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

39 Pages Posted: 3 Nov 2006

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: August 2006

Abstract

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

Armenter, Roc and Bodenstein, Martin, Does the Time Inconsistency Problem Make Flexible Exchange Rates Look Worse than You Think? (August 2006). FRB International Finance Discussion Paper No. 865. Available at SSRN: https://ssrn.com/abstract=941987 or http://dx.doi.org/10.2139/ssrn.941987

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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