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Policy Decentralization and Exchange Rate Management in Interdependent Economies

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  • Willem H. Buiter
  • Jonathan Eaton

Abstract

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.

Suggested Citation

  • Willem H. Buiter & Jonathan Eaton, 1980. "Policy Decentralization and Exchange Rate Management in Interdependent Economies," NBER Working Papers 0531, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0531
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    References listed on IDEAS

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    1. Canzoneri, Matthew B., 1982. "Exchange intervention policy in a multiple country world," Journal of International Economics, Elsevier, vol. 13(3-4), pages 267-289, November.
    2. Jonathan Eaton & Stephen J. Turnovsky, 1984. "The Forward Exchange Market, Speculation, and Exchange Market Intervention," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 99(1), pages 45-69.
    3. Daniel Gros & Timothy Lane, 1992. "Monetary policy interaction within or without an exchange-rate arrangement," Open Economies Review, Springer, vol. 3(1), pages 61-82, February.
    4. Buiter, Willem H., 1983. "Real effects of anticipated and unanticipated money : Some problems of estimation and hypothesis testing," Journal of Monetary Economics, Elsevier, vol. 11(2), pages 207-224.
    5. Eaton, Jonathan, 1985. "Optimal and time consistent exchange-rate management in an overlapping-generations economy," Journal of International Money and Finance, Elsevier, vol. 4(1), pages 83-100, March.
    6. Santiago García-Verdú & Miguel Zerecero, 2013. "On central bank interventions in the Mexican peso/dollar foreign exchange market," BIS Working Papers 429, Bank for International Settlements.

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