Stochastic Monetary Interdependence: The Case for Flexible Exchange Rates Revisited

A theory is developed to explain the following two stylized facts now well known to international economists: first, countries' real and nominal exchange rates tend to move together under flexible exchange rate systems with the ratios of domestic to rest-of-world price levels showing much less variability; and second, business cycles and medium- term price level movements tend to be international in scope. It ascribes these phenomena to the maximizing behavior of central banks, each pursuing similar objectives, in a world where information about the future course of economic activity and the timing of the influence of central bank policy upon it is extremely poor. It shows how central banks, given the limited information available to them, are induced to set a path of monetary growth that will neutralize the effects of international portfolio shocks on the exchange rate, while allowing movements in exchange rates that result from changes in technology, oil shocks, the terms of trade and other real forces to go through unopposed. The result is a similarity of credit conditions across countries leading to world-wide variations of outputs and inflation rates. The theory also explains important details regarding the functioning of foreign exchange markets, as well as the conditions under which countries will chose flexible exchange rates rather than fixed rates. This gives a new perspective on the old question of whether fixed or flexible exchange rates are the best regime and brings us a bit closer to a theory of optimal currency areas.