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Does the time inconsistency problem make flexible exchange rates look worse than you think?

  • Roc Armenter
  • Martin Bodenstein

The Barro-Gordon inflation bias has provided the most influential argument for fixed exchange rate regimes. However, with low inflation rates now widespread, credibility concerns seem no longer relevant. Why give up independent monetary policy to contain an inflation bias that is already under control? We argue that credibility problems do not end with the inflation bias and they are a larger drawback for flexible exchange rates than usually thought. Absent commitment, independent monetary policy can induce expectation traps---that is, welfare ranked multiple equilibria---and perverse policy responses to real shocks, i.e., an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply that flexible exchange rates feature unnecessary macroeconomic volatility.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 865.

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Date of creation: 2006
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Handle: RePEc:fip:fedgif:865
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  15. Andres Velasco & Roberto Chang, 2000. "Exchange-Rate Policy for Developing Countries," American Economic Review, American Economic Association, vol. 90(2), pages 71-75, May.
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  17. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
  18. Roc Armenter & Martin Bodenstein, 2006. "Can the U.S. monetary policy fall (again) in an expectation trap?," International Finance Discussion Papers 860, Board of Governors of the Federal Reserve System (U.S.).
  19. Cooley, Thomas F & Quadrini, Vincenzo, 2001. "The Cost of Losing Monetary Independence: The Case of Mexico," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 370-97, May.
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  21. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc.
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