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The Flexible Exchange Rate System: Experience and Alternatives

  • Rudiger Dornbusch
  • Jeffrey A. Frankel

We review ten aspects of how floating exchange rates have worked in practice, contrasted with ten characteristics that the system was supposed to have in theory. We conclude that the foreign exchange market is characterized by high transactions-volume, short-term horizons, and an absence of stabilizing speculation. As a result, the exchange rate at times strays from the equilibrium level dictated by fundamentals, contrary to theory. We then look at ten proposed alternatives to the current system. Four entail decentralized policy rules: new classical macroeconomics, a gold standard, monetarism, and nominal income targeting. Four foresee enhanced international coordination: G-7 "objective indicators," Williamson target zones, McKinnon "world monetarism," and a "Hosomi Fund." Two propose enhanced independence: a "Tobin tax" on transactions, and a dual exchange rate. We conclude that one might build a case for intervention from the observed failure of international financial markets to behave as in the theoretical ideal, but that government intervention in practice is just as likely to fall short of the theoretical ideal

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2464.

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Date of creation: Dec 1987
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Publication status: published as International Finance and Trade in a Polycentric World, edited by Silvio Borner, pp. 151-197. London: Macmillan Press, 1988. Reprinted in On Exchange Rates, J. Frankel, MIT Press, Cambridge, 1993
Handle: RePEc:nbr:nberwo:2464
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