The Case for Flexible Exchange Rates in a Great Recession

42 Pages Posted: 16 Aug 2016

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Gernot J. Müller

University of Tuebingen - Department of Economics

Date Written: August 2016

Abstract

We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show that for the economy to remain isolated from the shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited. Still, in this case there is a "benign coincidence": fiscal policy is particularly effective in stabilizing economic activity. Under fixed exchange rates, instead, the impact of the external shock is particularly severe and the effectiveness of fiscal policy reduced.

Keywords: Benign coincidence, Exchange rate, external shock, External-demand multiplier, Fiscal Multiplier, great recession, zero lower bound

JEL Classification: E31, F41, F42

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Müller, Gernot J., The Case for Flexible Exchange Rates in a Great Recession (August 2016). CEPR Discussion Paper No. DP11432, Available at SSRN: https://ssrn.com/abstract=2823457

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Keith Kuester

Federal Reserve Banks - Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

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