Unit 7 Macroeconomic policy in the global economy
7.5 Exchange rate and monetary regimes: The story so far
Figure 7.13 summarizes the comparison between the three regimes we have analysed. While these regimes are stylized, most of the insights extend to the range of regimes that we observe in the world. Although membership of a common currency regime is relatively uncommon, the insights it provides extend to a wide range of fixed and target exchange rate regimes.
Extension 5.9 discusses the theoretical arguments and evidence that this makes monetary policy more effective in controlling inflation.
A common feature of the first and third regimes is that monetary policy is constrained in terms of the actions the government can take. Many governments in recent decades have deliberately decided to ‘tie their own hands’ by handing over control of monetary policy to an independent central bank. The government’s hands are tied even more tightly if it commits to fix the exchange rate.
In contrast, in the FlexNIT regime, monetary policy is unconstrained either by a commitment to an explicit target for inflation or via a fixed exchange rate to the inflation target set by another country’s central bank (or by the ECB). We have shown that the lack of constraints can be dangerous.
| Regime | FlexIT | FlexNIT | Fix |
|---|---|---|---|
| Exchange rate regime | Flexible | Flexible | Fixed (extreme case: common currency area) |
| Monetary policy | National monetary policy with inflation target | National monetary policy, no inflation target | Dependent monetary policy |
| ‘Hands tied’? | Usually by making central bank independent | No | Yes |
| Examples | UK from 1997 (after Bank of England independence) USA, eurozone Germany before 1999 |
UK (before 1997), Spain before 1999, Argentina | Spain & Germany from 1999 |
| At supply-side equilibrium in home’s economy | $$\pi = \pi^T$$ | $$\delta = \pi - \pi^*$$ (No anchor for inflation) |
$$\pi = \pi^* = \pi^T_{ECB}$$ |
| Role of exchange rate in stabilizing a positive demand shock | Stabilizing: monetary tightening, nominal and (rapid) real appreciation | Possibly destabilizing: if policymaker attempts to maintain competitiveness by nominal depreciation | Stabilizing: home inflation causes (slow) real appreciation |
Figure 7.13 Three monetary policy and exchange rate regimes.
