The Relative Stability of Alternative Exchange Rate Systems in the Presence of Random Disturbances

Abstract

The relative advantages of fixed and flexible exchange rates have been debated at length in the literature.l One of the most important aspects of this debate concerns the relative stability of the two systems in the face of random disturbances. But despite the importance of this problem and the fact that it has been discussed at some length in a rather general way, it has so far received surprisingly little formal analysis. A rnost recent exception is the paper by Fischer [3] which compares the asymptotic stability of the two exchange rate systems within the context of a simple monetarist model of the balance of payments.2 However, his model is perhaps overly simple in that it abstracts from several important factors; most significantly it excludes international capital flows. On the other hand, Argy and Porter [2] consider the short-run (one period) instability in a simple Keynesian model where capital is perfectly mobile internationally. In this paper we examine the stability of a small open economy subject to various random disturbances and operating under both fixed and flexible exchange rates in turn, in the intermediate but most realistic case where capital is only imperfectly mobile internationally. This case turns out to be important, since the degree of capital mobility is shown to play a crucial role in determining the relative stability of the two exchange rate systems. Our primary consideration is the first period or