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Monetary policy in the open economy revisited: The case for exchange-rate flexibility restored

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  • Duarte, Margarida
  • Obstfeld, Maurice

Abstract

This paper revisits the sticky-price pricing-to-market model of Devereux and Engel [Devereux, M.B., Engel, C., 2003. Monetary policy in the open economy revisited: price setting and exchange-rate flexibility. Review of Economic Studies 70(4), 765-783], in which fixed exchange rates are optimal even in the face of country-specific nonmonetary shocks. We show that this result hinges critically on the Devereux-Engel model's prediction that international consumption levels are perfectly synchronized under flexible prices. Realistic modifications of the model that produce nonsynchronous consumption movements - such as, the presence of nontraded goods - upset the fixed exchange rate prescription even in the absence of an expenditure-switching role of exchange rate changes.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 27 (2008)
Issue (Month): 6 (October)
Pages: 949-957

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Handle: RePEc:eee:jimfin:v:27:y:2008:i:6:p:949-957

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Web page: http://www.elsevier.com/locate/inca/30443

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  1. Charles Engel, 2002. "Expenditure Switching and Exchange Rate Policy," NBER Working Papers 9016, National Bureau of Economic Research, Inc.
  2. Giancarlo Corsetti & Paolo Pesenti, 2001. "International Dimensions of Optimal Monetary Policy," NBER Working Papers 8230, National Bureau of Economic Research, Inc.
  3. Alan C. Stockman & Linda L. Tesar, 1990. "Tastes and Technology in a Two-Country Model of the Business Cycle: Explaining International Comovements," NBER Working Papers 3566, National Bureau of Economic Research, Inc.
  4. James E. Anderson & Eric van Wincoop, 2004. "Trade Costs," Journal of Economic Literature, American Economic Association, vol. 42(3), pages 691-751, September.
  5. David K. Backus & Gregor W. Smith, 1993. "Consumption and Real Exchange Rates in Dynamic Economies with Non-Traded Goods," Working Papers 1252, Queen's University, Department of Economics.
  6. Maurice Obstfeld and Kenneth Rogoff., 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research (CIDER) Working Papers C99-107, University of California at Berkeley.
  7. Maurice Obstfeld., 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," Center for International and Development Economics Research (CIDER) Working Papers C01-121, University of California at Berkeley.
  8. Michael B. Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibility," Working Papers 042000, Hong Kong Institute for Monetary Research.
  9. Pinelopi Koujianou Goldberg & Michael M. Knetter, 1997. "Goods Prices and Exchange Rates: What Have We Learned?," Journal of Economic Literature, American Economic Association, vol. 35(3), pages 1243-1272, September.
  10. Margarida Duarte, 2004. "Monetary policy and the adjustment to country-specific shocks," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 21-40.
  11. Maurice Obstfeld, 2006. "Pricing-to-Market, the Interest-Rate Rule, and the Exchange Rate," NBER Working Papers 12699, National Bureau of Economic Research, Inc.
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