On the outcome of inconsistent programs under exchange rate and monetary rules: Allowing the market to compensate for government mistakes |
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Institution: | 1. RAND Corporation, 1776 Main Street, P.O. Box 2138, Santa Monica, CA 90407, USA;2. Department of Political Science, Texas Tech University, 2500 Broadway, Lubbock, TX 79409, USA;3. Free Market Institute, Texas Tech University, 2500 Broadway, Lubbock, TX 79409, USA |
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Abstract: | This paper studies the case of ‘inconsistent’ programs of monetary policy — that is, programs incompatible in the long run with a given budget deficit, so that at some point in the future there is an eventual crisis and demise of the program, all of which is from the outset anticipated by the public. The context is one of a small open economy, with perfect foresight, in which two sets of possibilities are analyzed: (i) a ‘monetary’ or an ‘exchange rule’ for the conduct of monetary policy and (ii) presence or absence of capital mobility. It is found that while the choice of the rule is ‘unimportant’, restrictions on capital mobility determine a very different response, for the case of either rule, concerning side effects of the program on non-monetary variables and on the post-crisis level of country indebtedness. |
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