Abstract:
When the exchange rate is flexible, and thus responds to market forces, it provides agents with useful information, while when it is fixed (by a feedback rule) it does not. The implications of this asymmetry for the stability of real output under the two regimes is discussed. It is shown that whenever shocks are predominantly of one variety, or when domestic monetary shocks accompanied by one real shock, a flexible exchange rate does a better job of stabilizing real output than does a fixed exchange rate. These results undermine arguments favoring fixed exchange rates because they ‘discipline’ monetary policy. In addition, it is demonstrated that managed floating rules and exchange rate feedback rules are irrelevant for the distribution of real output.
