Real Exchange Rate Fluctuations in a Small Open Economy Under Fixed and Flexible Exchange Rates
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Real Exchange Rate Fluctuations in a Small Open Economy Under Fixed and Flexible Exchange Rates
Journal of Contextual Economics – Schmollers Jahrbuch, Vol. 107 (1987), Iss. 1 : pp. 51–66
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Klein, Martin
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Abstract
The two central questions of this paper are as follows. First, does macroeconomic theory offer an explanation for the observed high level of real exchange rate fluctuations in the flexible exchange rate period? Second, are these fluctuations destabilizing with respect to domestic output, or are they rather the symptom of the proper functioning of the real exchange rate as an automatic stabilizer? We establish the following results. First, the transition from fixed to flexible exchange rates does not per se imply greater volatility of real exchange rates. Rather, this depends on the flexibility of domestic output prices. Second, with flexible output prices the relative degree of real exchange rate fluctuations in both regimes depends crucially on the origin of the exogenous disturbances. Third, even if - with sticky prices - the flexible rate regime leads to higher real exchange rate fluctuations this does not necessarily imply higher output fluctuations. Rather, depending on the origin of the exogenous disturbances real exchange rate fluctuations may be stabilizing.