Working Paper: CEPR ID: DP304
Authors: George S. Alogoskoufis
Abstract: This paper provides a theoretical evaluation of two of the most influential recent proposals for international monetary reform, namely McKinnon's standard with fixed exchange rates and Williamson's target zones. The focus is on the implications of the proposals for short-run stabilization policy. The results suggest that in a first-best world where all countries have recourse to both monetary and fiscal policy, the McKinnon standard would be not only desirable, but also feasible, in the sense that if world monetary policy is set optimally, there is no incentive for individual economies to engage in exchange rate management. In the absence of fiscal flexibility, even when world monetary policy is set optimally, exchange rate management becomes necessary to counteract the distortions arising from country-specific supply shocks. The nominal exchange rate flexibility inherent in the target zones proposal is then a necessary part of the optimal (second-best) world monetary system. The analysis, however, suggests no role for either explicit bands or nominal income targets.
Keywords: international monetary reform; fixed exchange rates; target zones
JEL Codes: 432
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| McKinnon standard is desirable and feasible (D63) | optimal world monetary policy (E52) |
| optimal world monetary policy (E52) | eliminate the need for exchange rate management (F31) |
| without fiscal flexibility (H60) | exchange rate management becomes necessary (F31) |
| nominal exchange rate flexibility is essential to respond to shocks (F31) | distinguishes Williamson's target zones from McKinnon's fixed exchange rates (F31) |
| pursuit of fixed nominal income targets (E63) | inadequate address of monetary stability (E49) |
| pursuit of fixed nominal income targets (E63) | suboptimal responses to supply shocks (F41) |