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

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  • Roc Armenter
  • Martin Bodenstein

Abstract

Lack of commitment in monetary policy leads to the well known Barro-Gordon inflation bias. In this paper, we argue that two phenomena associated with the time inconsistency problem have been overlooked in the exchange rate debate. We show that, absent commitment, independent monetary policy can also induce expectation traps-that is, welfare-ranked multiple equilibria-and perverse policy responses to real shocks-that is, an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply higher macroeconomic volatility under flexible exchange rates than under fixed exchange rates.

Suggested Citation

  • Roc Armenter & Martin Bodenstein, 2005. "Does the time inconsistency problem make flexible exchange rates look worse than you think?," Staff Reports 230, Federal Reserve Bank of New York.
  • Handle: RePEc:fip:fednsr:230
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    References listed on IDEAS

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    Cited by:

    1. Bodenstein Martin R. & Armenter Roc, 2009. "Of Nutters and Doves," The B.E. Journal of Macroeconomics, De Gruyter, vol. 9(1), pages 1-22, September.
    2. Armenter, Roc & Bodenstein, Martin, 2008. "Can The U.S. Monetary Policy Fall (Again) In An Expectation Trap?," Macroeconomic Dynamics, Cambridge University Press, vol. 12(05), pages 664-693, November.
    3. Roc Armenter & Martin Bodenstein, 2005. "Can U.S. monetary policy fall (again) into an expectation trap?," Staff Reports 229, Federal Reserve Bank of New York.
    4. Cooke, Dudley, 2006. "Openness and Inflation," Economics Discussion Papers 8907, University of Essex, Department of Economics.
    5. Michael D. Bordo & Barry Eichengreen, 2008. "Bretton Woods and the Great Inflation," NBER Working Papers 14532, National Bureau of Economic Research, Inc.

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    Keywords

    Foreign exchange rates ; Equilibrium (Economics) ; Monetary policy;

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