Monetary Policy under Exchange- Rate Flexibility and Discussion

The continuing depreciation of the dollar stands out as one of the big policy issues, it has started to impinge on U.S. monetary policy; it influences the chances for international commercial diplomacy, and it is enhancing the move toward European monetary integration. Above all it leaves most observers with a puzzle as to the causes of the ongoing depreciation. This paper will, of course, not resolve the puzzle. It rather attempts to lay out the basic analytical framework that has been developed for the analysis of exchange-rate questions and to relate it to the question of monetary policy. Part I concentrates on the development of the relevant theoretical framework. The main points to be made here are: (i) exchange rates are primarily determined in asset markets with expectations playing a dominant role; (ii) the sharpest formulation of exchange-rate theory is the "monetary approach," Chicago’s quantity theory of the open economy; (iii) purchasing pgwer parity is a precarious reed on which to hang short-term exchange-rate theory; (iv) the current account has just made it back as a determinant of exchange rates. In Part II we review the main strands of empirical research on exchangerate determination. The review concentrates mainly on the monetary approach where work has been quite plentiful, but also looks at some alternative formulations. Part IlI pulls together these elements to form some conjectures about the working of monetary policy under flexible rates and about the dollar depreciation. In particular we draw attention to the trade-off between increased net exports and the inflationary impact induced by a depreciation. The topic covered in this paper has received an extraordinary amount of professional attention in the last few years and much fruitful research has been accomplished. The fine surveys by Isard (1978), Kohlhagen (1978) and Schadler (1977) will place our sketchy review in the perspective of the literature and the books by Black (1977) and Willett (1977) help relate our topic to the ongoing policy discussions.