Optimal Exchange Rate Regimes: Turning Mundell-Fleming's Dictum on its Head

23 Pages Posted: 20 Nov 2006 Last revised: 3 Oct 2010

See all articles by Amartya Lahiri

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics

Rajesh Singh

Iowa State University

Carlos A. Vegh

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS); University of Maryland - Department of Economics; University of California at Los Angeles; National Bureau of Economic Research (NBER)

Date Written: November 2006

Abstract

A famous dictum in open economy macroeconomics -- which obtains in the Mundell-Fleming world of sticky prices and perfect capital mobility -- holds that the choice of the optimal exchange rate regime should depend on the type of shock hitting the economy. If shocks are predominantly real, a flexible exchange rate is optimal, whereas if shocks are mainly monetary, a fixed exchange rate is optimal. There is no obvious reason, however, why this paradigm should be the most appropriate one to think about this important issue. Arguably, asset market frictions may be as pervasive as goods market frictions (particularly in developing countries). In this light, we show that in a model with flexible prices and asset market frictions, the Mundell-Fleming dictum is turned on its head: flexible rates are optimal in the presence of monetary shocks, whereas fixed rates are optimal in response to real shocks. We thus conclude that the choice of an optimal exchange rate regime should depend not only on the type of shock (real versus monetary) but also on the type of friction (goods versus asset market).

Suggested Citation

Lahiri, Amartya and Singh, Rajesh and Vegh, Carlos A., Optimal Exchange Rate Regimes: Turning Mundell-Fleming's Dictum on its Head (November 2006). NBER Working Paper No. w12684, Available at SSRN: https://ssrn.com/abstract=942979

Amartya Lahiri

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada
604.822.8606 (Phone)

HOME PAGE: http://www.econ.ubc.ca/alahiri/

Rajesh Singh

Iowa State University ( email )

613 Wallace Road
Ames, IA 50011
United States

Carlos A. Vegh (Contact Author)

Johns Hopkins University - Paul H. Nitze School of Advanced International Studies (SAIS) ( email )

1740 Massachusetts Avenue, NW
Washington, DC 20036-1984
United States

University of Maryland - Department of Economics ( email )

College Park, MD 20742
United States

University of California at Los Angeles ( email )

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United States
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310-825-9528 (Fax)

HOME PAGE: http://vegh.sscnet.ucla.edu

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