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The Stabilizing vs. Destabilizing Role of the Exchange Rate
Explain why a flexible exchange rate is often considered a stabilizing mechanism in an economy with a credible inflation target, but can become a source of instability in an economy without one. In your answer, describe the key channel through which this difference operates.
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A small, open economy with a flexible exchange rate faces a severe negative shock to global demand for its primary export. How does the role of the exchange rate in adjusting to this shock differ if the central bank has a credible inflation target versus if it has no explicit policy anchor?
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In any small open economy with a flexible exchange rate, a significant currency depreciation will invariably function as an automatic stabilizer by stimulating net exports and supporting aggregate demand.
The Stabilizing vs. Destabilizing Role of the Exchange Rate