Foreign Exchange Rates
Exchange rate movements are an important channel through which monetary
policy affects the economy, and exchange rates tend to respond promptly to a
change in the federal funds rate. Moreover, information on exchange rates, like
information on interest rates, is available continuously throughout the day.
Interpreting the meaning of movements in exchange rates, however, can
be difficult. A decline in the foreign exchange value of the dollar, for
example, could indicate that monetary policy has become, or is expected to
become, more accommodative, resulting in inflation risks. But exchange rates
respond to other influences as well, notably developments abroad; so a weaker
dollar on foreign exchange markets could instead reflect higher interest rates
abroad, which make other currencies more attractive and have fewer implications
for the stance of
Some have advocated taking the exchange rate guide a step further and
using monetary policy to stabilize the dollar’s value in terms of a particular
currency or in terms of a basket of currencies. However, there is a great deal
of uncertainty about which level of the exchange rate is most consistent with
the basic goals of monetary policy, and selecting the wrong rate could lead to a
protracted period of deflation and economic slack or to an overheated economy.
Also, attempting to stabilize the exchange rate in the face of a disturbance
from abroad would short-circuit the cushioning effect that the associated
movement in the exchange rate would have on the