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Macroeconomic Stabilization: Fixed Exchange Rates Vs Inflation Targeting Vs Price Level Targeting

  • Dehejia, Vivek
  • Rowe, Nicholas

We argue that the traditional question 'fixed vs. flexible exchange rates?' is not well-defined, because 'flexible exchange rates' does not explicitly specify any particular monetary policy. In traditional analyses, 'flexible exchange rates' was interpreted as implying a fixed money supply. But fixing the money supply (or fixing its growth rate at k%) is rarely advocated nowadays. To reflect today's policy debate, the traditional question should be replaced by the question 'fixed exchange rates vs. inflation targeting vs. price level targeting?'. We then build a simple macroeconomic model of a small open economy. The model incorporates an 'outside lag' in the effect of monetary policy on aggregate demand, so that inflation targeting and price level targeting are always imperfect. We use this model to compare the stabilization properties of three different monetary rules: a fixed exchange rate, a fixed inflation target, and a fixed price level target. We show that price level targeting is best for stabilizing output, the real exchange rate and the real interest rate, relative to their natural rates.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 2460.

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Date of creation: May 2000
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Handle: RePEc:cpr:ceprdp:2460
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  1. Michael B. Devereux & Charles Engel, 2001. "The Optimal Choice of Exchange Rate Regime: Price-Setting Rules and Internationalized Production," NBER Chapters, in: Topics in Empirical International Economics: A Festschrift in Honor of Robert E. Lipsey, pages 163-194 National Bureau of Economic Research, Inc.
  2. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
  3. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1045-55, December.
  4. Laidler, David, 1999. "The Exchange Rate Regime and Canada's Monetary Order," Working Papers 99-7, Bank of Canada.
  5. Srour, Gabriel, 1999. "Inflation Targeting under Uncertainty," Technical Reports 85, Bank of Canada.
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