Exchange Rate Flexibility Under the Zero Lower Bound

55 Pages Posted: 21 Oct 2014

See all articles by David E. Cook

David E. Cook

Hong Kong University of Science & Technology (HKUST) - Department of Economics; Hong Kong University of Science & Technology (HKUST) - Department of Economics

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Date Written: October 2014

Abstract

An independent currency and a flexible exchange rate generally helps a country in adjusting to macroeconomic shocks. But recently in many countries, interest rates have been pushed down close to the lower bound, limiting the ability of policy-makers to accommodate shocks, even in countries with flexible exchange rates. This paper argues that if the zero bound constraint is binding and policy lacks an effective `forward guidance' mechanism, a flexible exchange rate system may be inferior to a single currency area. With monetary policy constrained by the zero bound, under flexible exchange rates, the exchange rate exacerbates the impact of shocks. Remarkably, this may hold true even if only a subset of countries are constrained by the zero bound, and other countries freely adjust their interest rates under an optimal targeting rule. In a zero lower bound environment, in order for a regime of multiple currencies to dominate a single currency, it is necessary to have effective forward guidance in monetary policy.

Keywords: Forward Guidance, Lower Bound, Monetary Policy, Optimal Currency Area

JEL Classification: E2, E5, E6

Suggested Citation

Cook, David E. and Devereux, Michael B., Exchange Rate Flexibility Under the Zero Lower Bound (October 2014). CEPR Discussion Paper No. DP10202, Available at SSRN: https://ssrn.com/abstract=2512730

David E. Cook (Contact Author)

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

Hong Kong University of Science & Technology (HKUST) - Department of Economics ( email )

Clear Water Bay
Kowloon, Hong Kong
China
2538 7614 (Phone)

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604-822-2542 (Phone)
604-946-6271 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

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