Some problems of exchange-rate policy and stabilization in an open economy
The immediate objectives of exchange-rate policy should be stability of output, stability of the rate of inflation and stability of the exchange rate itself. Moreover, exchange-rate policy is likely to be of some use in achieving these aims, as the modifications to the rational expectations theory which make monetary policy effective do so for exchange-rate policy as well, and additional channels of effectiveness operate in an open economy. There are various explanations for the volatility of exchange rates under free floating, but a more realistic picture of the reaction to external disturbances is obtained if step changes in interest rates are allowed for by considering the term structure of interest rates and the influence of the terms of trade on the demand for money. Capital is not in fact perfectly mobile internationally, which widens the range of policy options, and some modifications of the theory are required to study the determinants of capital flows in an imperfect world. One can use the correlation between deviations of output and inflation from trend to study the origin of disturbances. This is illustrated by a study of eighteen sub-Saharan African countries. Furthermore, the type and origin of disturbances have implications for whether some sort of dual exchange-rate or dual interest-rate system is desirable. Finally, a model of an open economy is presented in which exchange-rate policy can be analyzed whether specified in terms of exchange-rate targets or the degree of intervention, and with the possibility of a restricted forward foreign-exchange market. A variant of the model is estimated for South Africa for the period 1974-1981 and various exchange-rate policies are simulated.