Optimal and Sustainable Exchange Rate Regimes: A Simple Game-theoretic Approach, Issues 92-100
This paper examines the question of how to design an optimal and sustainable exchange rate regime in a world economy of two interdependent countries. It develops a Barro-Gordon type two-country model and compares noncooperative equilibria under different assumptions of monetary policy credibility and different exchange rate regimes. Using a two-stage game approach to the strategic choice of policy instruments, it identifies optimal (in a Pare to sense) and sustainable (self-enforcing) exchange rate regimes. The theoretical results indicate that the choice of such regimes depends fundamentally on the credibility of monetary policy commitments by the two countries’ authorities. The nature of shocks to the economies and the substitutability between goods produced in the two countries also play some role. International coordination on instrument choice is necessary to design optimal and sustainable exchange rate regimes.
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Choice of Exchange Rate Regimes
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acquire credibility alternative exchange asymmetric credibility authority fixing authority is credible authority's payoff Barro-Gordon choice of exchange closed-economy control the money Credibility Foreign Authority credible authority credible home authority currency equilibrium solutions exchange market trader exchange rate commitment exchange rate management exchange rate regime exchange rate stability fixed exchange rate fixed rate regime fixing the exchange flexible and managed flexible exchange rate flexible or managed flexible rate regime foreign authority's foreign inflation Giavazzi and Giovannini home and foreign home authority sets home authority's incentive inflationary managed exchange rate manages the exchange monetary policy autonomy money supply commitment money supply rule Nash equilibrium nominal interest rate non-credible foreign authority noncooperative optimal and sustainable Pareto Pareto optimal payoff matrix policy credibility policy rule qt+1 rate of inflation rational expectations reaction functions real output real shocks reduced form solutions spot exchange rate stēl symmetric two-country welfare outcomes