Optimal exchange rate regimes: Turning Mundell-Fleming's dictum on its head

Amartya Lahiri, Rajesh Singh, Carlos A. Vegh

NBER Working Paper No. 12684
Issued in November 2006
NBER Program(s):International Finance and Macroeconomics

A famous dictum in open economy macroeconomics -- which obtains in the Mundell-Fleming world of sticky prices and perfect capital mobility -- holds that the choice of the optimal exchange rate regime should depend on the type of shock hitting the economy. If shocks are predominantly real, a flexible exchange rate is optimal, whereas if shocks are mainly monetary, a fixed exchange rate is optimal. There is no obvious reason, however, why this paradigm should be the most appropriate one to think about this important issue. Arguably, asset market frictions may be as pervasive as goods market frictions (particularly in developing countries). In this light, we show that in a model with flexible prices and asset market frictions, the Mundell-Fleming dictum is turned on its head: flexible rates are optimal in the presence of monetary shocks, whereas fixed rates are optimal in response to real shocks. We thus conclude that the choice of an optimal exchange rate regime should depend not only on the type of shock (real versus monetary) but also on the type of friction (goods versus asset market).

download in pdf format
   (179 K)

email paper

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w12684

Published: Amartya Lahiri & Rajesh Singh & Carlos A. Vegh, 2007. "Optimal Exchange Rate Regimes: Turning Mundell-Fleming's Dictum on its Head," Panoeconomicus, Faculty of economics, Department of Economics, vol. 54(3), pages 249-270, September. citation courtesy of

Users who downloaded this paper also downloaded* these:
Lahiri, Singh, and Vegh w13154 Segmented Asset Markets and Optimal Exchange Rate Regimes
Obstfeld w8369 International Macroeconomics: Beyond the Mundell-Fleming Model
Frenkel and Razin w2321 The Mundell-Flemming Model: A Quarter Century Later
Rebelo and Vegh w12793 When Is It Optimal to Abandon a Fixed Exchange Rate?
Mendoza and Uribe w7045 The Business Cycles of Balance-of-Payment Crises: A Revision of Mundellan Framework
NBER Videos

National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email:

Contact Us