M. June Flanders

The role of elasticity optimism in choosing an optimal currency basket with applications to Israel

Abstract In a world in which exchange rates are floating each country must have some device for measuring the average exchange rate change, whatever exchange rate policy it chooses. The weight for each currency in computing such an average depends on the objective which exchange rate stabilization, or change, is expected to achieve. If balance of trade stability is the desideratum, the optimum weights (optimum currency basket) are shown to be a function of demand elasticities, GNP, trade shares, etc. We derive a loss function measuring the cost of using a ‘wrong’ basket, and compute the value of this function for our ‘optimal’ Israeli basket as a case study.

The Open Economy Macromodel: Interactions between Theoretical Developments and Real-World Behavior

The development of the open-economy macro-model over the past half century can be viewed as a running, and still uncompleted, saga of the interaction between advances in economic theory and developments in the practitioners’ world where economic policies are formulated and international economic transactions take place. As Maurice Obstfeld, one of the major contributors to, as well as the leading synthesizer of these developments in macro-theory, notes: “Frequently, prominent international policy problems, even crises, provide the inspiration for new [theoretical] explanations ” (Obstfeld 2000b, 1).

SOME PROBLEMS OF STABILIZATION POLICY UNDER FLOATING EXCHANGE RATES

Publisher Summary This chapter discusses some problems of stabilization policy under floating exchange rates. The prime advantage of flexibility in exchange rates is that it recognizes the desire, if not the desirability, of countries to pursue independent policies and to insulate themselves from one another. Any change in a single economy, including a change in the growth rate, which depends on there being a change in the rate of interest, and, hence, may depend on the rate of interest in that economy being different from that in the rest of the world, becomes difficult. Some of the problems encountered in recent years on the international monetary front have arisen from the rigidity of exchange rates; others from the high degree of international capital mobility; and others still from the inherent difficulty of managing an effective macroeconomic stabilization policy. Not all of these difficulties can be eliminated by a movement to highly or completely flexible exchange rates. Floating exchange rates would clear the foreign exchange markets; they would minimize the structural upheavals brought on by monetary disturbances; and they would, or might, prevent stubborn finance ministers from going to great and painful lengths to defend inappropriate exchange rates.