Exchange Rate Flexibility Under the Zero Lower Bound

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