Does the Time Inconsistency Problem Make Flexible Exchange Rates Look Worse than You Think?
39 Pages Posted: 3 Nov 2006
Date Written: August 2006
The Barro-Gordon inflation bias has provided the most influential argument for fixed exchange rate regimes. However, with low inflation rates now widespread, credibility concerns seem no longer relevant. Why give up independent monetary policy to contain an inflation bias that is already under control? We argue that credibility problems do not end with the inflation bias and they are a larger drawback for flexible exchange rates than usually thought. Absent commitment, independent monetary policy can induce expectation traps - that is, welfare ranked multiple equilibria - and perverse policy responses to real shocks, i.e., an equilibrium policy response that is welfare inferior to policy inaction. Both possibilities imply that flexible exchange rates feature unnecessary macroeconomic volatility.
Keywords: time inconsistency, independent monetary policy, exchange rate regimes
JEL Classification: E33, E61, F41
Suggested Citation: Suggested Citation