DP12197 Fixed on Flexible: Rethinking Exchange Rate Regimes after the Great Recession

Author(s): Giancarlo Corsetti, Keith Kuester, Gernot Müller
Publication Date: August 2017
Keyword(s): Benign coincidence, Currency union, Exchange rate, Exchange rate peg, external shock, Fiscal Multiplier, great recession, zero lower bound
JEL(s): E31, F41, F42
Programme Areas: International Macroeconomics and Finance
Link to this Page: www.cepr.org/active/publications/discussion_papers/dp.php?dpno=12197

The zero lower bound problem during the Great Recession has exposed the limits of monetary autonomy, prompting a reevaluation of the relative benefits of currency pegs and monetary unions (see e.g. Cook and Devereux, 2016). We revisit this issue from the perspective of a small open economy. While a peg can be beneficial when the recession originates domestically, we show that a float dominates in the face of deflationary demand shocks abroad. When the rest of the world is in a liquidity trap, the domestic currency depreciates in nominal and real terms even in the absence of domestic monetary stimulus (if domestic rates are also at the zero lower bound) -- enhancing the country's competitiveness and insulating to some extent the domestic economy from foreign deflationary pressure.