chapter  8
17 Pages

Monetary policy and exchange rates: Theory and practice


The main challenge facing the central bank in an open economy is to achieve both internal and external stabilization, as discussed in Mundell (1968). The central bank thus needs to design its policy, taking account of the impact on the exchange rate as well as on international capital flows. The analysis assumes that the central bank’s ultimate objective is to stabilize the business cycle, and focuses on which intermediate objective was best suited. In particular, should the central bank stabilize the interest rate or smooth fluctuations of exchange rates? The standard paradigm used to think about the issue in the late 1970s was Boyer’s (1978) open economy extension of Poole’s (1970) celebrated closed economy analysis of the central bank’s choice between operating with an interest rate or money stock objective.2 The framework inherits the main aspects of the Poole model: the analysis is static, and prices are assumed to be sticky and determined by aggregate demand (thus, direct exchange rate effects on prices were disregarded). By stabilizing aggregate demand, the central bank can therefore stabilize inflation. The analysis emphasizes how the optimal policy depends on the exact nature of the shocks affecting the economy. Specifically, a flexible exchange rate is preferable when the economy is mostly subject to aggregate demand shocks. A rise in aggregate demand boosts GDP and the demand for money, leading interest rates to rise in order to ensure monetary equilibrium. Higher interest rates in turn attract capital inflows, leading under floating exchange rates to an appreciation of the currency that reduces export competitiveness and aggregate demand. In equilibrium, the aggregate demand shock has no impact on aggregate output as it is exactly offset by the exchange rate appreciation. By contrast, a fixed exchange rate requires the central bank to accommodate the capital inflow through a monetary expansion, leading to a rise in output. The policy prescription is reversed if monetary shocks are predominant. Under floating exchange rates, an increase in velocity shock leads to a reduction in the interest rate as the demand for money demand falls. Capital then flows out of the country, attracted by the higher returns in foreign currency. This triggers a depreciation of the exchange rate, leading to an increase in output by improving the trade balance. Under a fixed exchange rate, however, such a shock has no impact on economic activity, as the incipient depreciation of the exchange rate would force the central bank to tighten monetary policy. With the exchange rate remaining unchanged, exports and output are kept constant.