March 2020 issue contents
The Continuing Validity of Monetary Policy Autonomy under Floating Exchange Rates

Edward Nelson
Federal Reserve Board


Economic research in recent years has highlighted the issue of whether a floating exchange rate provides autonomy with regard to monetary policy to a central bank in an economy that is highly open. In particular, Rey (2016) has argued that inflation-targeting advanced economies lack monetary policy autonomy by pointing to results suggesting that U.S. monetary policy shocks matter for the behavior of key financial variables in these economies. In contrast, it is argued in this paper that monetary autonomy does prevail in inflation-targeting advanced economies, notwithstanding the reaction of these economies' asset prices to U.S. monetary policy developments. The monetary-autonomy argument-which was advanced by Milton Friedman and rests on the existence of features that are present in new open-economy models-refers to the fact that the monetary authority under a floating rate is able to have a decisive influence on nominal variables in the long run, as well as a short-run influence on real variables. The result that rest-of-world monetary policy is among the other factors affecting the short-run behavior of real variables (including real asset prices) in a small, floating-rate open economy is in keeping with the traditional and appropriate concept of  monetary policy autonomy under floating exchange rates. It follows that such influences of rest-of-world monetary policy on the home economy are consistent with the celebrated open-economy trilemma.

JEL Code: E51, E52, F41.

Full article (PDF, 43 pages, 312 kb)