The case for flexible exchange rates after the Great Recession

Abstract

The Great Recession has revived interest in the question of the optimal exchange rate regime. This debate is of immense practical importance: we argue that the exchange rate regime may be a key element in explaining the different experiences of the Scandinavian countries in the Great Recession and their recovery experience thereafter. The recent literature has shown that, according to standard monetary models, fixed exchange rates can provide reasonable insulation against severe demand shocks of domestic origin. We show that, according to the same model, shocks that originate abroad, as arguably was the case for the Scandinavian countries in the Great Recession, or shocks to domestic sovereign risk seem to be best served by a regime of flexible exchange rates. We conclude that the classic case for flexible exchange rates appears to be alive and well.