Stability, Random Disturbances and the Exchange Rate Regime

Economists have long debated the relative merits of fixed versus flexible exchange rate systems. One of the major issues in this debate concerns the ability of the exchange rate system to isolate a nation from external disturbances: see for example, papers by Mundell (1960), Stern (1963), Tower and Courtney (1974), and Enders (1977), Fischer, (1977) added another dimension to the controversy by examining the relative stability of real consumption and prices, assuming that the economy is subject to stochastic disturbances. His principle conclusion for the small open economy is that if disturbances are. external, then a flexible exchange rate regime is better in that foreign disturbances have no impact on the domestic economy. Under a fixed exchange rate system, these disturbances lead to variances in both the domestic price level and real consumption. However, if the disturbances are internal — due to either disturbances in real output or real demand — a fixed exchange rate leads to a constant pric