Exchange rate puzzles and policies

Abstract

What is the optimal exchange rate policy? Should exchange rates be optimally pegged, managed, or allowed to freely float? What defines a freely floating exchange rate? Do open economies face a trilemma constraint in choosing between inflation and exchange rate stabilization, unlike divine coincidence in a closed economy? These are generally difficult questions, as the exchange rate is neither a policy instrument, nor a direct objective of the policy, but rather an endogenous general-equilibrium variable tied by equilibrium relationships in both goods and financial markets. At the same time, equilibrium exchange rate behavior features a variety of puzzles from the point of view of conventional business-cycle models typically used for policy analysis in open economy.