Why and how to use fiscal policy to target the exchange rate

Authored by: DeLisle Worrell

Handbook of Caribbean Economies

Print publication date:  November  2020
Online publication date:  November  2020

Print ISBN: 9780367210489
eBook ISBN: 9780429265105
Adobe ISBN:

10.4324/9780429265105-11

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Abstract

The motivation for this chapter is the observed discomfort with the conventional approaches to stabilization and growth policies that is manifest in a majority of small open economies. Open economies are faced with a choice of an independent monetary policy with a floating exchange rate and open financial markets or a fixed exchange rate with a financial market which is segregated from the international market by use of exchange controls. Conventional wisdom, informed by the widespread failure of exchange controls in the 1970s and 1980s, advocates choosing exchange rate flexibility. However, in open economies flexible exchange rates have proved to be excessively volatile, depressing investment and growth, and increasing the risk of financial crisis. In recent years there has been growing acknowledgement that predictable exchange rates with low volatility contribute to macroeconomic and financial stability in small open economies; an International Monetary Fund (IMF) study tried (unsuccessfully, in my opinion) to accommodate this reality within the conventional policy framework (Ostry et al. 2012). However, actual practice still does not vary appreciably from the standard approach to macroeconomic management, with a preference for flexible exchange rates and inflation targeting using monetary policy.

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