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December 1986

International Interdependence and the Constraints on Macroeconomic Policies

by Jacob A. Frenkel

Focusing primarily on monetary policy, the author shows that the combination of a more open economy and a flexible exchange rate regime quickens the effects of monetary changes on prices and wages. Moreover, he argues that using a policy guide such as purchasing power parity serves to keep domestic price and exchange rate behavior in perspective. That is, domestic policies to influence the domestic price level will also effect the exchange rate. Thus, the author suggests that the monetary authority’s main consideration should be the achievement of price stability and that by reducing the variability of monetary expansion, the monetary authority can positively contribute to reducing costly exchange rate fluctuations. With regard to policy in the current environment, the author argues that “it makes no sense to agree just on real exchange rate targets without accompanying such an arrangement with a similar agreement about other targets for macroeconomic policies including, of course, fiscal policies.