Monetary Policy Interactions under Managed Exchange Rates

This paper studies a two-country monetary system where one country sets its money stock, but gives up control of the exchange rate, and the other country gives up control of its own money stock, but can set the exchange rate independently. Cournot-Nash equilibria under managed rates differ significantly from those under fixed or floating rates. The country that controls the exchange rate can effectively offset inflationary shocks by changing the exchange rate, at the expense of the foreign country, and, as a result, can be better off than the foreign country. This result provides an example of a successful disinflation through an exchange rate appreciation in a two-country world, and it indicates that managed exchange rate regimes tend to be unstable, since both countries find it desirable to affect the exchange rate. Managed exchange rates, however, are a stable outcome when the center country is so much larger than its partner that changes in the real exchange rate do not affect its output and real income. Copyright 1989 by The London School of Economics and Political Science.