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Policy Decentralization and Exchange Rate Management in Interdependent Economies

  • Willem H. Buiter
  • Jonathan Eaton

The paper provides a theoretical framework for analyzing policy formation among independent authorities operating in an interdependent environment. This is then applied to the analysis of optimal monetary policy in a stochastic two-country model with rational expectations. The main conclusions are 1) Optimal monetary policy requires a finite response of the money supply to the exchange rate (which is the only contemporaneously observed variable.) Neither a fixed nor a freely floating exchange rate is likely to be optimal. 2) Output stabilizing monetary policy may well require 'leaning with the wind' in the foreign exchange market, expanding the money supply when the home currency depreciates, thus increasing the volatility of the exchange rate. 3) The ability of the monetary authorities to influence real variables is due to the assumption that the private sector does not make exchange rate-contingent forward contracts.4) There are likely to be gains from policy coordination.

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File URL: http://www.nber.org/papers/w0531.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 0531.

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Date of creation: Aug 1980
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Publication status: published as Buiter, Willem H. and Jonathan Eaton. "Policy Decentralization and Exchange Rate Management in Interdependent Economies." Exchange Rate Management under Uncertainty, edited by J.S. Bhandari, (1985), pp. 31-54, MIT Press, Cambridge, MA.
Handle: RePEc:nbr:nberwo:0531
Note: ITI IFM
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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  1. Barro, Robert J, 1978. "A Stochastic Equilibrium Model of an Open Economy under Flexible Exchange Rates," The Quarterly Journal of Economics, MIT Press, vol. 92(1), pages 149-64, February.
  2. Robert A. Mundell, 1962. "The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability," IMF Staff Papers, Palgrave Macmillan, vol. 9(1), pages 70-79, March.
  3. Aoki, Masanao, 1976. "On decentralized stabilization policies and dynamic assignment problems," Journal of International Economics, Elsevier, vol. 6(2), pages 143-171, May.
  4. McCallum, B. T. & Whitaker, J. K., 1979. "The effectiveness of fiscal feedback rules and automatic stabilizers under rational expectations," Journal of Monetary Economics, Elsevier, vol. 5(2), pages 171-186, April.
  5. Richard G. Harris & Douglas D. Purvis, 1978. "Diverse Information and Market Efficiency in a Monetary Model of the Exchange Rate," Working Papers 309, Queen's University, Department of Economics.
  6. Weiss, Laurence, 1982. "Information Aggregation and Policy," Review of Economic Studies, Wiley Blackwell, vol. 49(1), pages 31-42, January.
  7. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
  8. Robert S. Pindyck, 1976. "The Cost of Conflicting Objectives in Policy Formulation," NBER Chapters, in: Annals of Economic and Social Measurement, Volume 5, number 2, pages 239-248 National Bureau of Economic Research, Inc.
  9. Matthew B. Canzoneri, 1979. "Rational destabilizing speculation and exchange intervention policy," International Finance Discussion Papers 157, Board of Governors of the Federal Reserve System (U.S.).
  10. Taylor, John B, 1977. "Conditions for Unique Solutions in Stochastic Macroeconomic Models with Rational Expectations," Econometrica, Econometric Society, vol. 45(6), pages 1377-85, September.
  11. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 1045-55, December.
  12. William Poole, 1970. "Optimal choice of monetary policy instruments in a simple stochastic macro model," Staff Studies 57, Board of Governors of the Federal Reserve System (U.S.).
  13. Turnovsky, Stephen J, 1980. "The Choice of Monetary Instrument under Alternative Forms of Price Expectations," The Manchester School of Economic & Social Studies, University of Manchester, vol. 48(1), pages 39-62, March.
  14. Lucas, Robert Jr., 1972. "Expectations and the neutrality of money," Journal of Economic Theory, Elsevier, vol. 4(2), pages 103-124, April.
  15. Patrick, John D., 1973. "Establishing convergent decentralized policy assignment," Journal of International Economics, Elsevier, vol. 3(1), pages 37-51, February.
  16. Hamada, Koichi, 1976. "A Strategic Analysis of Monetary Interdependence," Journal of Political Economy, University of Chicago Press, vol. 84(4), pages 677-700, August.
  17. Woglom, Geoffrey, 1979. "Rational Expectations and Monetary Policy in a Simple Macroeconomic Model," The Quarterly Journal of Economics, MIT Press, vol. 93(1), pages 91-105, February.
  18. Cooper, Richard N, 1969. "Macroeconomic Policy Adjustment in Interdependent Economies," The Quarterly Journal of Economics, MIT Press, vol. 83(1), pages 1-24, February.
  19. Don E. Roper & Stephen J. Turnovsky, 1980. "Optimal Exchange Market Intervention in a Simple Stochastic Macro Model," Canadian Journal of Economics, Canadian Economics Association, vol. 13(2), pages 296-309, May.
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