AR TICL ES THE INSULATION ARGUMENT IN NEOCLASSICAL INTERNATIONAL ECONOMICS: a CRITIQUE BOGDAN GLA.VAN A mong the arguments advanced by mainstream economists in favor of independent fiat currencies, the thesis that the exchange rate com- pletely insulates the economy from changes in foreign prices has a central importance. For example, "In a fiat money regime, in theory, monetary authorities could use open market operations, or other policy tools, to avoid the types of shocks that may jar the price level and real activity under a specie standard and hence provide short-run and long-run nominal stability" (Bergman, Bordo, and Jonung (1994, p. 68). 1 In particular, "there is a widespread belief that countries tied to a fixed exchange rate regime are more susceptible to foreign monetary disturbances" and "textbook open economy macroeconomic models suggest that a stan- dardized foreign monetary policy shock will have a smaller impact on coun- tries that maintain flexible exchange rates" (Kouparitsas 1999, pp. 48, 60). In other words, "one of the most telling arguments in favor of floating rates was their ability, in the theory, to bring about exchange-rate changes that insulate economies from foreign inflation" (Krugman and Obstfeld 1991, p. 539). 2 The occurrence of changes or shocks emanating from foreign markets is not a sufficient condition, however, for monetary nationalism. Another con- dition for the independent fiat currencies to be desirable in mainstream liter- ature, are the "asymmetrical" effects these shocks can have on different economies. That is because only an asymmetric shock requires asymmetric responses, that is, different exchange rate policies) BOGDAN GL,~\/ANis a lecturer of economics at the Romanian-American University in Bucharest. The author wishes to thank Guido Htilsmann, Walter Block, Diana Costea, and Nikolay Gertchev for comments. All remaining errors are my own. 1This view is supported by Obstfeld and Rogoff (2002, pp. 631-34). 2Meyer (1997, p. 8) is also clear on this issue: "floating exchange rates tend to insu- late a country from monetary shocks abroad." See also Lahiri, Singh, and Vegh (2003). 3For instance, Corsetti and Pesenti (2001, p. 2) state: Fixed exchange rates can be supported by optimal monetary policies only when all shocks are correlated worldwide or when local prices are THE QUARTERLYJOURNAL OF AUSTRIAN ECONOMICS VOL. 8, NO. 3 (FALL 2005): 3-19