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What to stabilize in the open economy *
Author(s) -
Bencivenga Valerie R.,
Huybens Elisabeth,
Smith Bruce D.
Publication year - 2002
Publication title -
international economic review
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 2.658
H-Index - 86
eISSN - 1468-2354
pISSN - 0020-6598
DOI - 10.1111/1468-2354.t01-1-00056
Subject(s) - economics , volatility (finance) , indeterminacy (philosophy) , stabilization policy , monetary policy , exchange rate , open economy , monetary economics , small open economy , exchange rate regime , price level , fixed interest rate loan , interest rate , econometrics , microeconomics , physics , quantum mechanics
We consider the question how “best” to maintain price‐level stability in an open economy, and evaluate three possible policy choices: (a) a constant money growth rate rule; (b) a fixed exchange rate; and (c) a policy of explicit commitment to a price‐level target. In each case we assume that policy is conducted by injecting reserves into or withdrawing reserves from the “banking system.” In evaluating the three regimes, we adopt the criterion that the “best” policy should leave the least scope for indeterminacy and “excessive” economic volatility. In a steady‐state equilibrium, the choice of regime is largely irrelevant; any steady‐state equilibrium under one regime can be duplicated by an appropriate choice of the “control” variable under any other regime. However, we show that the sets of equilibria under the three regimes are dramatically different. When all countries follow the policy of fixing a constant rate of money growth, there are no equilibria displaying endogenously arising volatility and there is no indeterminacy of equilibrium. Under a regime of fixed exchange rates, indeterminacies and endogenously arising fluctuations are impossible if and only if the country with the low “reserve‐to‐deposit” ratio is charged with maintaining the fixed rate. Finally, when one country targets the time path of its price level, under very weak conditions, there will be indeterminacy of equilibrium and endogenously arising volatility driven by expectations.