Does the Time Inconsistency Problem Make Flexible Exchange Rates Look Worse than You Think?

33 Pages Posted: 26 Nov 2005

See all articles by Roc Armenter

Roc Armenter

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Martin Bodenstein

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: November 2005

Abstract

Lack of commitment in monetary policy leads to the well known Barro-Gordon inflation bias. In this paper, we argue that two phenomena associated with the time inconsistency problem have been overlooked in the exchange rate debate. We show that, absent commitment, independent monetary policy can also induce expectation traps - that is, welfare-ranked multiple equilibria - and perverse policy responses to real shocks - that is, an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply higher macroeconomic volatility under flexible exchange rates than under fixed exchange rates.

Keywords: time inconsistency, independent monetary policy, exchange rate regimes

JEL Classification: E61, E33, F41

Suggested Citation

Armenter, Roc and Bodenstein, Martin, Does the Time Inconsistency Problem Make Flexible Exchange Rates Look Worse than You Think? (November 2005). FRB of New York Staff Report No. 230. Available at SSRN: https://ssrn.com/abstract=854244 or http://dx.doi.org/10.2139/ssrn.854244

Roc Armenter (Contact Author)

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

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Martin Bodenstein

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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