Financial Policies in Open Economies

Abstract

In analyzing the extent to which alternative financial stabilization policies can be expected to dampen the effects of shocks to macro-economic equilibrium in a single open economy, it has often been assumed that the authorities must choose between fixing the exchange rate and allowing it to fluctuate freely. Which of these two pure intervention policies is better usually depends not only on the source of the shocks to the economy (see Robery Mundell, Jerome Stein, and Edward Tower and Thomas Willet), but also on the specification of monetary policy. The nature of the truly optimal financial policy is a determined by the kind of information available to the authorities about the structure of the ecnomy and about the shocks to which it is subjected. Under plausible assumptions it is not optimal for a single open economy to adopt either pure intervention policy. However, interations in two-country world economy must be considered when choosing financial policies, and an agreement to pursue a pure intervention policy may lead to better outcomes than those implied by noncooperative behavior.