Exchange rate puzzles and policies
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Date
2023-08-09
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Publisher
Banco Central de Chile
Abstract
What is the optimal exchange rate policy? Should exchange rates be optimally pegged, managed, or allowed to freely float? What defines a freely floating exchange rate? Do open economies face a trilemma constraint in choosing between inflation and exchange rate stabilization, unlike divine coincidence in a closed economy? These are generally difficult questions, as the exchange rate is neither a policy instrument, nor a direct objective of the policy, but rather an endogenous general-equilibrium variable tied by equilibrium relationships in both goods and financial markets. At the same time, equilibrium exchange rate behavior features a variety of puzzles from the point of view of conventional business-cycle models typically used for policy analysis in open economy.
Description
What is the optimal exchange rate policy? Should exchange rates be optimally pegged, managed, or allowed to freely float? What defines a freely floating exchange rate? Do open economies face a trilemma constraint in choosing between inflation and exchange rate stabilization, unlike divine coincidence in a closed economy? These are generally difficult questions, as the exchange rate is neither a policy instrument, nor a direct objective of the policy, but rather an endogenous general-equilibrium variable tied by equilibrium relationships in both goods and financial markets. At the same time, equilibrium exchange rate behavior features a variety of puzzles from the point of view of conventional business-cycle models typically used for policy analysis in open economy.