Expectations and the Behaviour of Prices and Output under Flexible Exchange Rates

Abstract

A good deal of recent work in the tradition of the monetary approach to balance of payments theory under fixed exchange rates views reserve flows, not as transmitting inflationary impulses, but as accommodating the behaviour of the domestic money supply to variations in the inflation rate brought about by other means. A direct transfer mechanism, justified in earlier analysis by making the small open economy a price-taker in world markets, at least for tradable goods, and in more recent work by having inflation expectations, and hence domestic price setting, influenced by the behaviour of inflation in the rest of the world, is instead regarded as the important channel whereby inflation is transmitted between open economies operating fixed exchange rates. Moreover, a considerable amount of empirical evidence consistent with the operation of such a mechanism has accumulated in recent years.1 The above work deals with a regime of fixed exchange rates. This paper is concerned with investigating what the existence of a price-transfer mechanism implies about the view that a freely floating exchange rate provides complete insulation against nominal. shocks originating abroad. This view, after all, is based upon the hypothesis that, in severing the link between the domestic money supply and any foreign variables, such an exchange rate regime cuts off the only channel whereby such shocks can be imported. The analysis is carried out with the aid of an open economy version of a macroeconomic model which combines the quantity theory of money with an expectations augmented Phillips curve.2 It is shown that only in the long run does a flexible exchange rate regime in general guarantee the insulation of the economy from nominal shocks arising in the rest of the world. In the short run, the extent to which a flexible exchange rate can insulate domestic output and inflation from the consequences of variations in the world inflation rate turns out to depend crucially upon how inflation expectations are formed. The presence of a price transfer mechanism can undermine the insulating properties of flexible rates. As to the economy's response to variations in the domestic monetary expansion rate, it is only in the long run that this always takes the form of a change in the domestic inflation rate. In the short run the responses of output and inflation to such a variation also depend upon the inflation expectations mechanism embodied in the model.