Flexible Exchange Rates and the World Economy

Volatile exchange rates and how to manage them are a contentious topic whenever economic policymakers gather in international meetings. This book examines the broad parameters of exchange rate policy in light of both high-powered theory and real-world experience. What are the costs and benefits of flexible versus fixed exchange rates? How much of a role should the exchange rate play in monetary policy? Why don't volatile exchange rates destabilize inflation and output?

The principal finding of this book is that using monetary policy to fight exchange rate volatility, including through the adoption of a fixed exchange rate regime, leads to greater volatility of employment, output, and inflation. In other words, the "cure" for exchange rate volatility is worse than the disease. This finding is demonstrated in economic models, in historical case studies, and in statistical analysis of the data. The book devotes considerable attention to understanding the reasons why volatile exchange rates do not destabilize inflation and output. The book concludes that many countries would benefit from allowing greater flexibility of their exchange rates in order to target monetary policy at stabilization of their domestic economies. Few, if any, countries would benefit from a move in the opposite direction.

Joseph E. Gagnon, senior fellow since September 2009, was visiting associate director, Division of Monetary Affairs (2008–09) at the US Federal Reserve Board. Previously he served at the US Federal Reserve Board as associate director, Division of International Finance (1999–2008), and senior economist (1987–1990 and 1991–97). He has also served at the US Treasury Department (1994–95 and 1997–1999) and has taught at the Haas School of Business, University of California, Berkeley (1990–91). He is author of The Global Outlook for Government Debt over the Next 25 years: Implications for the Economy and Public Policy (2011).