Maintaining Price Stability Under Free-Floating: A Fearless Way Out of the Corner?

28 Pages Posted: 2 Dec 2003

See all articles by Carsten Detken

Carsten Detken

European Central Bank (ECB)

Vitor Gaspar

European Commission

Date Written: July 2003

Abstract

The behaviour of the exchange rate under a floating exchange rate regime for a small open economy with perfect capital mobility may appear like a managed float or even a firmer peg. We present a canonical new neo-classical synthesis open economy model where the central bank follows a strategy directed at maintaining price stability. It is shown that the behaviour of the exchange rate depends on the structure of the economy and on the nature of the relevant shocks. In the case of very open economies the exchange rate will look quasi-fixed in response to shocks stemming from the international capital markets. It is also shown that the joined endogeneity of the interest rate and the exchange rate has important implications for the empirical testing of uncovered interest rate parity.

Keywords: Price stability, small open economy, flexible exchange rates, managed floating, uncovered interest rate parity

JEL Classification: E58, E63, F41

Suggested Citation

Detken, Carsten and Gaspar, Vitor, Maintaining Price Stability Under Free-Floating: A Fearless Way Out of the Corner? (July 2003). Available at SSRN: https://ssrn.com/abstract=457308

Carsten Detken (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
0049 69 13440 (Phone)
0049 69 1344 6000 (Fax)

Vitor Gaspar

European Commission ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany
+49 69 1344 7200 (Phone)
+49 69 1344 6575 (Fax)

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