Working Paper: CEPR ID: DP725
Authors: Roel Beetsma; Frederick van der Ploeg
Abstract: This paper studies regimes of managed exchange rates for a small open economy with an integrated capital market, rational expectations in financial markets, sluggish nominal wages and prices, and supply shocks that follow a Brownian motion. Each regime can be characterized by the degree to which price shocks are accommodated and the width of the exchange rate band. Special cases of monetary accommodation are a peg, a clean float and a PPP exchange rate rule. First, the optimal degree of monetary accommodation of price shocks is analysed when there is no exchange rate band. Given that the welfare loss is a weighted sum of the asymptotic variances of output and of consumer prices, monetary accommodation is particularly strong when the authorities care relatively more about full employment than price stability. More flexible labour markets induce right-wing governments to move towards a cleaner float and left-wing governments towards a PPP exchange rate rule. Second, the effects of exchange rate bands and the accompanying inframarginal interventions are examined when allowance is made for intramarginal interventions as well. Such a framework can, in contrast to the pioneering Krugman analysis, explain the observed hump-shaped unconditional density functions of EMS exchange rates.
Keywords: exchange rate regimes; supply shocks; dirty floating; PPP exchange rate rules; exchange rate peg; Brownian motion; stochastic simulation
JEL Codes: E0; F3; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government preferences (D72) | monetary policy decisions (E52) |
| flexible labor markets (J46) | right-wing governments adopting cleaner float regimes (E65) |
| flexible labor markets (J46) | left-wing governments preferring PPP exchange rate rules (F31) |
| government priorities (H59) | optimal degree of monetary accommodation (E52) |
| degree of monetary accommodation (E52) | hump-shaped density functions of exchange rates during EMS period (F31) |
| type of monetary policy regime (E63) | welfare loss (D69) |