Exchange Rates, Nominal Inertia and Inflation

This paper examines the use of the nominal exchange rate in achieving disinflation under managed exchange rate regimes. Most previous empirical studies have not explicitly identified expectations in the wage and price setting behaviour of their econometric models, despite the importance of expectations both during a disinflation and in correcting misalignments. This has meant that costs due to nominal inertia and non‐neutralities have not been addressed separately from questions of credibility. We present results for the UK economy using both a theoretical and empirical model in which firms and workers form rational expectations, but where there is also nominal inertia. We identify costs in using the exchange rate to change the inflation rate, and also the costs involved in correcting any disequilibria in the real exchange rate.