||WORRELL, DELISLE; (2013)
In their 2010 IMF policy paper, Blanchard, Dell’Ariccia and Mauro1 observed that central banks of smaller economies were well advised to manage their exchange rates, as well as to contain inflation. They admitted that many countries did in fact pursue both inflation and exchange rate objectives. The present paper takes this argument one step further, demonstrating that the management of aggregate demand, using fiscal policy, is an effective means of achieving an exchange rate target, whether that target is an unchanged exchange rate anchor to a single currency or a basket of currencies, or a stable rate with low volatility. The key insight is that the foreign exchange markets of small economies are very insensitive to relative price changes, and that a balance of inflows and outflows can be achieved only by adjustment of quantities. Both the exchange rate anchor and the inflation target are attained through the management of aggregate demand: fiscal policy anchors the exchange rate through its effects on the demand for imports, and by avoiding money creation the central bank eliminates domestic inflationary pressure, which is the best it can do.
Exchange Rate Targetting through Aggregate Demand Management.pdf