Evaluating Alternative Exchange Rate Regimes: Time Consistency, Inertia and the Identification of Shocks in a New Keynesian Model

An ability to adequately assess the functioning of exchange rate regimes is crucial. Such an assessment will be based on a priori beliefs about how different regimes react to shocks and therefore which regime will be appropriate for a given economy. This paper contributes to this literature by examining how a wide variety of potential exchange rate regimes operate in the face of demand and supply shocks. The results show that the choice of exchange rate regime can significantly affect the transmission mechanism, particularly for supply shocks. This therefore has important implications for any methodology which uses VAR decompositions to judge the compatibility of economies to participate in fixed exchange rate regimes. In particular, when preexisting differences in exchange rate regimes are not accounted for, the results may be highly misleading. The constraint that policies are time consistent plays a significant role in determining the welfare costs associated with different regimes, particularly for supply shocks where a free float no longer dominates possible alternatives. Another important aspect is the degree of nominal inertia, which has a strong bearing on the costs associated with each regime. In particular, the reduction in the welfare loss if nominal inertia falls is significantly greater for EMU.