Abstract

Can Fixed Rates of Exchange solve the Credibility Problem of Monetary Policy in an Environment of Persistent Unemployment?

One of the key questions of the stability-policy discussion is how to get the credibility problem of monetary policy adequately under control. An important proposal, which is the subject of a highly controversial debate, suggests that countries with elevated rates of inflation resort to fixed nominal rates of exchange visä- vis reserve-currency countries whose rates of inflation are lower. The advocates of this proposal argue that this helps reduce the inflationary bias at the cost of just a small rise in unemployment. This contribution shows that this is so in a model of natural unemployment. However, if it is assumed - which would be more realistic - that at least Europe is afflicted by persistent unemployment, any rigid monetary-policy rule such as fixed nominal rates of exchange does not necessarily help reduce the credibility problem of monetary policy. In such an environment, preference should rather be given to more flexible institutional arrangements possibly by creating a politically independent conservative central bank which could only be outvoted by the government where the latter is prepared to assume substantial amounts of costs. However, such a central bank’s monetary-policy credibility would largely depend from the functioning ability of the labour market as well.