research, Inc.
    2. Gauti B. Eggertsson & Neil R. Mehrotra & Sanjay R. Singh & Lawrence H. Summers, 2016. "A Contagious Malady? Open Economy Dimensions of Secular Stagnation," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 64(4), pages 581-634, November.
    3. Corsetti, G. & Mavroeidi, E. & Thwaites, G. & Wolf, M., 2016. "Step away from the zero lower bound: Small open economies in a world of secular stagnation," Cambridge Working Papers in Economics 1645, Faculty of Economics, University of Cambridge.
    4. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August.
    5. Kriwoluzky, Alexander & Müller, Gernot J. & Wolf, Martin, 2015. "Exit Expectations and Debt Crises in Currency Unions," IWH Discussion Papers 18/2015, Halle Institute for Economic Research (IWH).
    6. Marcin Kolasa & Giovanni Lombardo, 2014. "Financial Frictions and Optimal Monetary Policy in an Open Economy," International Journal of Central Banking, International Journal of Central Banking, vol. 10(1), pages 43-94, March.
    7. Banerjee, Ryan & Devereux, Michael B. & Lombardo, Giovanni, 2016. "Self-oriented monetary policy, global financial markets and excess volatility of international capital flows," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 275-297.
    8. Benigno, Gianluca & Benigno, Pierpaolo & Ghironi, Fabio, 2007. "Interest rate rules for fixed exchange rate regimes," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2196-2211, July.
    9. Gertler, Mark & Karadi, Peter, 2011. "A model of unconventional monetary policy," Journal of Monetary Economics, Elsevier, vol. 58(1), pages 17-34, January.
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    Cited by:

    1. Corsetti, G. & Mavroeidi, E. & Thwaites, G. & Wolf, M., 2016. "Step away from the zero lower bound: Small open economies in a world of secular stagnation," Cambridge Working Papers in Economics 1645, Faculty of Economics, University of Cambridge.
    2. 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.

    More about this item

    Keywords

    Benign coincidence; Exchange rate; external shock; External-demand multiplier; Fiscal Multiplier; great recession; zero lower bound;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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