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

  • Roc Armenter
  • Martin Bodenstein

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.

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Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 230.

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Date of creation: 2005
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Handle: RePEc:fip:fednsr:230
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  1. Reinhart, Carmen & Calvo, Guillermo, 2002. "Fear of floating," MPRA Paper 14000, University Library of Munich, Germany.
  2. V. V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectation Traps and Discretion," NBER Working Papers 5541, National Bureau of Economic Research, Inc.
  3. David Romer, 1991. "Openness and inflation: theory and evidence," Proceedings, Federal Reserve Bank of San Francisco, issue Nov.
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  7. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  8. 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.
  9. Stefania Albanesi & V. V. Chari & Lawrence J. Christiano, 2003. "Expectation traps and monetary policy," Staff Report 319, Federal Reserve Bank of Minneapolis.
  10. Roc Armenter, 2008. "A General Theory (and Some Evidence) of Expectation Traps in Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 867-895, 08.
  11. King, Robert G. & Wolman, Alexander L., 2004. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Working Paper Series 0343, European Central Bank.
  12. Mendoza, Enrique G, 2001. "The Benefits of Dollarization When Stabilization Policy Lacks Credibility and Financial Markets Are Imperfect," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 440-74, May.
  13. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Discussion Papers in Economics at the University of Washington 0016, Department of Economics at the University of Washington.
  14. Kenneth S. Rogoff, 2003. "Globalization and global disinflation," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 45-78.
  15. Arellano, Cristina & Heathcote, Jonathan, 2007. "Dollarization and Financial Integration," CEPR Discussion Papers 6116, C.E.P.R. Discussion Papers.
  16. 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.
  17. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc.
  18. Obstfeld, Maurice & Duarte, Margarida, 2005. "Monetary Policy in the Open Economy Revisited: The Case for Exchange-Rate Flexibility Restored," 2005 Meeting Papers 386, Society for Economic Dynamics.
  19. Svensson, Lars E O, 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," CEPR Discussion Papers 1249, C.E.P.R. Discussion Papers.
  20. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
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