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Vol. 72, No. 5
Posted 1990-09-01

The Pitfalls of Exchange Rate Targeting: A Case Study from the United Kingdom

by Michael T. Belongia and K. Alec Chrystal

Michael T. Belongia and K. Alec Chrystal discuss the arguments, pro and con, surrounding the use of the exchange rate as a target objective for monetary policy. Many of the world’s central banks considered this strategy in the 1980s, primarily because of breakdowns in the historical relationships between monetary aggregates and economic activity and because of perceived misalignments in exchange rates and trade balances. Using a well-defined episode of monetary policy in the United Kingdom as a case study, Belongia and Chrystal argue that exchange rate targeting can have severe adverse consequences if a central bank uses monetary policy to offset a real exchange rate change. Specifically, resisting a real exchange rate change while trying to maintain a nominal exchange rate target can exacerbate recession or inflation. Examining the United Kingdom in the late 1980s, they argue that the rapid acceleration of its inflation rate is linked directly to the Bank of England's attempt to keep the exchange rate at a level of three DM per pound rather than let it appreciate to a higher value.

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