Has Australia's floating exchange rate regime been optimal

Abstract

This paper develops a straightforward theoretical framework for evaluating exchange rate regime choice for small economies. It proposes that a floating exchange rate minimises national income and employment variation when real macroeconomic shocks predominate, whereas a pegged exchange rate achieves this goal should monetary shocks predominate. It then shows econometrically that, in the case of Australia, a floating exchange rate best suited the economy for the period 1985 to 2010, because real shocks were more significant than monetary shocks. Moreover, consistent with the theory, further results showing that a stronger (weaker) exchange rate correlated with positive (negative) deviations from trend GDP affirm that a floating exchange rate regime was optimal for Australia over this time.

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Highlights

► Proposes an international macroeconomic model for assessing exchange rate choice. ► Reveals floating rates minimise income variation when real shocks predominate. ► Shows fixed rates minimise income variation when monetary shocks predominate. ► On empirical grounds, a floating rate was optimal for Australia from 1985 to 2010.

JEL classification

• F31; 
• F33; 
• F41

Keywords

• Real shocks; 
• Monetary shocks; 
• National income; 
• Exchange rate regime; 
• Australia
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