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Why floating exchange rates fall: A reconsideration of the liquidity trap

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  • Ronald McKinnon

Abstract

In the international capital market, interest rates would seem to be natural shock absorbers for balancing currency risk associated with expected inflation or differential taxation. Under a floating exchange rate, however, short-term interest rates in each national money market behave as if caught in a liquidity trap. The problem arises because the domains for national monetary circulation remain somewhat disjoint even though the bond market is fully integrated internationally. The national rate of interest is ncapable of equilibriating the domestic money market on the one hand and the international bond market on the other. The result is excessively high exchange-rate volatility that distorts the flow of international commodity trade and causes cycles of inflation and deflation in open economies. Copyright Kluwer Academic Publishers 1990

Suggested Citation

  • Ronald McKinnon, 1990. "Why floating exchange rates fall: A reconsideration of the liquidity trap," Open Economies Review, Springer, vol. 1(3), pages 229-250, October.
    • Handle: RePEc:kap:openec:v:1:y:1990:i:3:p:229-250
    DOI: 10.1007/BF01886157
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    References listed on IDEAS

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    1. Taylor, John B, 1980. "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy, University of Chicago Press, vol. 88(1), pages 1-23, February.
    2. Frenkel, Jacob A & Mussa, Michael L, 1980. "The Efficiency of Foreign Exchange Markets and Measures of Turbulence," American Economic Review, American Economic Association, vol. 70(2), pages 374-381, May.
    3. repec:bla:ecorec:v:0:y:1986:i:0:p:24-38 is not listed on IDEAS
    4. Ronald I. McKinnon, 1988. "An International Gold Standard without Gold," Cato Journal, Cato Journal, Cato Institute, vol. 8(2), pages 351-392, Fall.
    5. Aliber, Robert Z, 1973. "The Interest Rate Parity Theorem: A Reinterpretation," Journal of Political Economy, University of Chicago Press, vol. 81(6), pages 1451-1459, Nov.-Dec..
    6. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    7. repec:bla:econom:v:55:y:1988:i:220:p:437-60 is not listed on IDEAS
    8. RONALD I. McKINNON, 1990. "Interest Rate Volatility And Exchange Risk: New Rules For A Common Monetary Standard," Contemporary Economic Policy, Western Economic Association International, vol. 8(2), pages 1-17, April.
    9. Ronald McKinnon, 1990. "The exchange rate and the trade balance," Open Economies Review, Springer, vol. 1(1), pages 17-37, February.
    10. McKinnon, Ronald I, 1988. "Monetary and Exchange Rate Policies for International Financial Stability: A Proposal," Journal of Economic Perspectives, American Economic Association, vol. 2(1), pages 83-103, Winter.
    11. Omar F. Hamouda & Robin Rowley & Bernard M. Wolf (ed.), 1989. "The Future of the International Monetary System," Books, Edward Elgar Publishing, number 203.
    12. McKinnon, Ronald I., 1979. "Money in International Exchange: The Convertible Currency System," OUP Catalogue, Oxford University Press, number 9780195024098.
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    Cited by:

    1. de Groof, R.J. & van Tuijl, M.A., 1992. "Commercial integration and fiscal policy in interdependent, financially integrated two-sector economies with real and nominal wage rigidity," Other publications TiSEM 892948a8-83fa-42c0-96bf-b, Tilburg University, School of Economics and Management.
    2. de Groof, R.J. & van Tuijl, M.A., 1993. "The twin-debt problem in an interdependent world," Research Memorandum FEW 588, Tilburg University, School of Economics and Management.
    3. de Groof, R.J. & van Tuijl, M.A., 1991. "Financial integration and fiscal policy in interdependent two-sector economies with real and nominal wage rigidity," Research Memorandum FEW 526, Tilburg University, School of Economics and Management.
    4. de Groof, R.J. & van Tuijl, M.A., 1992. "Commercial integration and fiscal policy in interdependent, financially integrated two-sector economies with real and nominal wage rigidity," Research Memorandum FEW 567, Tilburg University, School of Economics and Management.
    5. de Groof, R.J. & van Tuijl, M.A., 1993. "The twin-debt problem in an interdependent world," Other publications TiSEM 50e0a068-20c7-4bf4-a6e3-8, Tilburg University, School of Economics and Management.

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