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The Role of the Exchange Rate in Monetary Policy Rules

For a country that chooses not to “permanently” fix its exchange rate through a currency board, or a common currency, or some kind of dollarization, the only alternative monetary policy that can work well in the long run is one based on the trinity of (1) a flexible exchange rate, (2) an inflation target, and (3) a monetary policy rule1. While not often put into this three-part format, the desirability of such a monetary policy in an open economy is, in my view, the clear implication of three corresponding strands of recent monetary research: (1) research on fixed exchange rates regimes, including the influential 1995 article “The Mirage of Fixed Exchange Rates” by Maurice Obstfeld and Kenneth Rogoff and the many analyses of the breakdown of fixed exchange rate regimes in the late 1990s; (2) research on the practical success with inflation targeting by Ben Bernanke et al. (1999); and (3) research on the benefits of simple monetary policy rules (see Taylor (1999a), for example).

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