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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. Stefania Albanesi & V.V. Chari & Lawrence J. Christiano, . "Expectation Traps and Monetary Policy," Working Papers 198, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  2. Maurice Obstfeld, 1995. "Models of Currency Crises with Self-Fulfilling Features," NBER Working Papers 5285, National Bureau of Economic Research, Inc.
  3. 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.).
  4. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," NBER Working Papers 7665, National Bureau of Economic Research, Inc.
  5. David Romer, 1991. "Openness and Inflation: Theory and Evidence," NBER Working Papers 3936, National Bureau of Economic Research, Inc.
  6. R. King & A. Wolman, 2003. "Monetary discretion, pricing complementarity and dynamic multiple equilibria," Proceedings, Board of Governors of the Federal Reserve System (U.S.).
  7. Arellano, Cristina & Heathcote, Jonathan, 2010. "Dollarization and financial integration," Journal of Economic Theory, Elsevier, vol. 145(3), pages 944-973, May.
  8. 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.
  9. 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.
  10. Jeffrey A. Frankel, 1999. "No Single Currency Regime is Right for All Countries or At All Times," NBER Working Papers 7338, National Bureau of Economic Research, Inc.
  11. Duarte, Margarida & Obstfeld, Maurice, 2008. "Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored," Journal of International Money and Finance, Elsevier, vol. 27(6), pages 949-957, October.
  12. 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.
  13. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  14. Guillermo A. Calvo & Carmen M. Reinhart, 2000. "Fear of Floating," NBER Working Papers 7993, National Bureau of Economic Research, Inc.
  15. V.V. Chari & Lawrence J. Christiano & Martin Eichenbaum, 1996. "Expectation traps and discretion," Working Paper Series, Macroeconomic Issues WP-96-5, Federal Reserve Bank of Chicago.
  16. Andres Velasco & Roberto Chang, 2000. "Exchange-Rate Policy for Developing Countries," American Economic Review, American Economic Association, vol. 90(2), pages 71-75, May.
  17. 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.
  18. Dupor, Bill, 2003. "Optimal random monetary policy with nominal rigidity," Journal of Economic Theory, Elsevier, vol. 112(1), pages 66-78, September.
  19. Roberto Chang & Andres Velasco, 2002. "Dollarization: Analytical Issues," NBER Working Papers 8838, National Bureau of Economic Research, Inc.
  20. Kenneth S. Rogoff, 2003. "Globalization and global disinflation," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-112.
  21. 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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