DP11432 The Case for Flexible Exchange Rates in a Great Recession
We analyze macroeconomic stabilization in a small open economy which faces a large recession in the rest of the world. We show that for the economy to remain isolated from the shock, the exchange rate must depreciate not only to offset the collapse in external demand, but also to decouple domestic prices from deflation in the rest of the world. If monetary policy becomes constrained by the zero lower bound, the scope of exchange rate depreciation is limited. Still, in this case there is a ``benign coincidence'': fiscal policy is particularly effective in stabilizing economic activity. Under fixed exchange
rates, instead, the impact of the external shock is particularly severe and the effectiveness
of fiscal policy reduced.