Exchange Rate Policies Charles Engel Department of Economics, University of Wisconsin Research Associate, National Bureau of Economic Research Senior Fellow, Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas July 28, 2009 Email:
[email protected]. Address: Department of Economics, 1180 Observatory Drive, University of Wisconsin, Madison, WI 53706-1393, USA. This note was prepared as background for the wrap-up conferences of the BIS Asian research programme, The International Financial Crisis and Policy Challenges in Asia and the Pacific, in Shanghai, 6-8 August 2009. I acknowledge support for my research from the Duisenberg Fellowship at the European Central Bank, and from the National Science Foundation under grant #MSN121092. A debate has continued over many years on the desirable degree of foreign exchange rate flexibility. One side of the debate has sometimes made the case that the exchange rate should be freely determined by market forces, independently of any foreign exchange intervention or targeting by central bank monetary policy. This argument takes the stance that the market can best determine the appropriate level of the exchange rate. From the standpoint of modern macroeconomics, particularly from the view of New Keynesian economics, that stance is potentially self-contradictory. Markets are able to achieve efficient, welfare-maximizing outcomes when they operate without distortions – that is, when markets are competitive and prices adjust instantly to reflect underlying costs. But in such a world, the nominal exchange rate regime is of no consequence in determining the real allocation of resources. The real exchange rate (the consumer price level in one country compared to the level in another country, expressed in a common currency) and the terms of trade (the price of a country’s imports relative to its exports) could adjust freely to efficient levels under a floating nominal exchange rate regime, a managed float or even a fixed exchange rate regime if goods markets were perfectly efficient.