The Cost of Disinflation in a Floating Exchange Rate Regime

Abstract

It is widely accepted that sticky prices can allow monetary policy to have a systematic effect on output and can explain persistent departures of output from its natural level, rational expectations notwithstanding. This position applies with equal force to open economies with flexible exchange rates, perfectly mobile capital internationally and forward-looking agents. The experience with floating exchange rates has dashed any early hopes that monetary policy, freed from the objective of pegging the exchange rate, can be used effectively for internal stabilisation purposes. Dornbusch (1976) and more recently Buiter and Miller (1981), (1982), (1983) have explained the stylised facts of sharp and persistent departures of competitiveness from fundamentals and the associated sharp and persistent departures of output from ‘natural’ levels. For instance, a policy of reducing the level of money supply or its trend rate of growth applied to an economy where expectations are rational, exchange rates are perfectly flexible, assets are perfectly mobile internationally and substitutable and prices are sticky is shown to be associated with a sharp and persistent loss in competitiveness. In turn, and to the extent that output is demand-determined, the sharp and persistent loss in competitiveness is shown to be associated with and is thought to contribute to a sharp loss in output which persists as long as competitiveness deviates from fundamentals. Although such deviations in output are seen to be transitory there is little comfort from this when the cumulative loss in output is substantial. The next section of this chapter focuses on the basic Buiter—Miller model which addresses the issue of the cost of disinflation in a floating exchange rate regime.