According to the classical model in international macro constructed by Robert Mundell and Marcus Fleming in the sixties, the central bank can pursue an active monetary policy under a floating exchange rate regime, in such a way that the exchange rate and the interest rate have a stabilizing effect on the economy. This principal argument is generally accepted, but the judgment of how important it in reality is, still remains an open question.
While it is obvious that the central bank can stabilize the economy under a floating exchange rate in the simple textbook model, the situation is more complex in practice (see e.g. Obstfeld and Rogoff (1996)). First, the central bank takes its decisions under imperfect information and monetary policy affects the economy with a lag. According to traditional macroeconomic theory, price and wage adjustments tend to stabilize the economy. This implies that the significance of the fact that the central bank can pursue an active monetary policy under a floating exchange rate regime depends on how quickly it can react, and how quickly the monetary policy affects the economy, as compared to how quickly wages and prices adapt. Second, stabilizing output is not the only target of the central bank; in fact an inflation target is often assigned as its most important target. Third, there may be some uncertainty about the monetary policy of the central bank, which in itself generates destabilizing exchange rate movements (overshooting).
This leads to several questions. Can we quantitatively say anything about the importance of the exchange rate for macroeconomic stability? What do we know empirically about the influence of the exchange rate on the economy? Is the basic proposition that the central bank can stabilize the economy under a floating exchange rate regime still valid, once we allow for reasonable lags in the implementation and effects of policy?
To shed some light on these questions, I will construct a simple model assumed to be stable across exchange rate regimes, and then simulate the hypothetical macroeconomic development under alternative exchange rate regimes in Sweden in the period 1974-1994. In that period, Sweden had a quasi-fixed exchange rate regime, where the Swedish currency was tied to various currencies and baskets of currencies, with three devaluations in 1976-1977, two devaluations at the beginning of the 1980’s and finally, the large depreciation in November 1992 leading to the float of the krona (see Figure 1). This actual regime will be compared to two hypothetical regimes: first a floating exchange rate regime and second, an irrevocably fixed exchange rate. Under the floating exchange rate regime, I assume that we have an independent central bank carrying out a credible monetary policy. In the latter case, five different fixed exchange rate regimes are considered; I consider both the case when the Swedish krona is fixed to a weighted basket of currencies and the cases when it is fixed to four different currencies.
The exercise of comparing the macroeconomic development under alternative exchange rate regimes is interesting, because it provides answers to questions like:
- 1) How important is the exchange rate regime for macroeconomic stability, is the development about the same under the three regimes or does it substantially deviate between different exchange rate regimes?
2) What is quantitatively the central bank’s possibility to stabilize the economy under a floating exchange rate regime?
3) Was the actual quasi-fixed exchange rate regime optimal from a stability point of view?
The results of my study indicate that under a floating exchange regime, the central bank can stabilize much of the macroeconomic shocks. Still, compared to the actual development, output volatility is only somewhat lower under the simulated floating exchange rate regime when the central bank has no information lags and is only interested in output stability. More precisely, under the simulated floating exchange rate regime, the central bank must pay a very high “price” in terms of volatility in exchange rate and prices to reach the same output stability as under the actual regime. This implies that the actual policy with a fixed exchange rate and a number of devaluations was quite successful from an output stability point of view; the devaluations were well timed in relation to the business cycle. As pointed out by Edin and Vredin (1993), Sweden tends to devalue when the economy goes into a recession. Finally, the outcomes under the hypothetical fixed exchange rate regimes are more volatile than under both the actual and the hypothetical floating exchange rate regime.
The rest of the paper is organized as follows. In the next section, I present the theoretical model. In section 3, I describe the data and estimate the model. The potential of monetary policy to stabilize output is examined in section 4. In section 5, sensitivity analyses are performed and the case with a fixed exchange rate regime is discussed in section 6. Finally, I discuss the results and draw some conclusions in sections 7 and 8.
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