Evaluating Alternative Exchange Rate Regimes: Time Consistency, Inertia and the Identification of Shocks in a New Keynesian Model

Paper number: 00/03

Paper date: 2000

Year: 2000

Paper Category: Working Paper

Authors

Rebecca L. Driver

Abstract

This paper aims to examine the costs and benefits of different regimes for managing the exchange rate and to assess what factors are likely to exacerbate any potential costs. The comparison is conducted using a small theoretical macromodel of two symmetric "European" economies (labelled France and Germany for convenience). These economies choose their policies 3 cooperatively in an optimal, time consistent fashion in the face of shocks and react with a passive rest of the world. This paper adds to the existing literature in part because a wider class of exchange rate regime is considered. Given the "European" context, and the current debate within Europe about the merits of European Monetary Union (EMU), the obvious comparison to make is that of EMU to a free float. Another obvious comparison is a regime which limits exchange rate fluctuations within Europe, similar to the existing European Exchange Rate Mechanism (ERM). However, a series of other forms of exchange rate management are also considered. These alternatives take the form of a world-wide fixed nominal exchange rate regime and regimes that aim to fix the real exchange rate to its fundamental equilibrium level, either in a world-wide or a European context. As such, this paper is an extension to Driver and Wren-Lewis, 1999, which compares the costs and benefits of EMU to those of a free float.

Evaluating Alternative Exchange Rate Regimes: Time Consistency, Inertia and the Identification of Shocks in a New Keynesian Model Evaluating Alternative Exchange Rate Regimes: Time Consistency, Inertia and the Identification of Shocks in a New Keynesian Model