Comments on “Monetary policy rules and exchange rate flexibility in a simple dynamic general equilibrium model”

Abstract

This very nice paper clearly fits in Devereux’s agenda of promoting exchange rate stability and international monetary cooperation as a better alternative to floating exchange rates and independent, uncoordinated policies. Our first comment has to do with whether or not the paper actually accomplishes this goal. A reader who is familiar with Benigno and Benigno’s (2003) work immediately recognizes from the setup of Devereux’s model that mimicking the flexible price equilibrium under flexible exchange rates is the optimal policy that central banks should commit to pursue to maximize welfare. All assumptions that ensure this result (along with a very elegant analytical solution of the model) are in place: unitary elasticity of substitution between domestic and foreign goods, purchasing power parity (PPP), log utility, subsidies that offset the monopolistic distortion in steady state. Given that the model delivers a clear indication as for what central banks should do, all other policy rules are bound to produce results that are inferior (or at best equal) to those generated by the independent pursuit of the flexible price allocation. Hence, it is not clear to us that the setup of the paper is the best one to argue in favor of exchange rate pegs and policy coordination. Doing so by comparing the outcome under what Devereux calls a cooperative peg to constant money growth rules is not convincing, as one is left wondering why central banks would want to follow such money growth rules in the first place. Perhaps, the more interesting question is how far a properly designed regime of fixed exchange rates leaves the economy from the performance under floating rates and optimal policies. Here, the answer is not far at all.’ The quantitative difference is quite small on welfare grounds.