Finding Equilibrium: On the Relation between Exchange Rates and Monetary Policy

Abstract

This paper deals with the relationship between exchange rates and monetary policy in small open economies. I also discuss the connection between policy rates in small countries and in major advanced economies. A main point is that central bankers need to know whether the currency is (approximately) close to its long-run equilibrium value. However, in the last 25 years there has been very little progress on finding the long-run exchange rate equilibrium. I argue that the economics profession needs to make a major effort to improve the relevant models. The historical situations discussed include the US abandonment of the gold standard in 1933, the East Asian crisis of 1997, and the recent fluctuations of the Mexican peso.

Full Publication: The Price, Real and Financial Effects of Exchange Rates

JEL Classification: E52, E58, F30, F32